The Economics of Price Controls (feat. Price Ceiling on Gasoline)

Cars lining up to fill their gas tank during the 1970s gas shortage in the US

Recently, I have heard that there is a short-term price cap (in economic term: “Price Ceiling”) on gasoline in Cambodia. Now, since this only lasts until, I believe, 21st of June, it should not be much of a concern.

Why should it be a concern otherwise? Because a long-term practice of limiting maximum price is bad, very bad. At least, that’s what both economics and history tell us. To illustrate, I will pass on to you one of my favorite examples.

In the 1970s, the US was struck by a severe shortage of gasoline. The amount of gasoline available, however, did not vary that much from the previous year. Neither did the number of vehicles. So, what caused the shortage despite not having actual physical insufficiency? This is clearly a question that demands an economic answer.

Remember that people are driven by their own self-interest (see NOTE at the bottom). Yes, that is not always true, but it still applies to a majority (it is true on average). With the economic miscalculation by the government, a false incentive can emerge as an unintended consequence. The US government back then set a price ceiling (i.e. set an upper bound so that the price could not exceed a certain threshold). That is to say, regardless of the increase in demand, price cannot rise above the upper limit imposed by the government.

With low and constant gas price despite being in high demand, people could consume much more gasoline without having to be thrifty. The consumption got higher and higher, and since price could not rise to reflect the rising demand, there was no market signal given to the public, no incentive to cut back on the gasoline consumption. Eventually, in many gas stations around the country, they ended up with long lines of vehicles waiting to fill up their tanks, and as getting gasoline gradually became a tedious time-consuming task, another problem occurred which was “Hoarding“.

People started to fill up their tanks to the fullest every single time they could. They feared the idea of having to drive around all day trying to find a gas station with available gasoline or waiting in a long queue of cars with no guarantee of having their tanks filled. The gas stations could not amass enough supply for the whole day (and had no incentive to do so since they could not charge more for their effort), so they only operated for a few hours and they closed way too early. That worsened the shortage, and people hoarded more. With more and more gasoline in individual gas tanks instead of the general inventories of the gas stations, it was impossible to reallocate the excess amount to the other locations with greater economic, social, and scientific activities (where most goods, services, innovations, and knowledge materials are produced). Growth stagnated as a consequence. This is how much economic and social damages a bad policy can cause you and your country.

In the case of Cambodia, this would probably also lead to worse traffic congestion. It would also contribute to more pollution and rising level of stress. At the same time, it lowers the incentive to save energy and to use alternative sources like renewable energy. For a developing nation like Cambodia, this sort of perverse preference can spell a long-term energy crisis, and therefore, completely defeat the purpose of green development.

Of course, there are a few EXCEPTIONS to consider. First, if price ceiling is flexible (i.e. a function of cost), then the effect can go either way. Regardless, the aforementioned adverse consequences will be less likely to arise.

Another exception is when there is a joint-monopoly controlling the petroleum market in the country (a point well-made by my friend, one-dollar economist, who only happened to say it first… and demand credit). This means that there is a collusion (illegal cooperation) to keep gas price excessively high above the market price. Price ceiling in this case might actually correct the distortion, lower price, increasing trade volume, and as a result, reducing the deadweight loss. However, a necessary condition is that the “price ceiling” imposed by the government be binding on the joint-monopoly’s price, NOT on the market price. So, if the colluded price is $2/litre and the market price is $1, then we want the price ceiling to be somewhere in between. The ideal is exactly at the $1 market price, but that is hard in practice because the market price can only be determined once a competitive market has been established (ex-post). As a good measure, the government can approximate price by looking into the gas price of neighboring countries or countries with similar characteristics as the affected country. Of course, this demands a different analysis on the formulation and implementation of price ceiling by the government. Generally speaking, governments do not have a good track record when it comes to the efficacy of its performance. So, while the knowledge of monopoly naturally leads us to discuss market failure, the inefficiency of the government begs the question of whether the government failure could actually be worse. The point is even when the market fails, the government intervention via price ceiling is not guaranteed to be potent.

NOTE: Self-interest and selfishness are essentially two different personalities/concepts. Selfishness is about a lack of consideration towards the well-being of the others (making oneself at the centre of everything), whereas self-interest is about making oneself happy/satisfied and some people achieve this goal through altruism. In this sense, the economic utility you often heard of is actually a much broader concept (that encompasses a wide range of selfless human behaviors). In the study of life-cycle behavior, for instance, leaving bequest to one’s children increases one’s economic utility.

That’s all for now. Hope you have learnt something useful from this post!

Economind

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