The fallacy of fixing prices

Our policymaking over the last few decades, if not more, has largely been devoid of any rational economic thought.  Economic problems are solved not by thinking them through, but through band-aids, and knee-jerk reactions.  Fixing the price of any commodity, or service is one such tool that has been abused to no end and has consistently led to unfavorable economic outcomes for the country, and the population at large.  Whether it be fixing the price of an agricultural commodity, an energy source, medicine, or a mundane service – there has never been a case where a price floor or a price ceiling has led to better economic outcomes for the consumer.  It mostly leads to the creation of an ecosystem where a chosen few benefit from the inefficiencies in the system, while welfare loss is borne by the consumer.

In a price floor, the government sets a minimum price below which any commodity cannot be sold, eventually making the government the buyer at that specific price to ensure the price doesn’t decrease further.  Due to such a price floor, the consumer cannot benefit from lower prices and has to buy more expensive products relative to what they can buy if there wasn’t a price floor.  A relevant example here is the support price that is given for wheat in the country.  Devoid of any economic rationale, support price for wheat is rooted in the desire to ensure food security.  However, food security cannot be attained through a price floor only.  It needs massive investment in the supply chain, and storage infrastructure, such that any surplus can be stored so that it can be utilized in subsequent years when stocks are running low. 

To ensure food security, the local price of wheat was higher than international prices for a large part of the last decade, with even the poorest segments of society paying a high price for wheat.  The government, to ensure the presence of a price floor, became the largest buyer of wheat, borrowing heavily from financial institutions to make such purchases, only for the same to be either wiped away or smuggled.  As international prices increased, it only took a few months before there was a shortage of wheat locally as suddenly stocks started disappearing, or were smuggled away to banks on the arbitrage available between local and international prices.  Similarly, as recent floods have demonstrated, millions of tons of wheat stocks have been lost as they were not stored in adequate facilities, and were simply lying out in the open, exposed to nature’s elements.  

The objective of ensuring food security was noble nonetheless, but the tool used to ensure that same was not appropriate, resulting in a transfer of wealth from the most vulnerable households, and the government to a few specific segments.  In effect, a price floor takes away the incentive to invest in improving yield, productivity, or supply chain infrastructure resulting in long-term productivity losses, as the benevolent government keeps funding such purchases with more debt. 

Due to such distortion in the market when prices increase, the government institutes price monitoring committees, as the district commissioners get opportunities for photo-ops, not realizing that price increases are more of a supply chain problem that can be fixed with supply chain infrastructure and sound economic policy rather than photo-ops.  The cycle continues till another commodity becomes the flavor of the week, and photo-ops are repeated. 

Another example is price ceilings, where a government fixes the price of the product, above which it cannot be sold.  In such a scenario, a shortage of that product is imminent resulting in more welfare losses for the consumer, while the government can proudly pretend that a price ceiling is actually working while the available quantity dries out at the fixed price.  A recent example of the same is how the government fixes the price of medicine.  Considering the largely inelastic nature of medicine, a strong regulatory regime is certainly essential, however, it is also important that the same regime is nimble, and works for consumer welfare through encouraging investment in infrastructure, and backward linkages.  Attacking the lowest hanging fruit of price creates more problems than it solves. 

As the PKR has depreciated significantly against many global currencies during the last six months, the active pharmaceutical ingredient of many medicines which is imported has also increased in price, resulting in a higher cost of production.  However, as the retail price is fixed, beyond a certain threshold it doesn’t make economic, or financial sense to produce much medicine, resulting in potential shortages.  There exists a moral argument that medicine should continue to be sold even at losses during times of crisis – that is certainly true, however, the same is not sustainable.  This is where heavy investment in supply chain infrastructure and technology is essential to localize critical raw materials to reduce dependence on the import of key medicine.  However, due to an archaic and anti-competitive regulatory regime, there has been massive divestment from the pharmaceutical segment in the country.  As hypothesized earlier, price ceilings cause more problems than they solve. 

Fixing prices is an easy win for the short term, and for photo-ops.  Fixing the supply chain which results in better prices, and better welfare outcomes for consumers and producers alike is a complex policy-oriented process.  Any government serious about fixing issues needs to stop relying on fixing prices to fix problems.  The problem isn’t prices, the problem is fixed prices.

Ammar H. Khan
Ammar H. Khan
The writer is a non-resident Senior Fellow at the Atlantic Council. He has previously worked at several financial institutions in Pakistan, both in commercial banking and capital markets.


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