Economic Theory

It’s politicians, not prices, that need to be controlled

Perhaps there is one thing worse than somebody who knows the price of everything and the value of nothing – it is a politician who believes that they know what the price of everything should be. During this election campaign we have seen new price controls proposed for energy, rents, wages, higher education and rail fares – and this is just the mainstream parties. Indeed, politicians have been competing with each other as if proposing price controls is some kind of virility symbol. The IEA’s latest publication Flaws and Ceilings, edited by Christopher Coyne and Rachel Coyne, shows the damage done by price controls.

Price controls are regarded by economists as one of the worst forms of intervention in markets. They arbitrarily prevent many welfare-enhancing transactions from taking place when other forms of intervention, such as subsidies, would have less pernicious effects. This is particularly clear in the labour market. It has now become common to argue that, if the government provides somebody whose productivity is low with welfare benefits, the government is subsidising their employer. For example, a recent Daily Mail headline read: “Supermarkets under fire as £11bn of benefits ‘subsidise’ low wages”. However, if an employee’s productivity is such that an employer is unwilling to pay a wage sufficient to keep somebody off means-tested benefits, it cannot be assumed that the individual will get a job at a higher wage that the government mandates. In a thorough review of the evidence, Stan Siebert in Flaws and Ceilings concludes: “It is indeed probable that the UK’s dismal youth labour market performance since 1999 is partly attributable to the imposition of the minimum wage interacting with high tax rates. This is also the case with the poorly functioning youth labour markets of Portugal and Greece, and others such as France and South Africa.”[1]

No amount of government legislation on wage rates will suddenly make less productive people more productive and employable. It will, however, make it more likely that they are replaced by self-scanning checkouts.

The regulation of prices can also prevent market participants from finding new ways to solve the very problems that price controls purport to solve. For example, if controls on the price of energy reduce investment in exploration or new sources of energy, in the medium term those controls may lead to higher energy costs. Similarly, limits on fees in higher education – especially if they are combined with regulation of the sector – may lead to reduced innovation so that low-cost alternatives to current models of provision do not develop.

It is remarkable how widespread price controls are. They are alive and well in several major industries which cover a huge percentage of national output. University fees are limited to £9,000 per annum; railway fares are capped; short-term consumer finance and also pension products are to be subject to a charge cap; there are proposals at different stages in different parts of the UK for the minimum pricing of alcohol; and the UK also has a national minimum wage. Furthermore, there are proposals for controls in the alcoholic drinks markets, on rented properties and on energy prices.

As well as creating unemployment, reducing innovation, reducing product quality and creating shortages of supply, price controls can suppress competition. Indeed, government bodies have expressed fears that controls on prices in both the pensions and consumer finance sector will reduce competition. In pensions, it has further been suggested that a price ceiling will become a floor as the smaller number of firms left in the market all price at the controlled level. Thus price control could lead to higher prices. In energy markets, companies can respond to the threat of future price freezes by buying energy in forward markets so that, if energy prices subsequently fall, companies will not be able to pass on the benefits to consumers. Price controls in some sectors (such as water in the US) also lead to catastrophic environmental consequences.

Given that there can be so many problems arising from legislated price floors and ceilings, why are they ubiquitous?

The answer may well lie in the ‘economics of politics’ or ‘public choice’. Organised interest groups often gain from price control. Interest groups might include incumbent firms that wish to see markets oligopolised because entry into markets becomes more difficult if prices are controlled. Certainly, once a control exists, it becomes difficult to remove because the losers from its removal can easily identify their losses whilst the gainers would be dispersed and may not realise that they could benefit from the removal of the control. Also, politicians often like to gain applause from interest groups who are, rationally, not well informed about economic issues and do not understand the second- and third-round effects of price regulation. Indeed, one of the most worrying aspects of price controls is that prices become politicised. We have seen with the minimum wage how parties compete with each other to propose higher minimum wages, regardless of the cost to the unemployed.

We saw both these processes at work when charge caps on pension charges were proposed. Steve Webb, not long after rejecting the idea of pension charge caps as analogous to price controls on baked beans, proposed a 0.75 per cent cap on pension charges. What happened next was instructive. Very shortly after Webb’s announcement, the Labour Party responded by promising that an initial 0.75 per cent cap would be reduced to 0.5 per cent in the course of a parliament[2] (round numbers are chosen in order to drive headlines). Webb then responded by suggesting that other charges would be brought within the 0.75 per cent cap. The process culminated in him saying: “We are going to put charges in a vice – and we will tighten the pressure year after year.”[3]

When the 0.75 per cent charge cap proposal was announced, Legal and General, one of the biggest incumbent insurers in the market argued that the cap was too high and should be reduced to 0.5 per cent.[4] Phil Loney, Chief Executive of a much smaller and mutual company, Royal London, noted that, after the announcement of the 0.75 per cent charge cap proposal, there was no fall in the share price of larger insurance companies and that the proposed ceiling would become a norm (in effect, both a floor and a ceiling) when the process of competition could have led to lower charges in the long term in the absence of a cap.[5] Indeed, it is very clear that competition is reducing charges.

When politicians believe they should control prices, the result is price determination by populism. The consequence is a widespread misallocation of resources and huge welfare costs.

Academic and Research Director, IEA

Philip Booth is Senior Academic Fellow at the Institute of Economic Affairs. He is also Director of the Vinson Centre and Professor of Economics at the University of Buckingham and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham. He also holds the position of (interim) Director of Catholic Mission at St. Mary’s having previously been Director of Research and Public Engagement and Dean of the Faculty of Education, Humanities and Social Sciences. From 2002-2016, Philip was Academic and Research Director (previously, Editorial and Programme Director) at the IEA. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. He is a Senior Research Fellow in the Centre for Federal Studies at the University of Kent and Adjunct Professor in the School of Law, University of Notre Dame, Australia. Previously, Philip Booth worked for the Bank of England as an adviser on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.

2 thoughts on “It’s politicians, not prices, that need to be controlled”

  1. Posted 21/04/2015 at 16:52 | Permalink

    It is worth noting, too, that prices control do not show up in some attempts to quantify the extent of government interference, such as total government spending or total taxes as a proportion of national income. Thus it is easy for the casual observer to underestimate the extent of government interference in the economy.

  2. Posted 18/06/2015 at 15:10 | Permalink

    Also, prices tend to be so much higher than they would have been had it not been for all the costs the state imposes on businesses in the form of regulatory compliance cost, business rates/property taxes, licensing cost, etc.

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