The government of the United Kingdom will cap energy prices paid by households, which have jumped following the reduction of supplies from Russia. Apparently, one goal, if not the goal (since households could have been simply subsidized to dampen the shock), is to reduce the rate of inflation (see “U.K. Government to Cap Household Energy Prices for Two Years,” Wall Street Journal, September 8, 2022):
The move is aimed at preventing inflation from rising even faster in a country that already has the highest rate among Western nations at 10.1%.
If inflation can be reduced by price caps on a few goods, capping all prices would eliminate inflation. Why didn’t we think of that before?
The error is that capping one (relative) price—for example, the price of natural gas—will do nothing to reduce inflation, which is an increase in all prices irrespective of the movement of prices relative to each other. Perhaps the confusion comes from the fact that the measure of inflation (the Consumer Price Index or other similar indexes) must, of necessity, rely on the observation of actual prices, which incorporate both inflation and changes in relative prices. A change in a price is equal to its change relative to other prices plus inflation, the latter being, to repeat, a change in the general price level (see my post “The Elementary Basics of Inflation”).
Another way to clear the confusion is the following. Suppose there were no inflation. The elimination by the Russian government of 40% of the gas supply in Europe would result in roughly the same increase in gas prices as we now see. The current rate of inflation, about 10%, is tiny compared by the recent increase in the European gas price of as much as 1000%. Without a cap, the jump in the price of gas would be compensated by a reduction of other prices as people would want to buy fewer other goods and services in order not to reduce too much their consumption of gas or gas-produced goods. (Technically, this approach is informed by the monetarist theory of inflation and by general-equilibrium theories where changes in relative prices come from a move along the production possibility frontier.)
My argument is not only that price caps will merely hide inflation, which is pretty obvious. It is that price caps interfere with the change in relative prices, which is essential to the transmission of price signals regarding relative scarcities in the economy and, thus, essential to economic efficiency. Capping a price (say, gas) whose increase would have signaled an increased scarcity of the related good will have two efects: it will modify the statistical estimate of inflation, but without changing the underlying inflation at all; and it will mess with the price of gas relative to other goods. Gas will remain no less scarce, as shortages or the need of government subsidies to producers will show. But the cap will blur the correct signaling of the new scarcity, encouraging more consumption and, without subsidies, less production of the scarcer good—that is, it will prevent an efficient adaptation to the new situation.
This is why “we,” meaning Western governments and most economists, do not generally think of reducing inflation by capping prices, let alone by capping only a few prices. Ignoring this will have dire economic and political consequences. (Incidentally, a few rulers, like president Richard Nixon in the early 1970s, did think of controlling inflation with economy-wide price controls, and failed: see Hugh Rockoff, Drastic Measures: A History of Wage and Price Controls in the United States [Cambridge University Press, 1984], even if this author does not agree with all my argument.)
READER COMMENTS
Spencer
Sep 12 2022 at 2:03pm
re: “essential to economic efficiency”.
You can “validate” the administered prices or cause a depression in other inelastic products.
Pierre Lemieux
Sep 12 2022 at 2:33pm
Spencer: I don’t understand what you mean. Care to elaborate?
vince
Sep 12 2022 at 6:43pm
“tapping one (relative) price—for example, the price of natural gas—will do nothing to reduce inflation, which is an increase in all prices irrespective of the movement of prices relative to each other. ”
But that’s the answer. They don’t want to reduce inflation. They want to reduce energy costs, and let other goods become more expensive. Maybe those other goods are not as socially regressive. Still, it’s a lame solution.
Pierre Lemieux
Sep 16 2022 at 11:49am
Vince: “Tapping” should of course have been “capping.” I corrected the typo.
Jose Pablo
Sep 13 2022 at 1:23am
All over Europe governments are tampering with the price signal. In gas and electricity markets in particular. In some places electricity markets are not marginal anymore (“because”, or so they say, it is the price of gas the one setting electricity prices and this should not be allowed).
But by tampering with this price signal what you get is:
More electricity consumption. In particular more “gas generated” electricity consumption. Precisely what Europe does not need.
Less generation from other sources. Precisely what Europe does need.
Have we learnt nothing?
Pierre Lemieux
Sep 16 2022 at 11:54am
Jose: You are right: the problem is deep. And it does not affect only Europe. Think of Nixon or state price controls on gasoline in the late 1970s or war price controls or “price gouging” laws. As per your hint, I have another post, on EU planned price controls, this morning.
Monte
Sep 13 2022 at 2:00pm
Excellent summation of the folly of price controls, Sir. Here’s another vis-a-vis Prof. Henderson. And how about this piece by Dr. Veronique De Rugy? Price controls have been discredited and argued against ad nauseam for centuries, but apparently to no avail, as they remain our government’s go-to folk material media for inflation. I believe it was Mises who said of the U.S., a rich country can afford to be foolish much longer than a poor one, or something similar.
Inflation of the kind we’re currently experiencing is a policy choice, not a vagary of market forces, as our politicians would have us believe. And price controls are as ineffective against inflation as spunk water from a rotten stump is against warts.
Quantilla prudentia mundus regatur? Nullus!
Monte
Sep 13 2022 at 2:03pm
That’s “folk materia medica”, not “folk material media”. D@#n spellcheck!
Pierre Lemieux
Sep 16 2022 at 11:47am
Monte:
Nice quote! We don’t have these popes anymore!
Craig
Sep 13 2022 at 3:41pm
Governments often don’t like the price of many things. Usually we see the things people usually complain about of course. Food, medicine, shelter and energy. Personally I complain about the cost of government itself but nobody pays me much heed of course.
Been like this since the Eeict kn Maximum Prices issued by the Roman Emperor Diocletian. WIN, Whip Inflation Now.
Governments will take responsibility for many things, inflation is usually not one of them. The caise must be external to governmeny from their point of view and coupled with the government’s bias to at least appear to be doing ‘something’ — the inevitable result seems to usually be price controls in one form or another.
Pierre Lemieux
Sep 16 2022 at 11:37am
Craig: You write:
Yes, it is a well kept secret that government has a cost. The question is whether or not that is a net cost and, of course, how to compare the costs to some individuals with the benefits to others. And there is a whole capitalist and liberal tradition that government (“the state”) is not actually necessary, from Gustave de Molinari to Robert Nozick and Anthony de Jasay, not to forget David Friedman, Murray Rothbard, Bryan Caplan, Michael Huemer, and many others.
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