CONFIDENTIAL 1

TO BE RETURNED AT THE END OF THE EXERCISE

NATIONAL INSTITUTE OF MANAGEMENT, LAHORE

10TH MID CAREER MANAGEMENT COURSE

(MONDAY, 20TH

SEPTEMBER, 2010 TO FRIDAY, 24TH

DECEMBER, 2010)

TUTORIAL DISCUSSION

(Faculty Guide)

ON

Functioning & Implications of Price Control Bodies at the

Operational & Tactical Level.

Sponsor DS: Mr. Salman Choudhry

CONFIDENTIAL 2

DISCLAIMER:

This document contains training material designed exclusively to promote

discussion by the participants of 10th MCMC at NIM. It is not prediction of the

future‟ nor does it necessarily reflect the views of the institution.

CONFIDENTIAL 3

FUNCTIONING & IMPLICATIONS OF PRICE CONTROL BODIES AT THE

OPERATIONAL & TACTICAL LEVEL

Methodology/Requirement:

Syndicate activity is planned in two phases, discussion and reducing its essence

into written form. First, the Syndicate DS would open the discussion by introducing the

topic. He would then invite the syndicate members to present their considered views

cross cutting all dimensions of the topic. The discussion will follow the sequence of the

stated parameters steered by the DS. This activity will be undertaken for about one and a

quarter hour.

The first five to ten minutes of the remaining forty five minutes will be utilized for

presentation of a nominated sub-syndicate on recapitulation of important points that come

up in the discussion. At the conclusion of the discussion, any one participant, a volunteer

or as nominated by the DS will be assigned to reduce the essence of the entire meeting

into a written form containing five to six pages, also adding his own views and

explanations as deemed appropriate. It is incumbent upon all members to continually jot

down the important points and issues that emerge out of the discussion which would later

facilitate the writing part.

Aim:

1. What is meant by price control?

2. The pitfalls of price control.

3. What is price ceiling?

4. Price control mechanism in Pakistan.

5. Price control policy and inflation.

6. Alternative to price controls.

Discussion Parameters

1. What do we mean by Price Controls?

The determining of market prices through the dynamic interaction of supply and

demand is the basic building block of economics. Consumer preferences for a product

determine how much of it they will buy at any given price. Consumers will purchase

more of a product as its price declines, all else being equal. Firms, in turn, decide how

much they are willing to supply at different prices. In general, if consumers appear

willing to pay higher prices for a product, then more manufacturers will try to produce

the product, will increase their production capacity, and will conduct research to improve

the product. Thus, higher expected prices lead to an increased supply of goods. This

dynamic interaction produces an equilibrium market price; when buyers and sellers

transact freely, the price that results causes the quantity demanded by consumers to

exactly equal the supply produced by sellers. But when government adopts a price

control, it defines the market price of a product and forces all, or a large percentage, of

transactions to take place at that price instead of the equilibrium price set through the

interaction between supply and demand. Since supply and demand shift constantly in

response to tastes and costs, but the government price will change only after a lengthy

CONFIDENTIAL 4

political process, the government price will effectively never be an equilibrium price.

This means that the government price will be either too high or too low.

2. The pitfalls of price controls:

When the price is too high, there is an excessive amount of the product for sale

compared to what people want. This is the situation with many U.S. and European farm

programs; government, in an effort to increase farm incomes, purchases the output that

consumers do not want. This, in turn, prompts farmers to raise more cows and convert

more land to pasture or cropland. However, the higher prices discourage consumers from

buying farm products, causing an excess of supply (e.g. a “butter mountain”).

Government then exacerbates this situation by continuing to purchase the excess crop at

the set price.

Serious problems also result when government sets prices below the equilibrium

level. This causes consumers to want more of the product than producers have available.

When the federal government restricted gasoline price increases in the 1970s, long lines

formed at gas stations and only those motorists who waited long hours in line received

the scarce gasoline.

In both cases of government price controls, serious welfare loss results because

not enough of the good is sold. The wasted chance to create both producer and consumer

surplus from those sales is known as „deadweight loss‟ because it is income that is lost

forever. In addition to creating deadweight loss, an artificially high price transfers profits

from consumers to producers; these rents are often wasted because producers spend them

on lobbying and other influence activities to maintain the regulated price. In the case of a

low price, producers transfer profits to consumers. Consumers, in competing for a limited

amount of the controlled product, may waste as much as they gain from getting it at a low

price. For instance, the people who waited in the 1970s gas lines probably shouldered as

much cost from the lost time queuing as they saved from the price controls on gasoline.

(Researchers Robert Deacon and Job Sonstelie have even argued that the gas lines cost

consumers more than they saved from the controlled gas prices.) Thus, the artificially low

prices not only hurt producers, but also consumers.

3. What are Price Ceilings?

Price ceilings occur when governments set a price above which producers are

unable to sell the good. If the price ceiling is to have any effect then the control should be

placed below the equilibrium market price. A price ceiling is shown in the diagram

below.

CONFIDENTIAL 5

The model suggest that setting the price ceiling at a price below the equilibrium

market price will create excess demand i.e. a shortage equal to Q3 to Q2. The model

above predicts that the artificially low price leads to an expansion along the demand

curve and a contraction along the supply curve.

In reality many maize farmers considered the price too low to continue

commercial production and considered switching to produce other commodities, known

as goods in competitive supply.

In the case of price ceilings and the resulting shortages alternative allocative

mechanisms will operate to alleviate the shortage. These might include:

Allocation on a first come first served basis

Allocation by sellers preference

Allocation by government rationing

Often when shortages occur a black market may develop. This occurs where those

consumers that have acquired the good sell it at an illegal price above the price ceiling.

In the case of Zambia where one of the purposes of the government policy was to

ensure continued and increased supply of the basic foodstuff, clearly a price ceiling by

itself would not produce the desired effect. The government had to look for alternative

ways of expanding supply.

4. Price Control Mechanism in Pakistan: The government, for political exigencies, interferes in commodity prices through

announcement of minimum support price (MSP) for various crops, particularly wheat and

sugarcane. Historically, the MSP for wheat has been much lower than the import parity

price for wheat, discouraging farmers to invest in optimal inputs for wheat cultivation.

CONFIDENTIAL 6

Similarly, subsidies on wheat flour also lead to misdirected benefits and exclude poor

consumers who do not have access to the public sector wheat distribution outlets.

Similarly, the price of sugarcane is fixed higher than the import parity price. As a result

the consumers have to purchase sugar at a higher price, which otherwise could be

imported at a lower price. Similarly, the district administrations occasionally fix the

prices of milk, beef and mutton, vegetables, and fruits such that they are lower than the

cost of production, when the supply of these commodities exceeds demand. The price

interference thus discourages the suppliers/producers to invest in higher technology

packages, and restrains the growth of commodity. Moreover, the subsidy, being

misdirected, does not reach the poorer consumers. Furthermore there is Price Control Act

1977 available for implementation.

Furthermore a discussion is required on pre devolution and post devolution

instruments like price control magistrates.

5. Price Control and inflation: Price controls are potent policy measures that can have important impacts on

production and personal incomes, although in practice it is extremely difficult to identify

these impacts. For example, although lower electricity prices may reduce what a

household pays for the electricity it receives, they also reduce the amount of investment

in electrical generating capacity and thus reduce the quantity of electricity that that same

household receives through load shedding. Furthermore, this household loses because of

higher taxes and higher interest rates that result from the alternative means used to

finance power sector spending that might otherwise have been paid for by full-cost

electricity tariffs. Perhaps the total tax burden would have been the same even if

electricity rates had been higher, but then the tax revenues would have been spent on

something else, say schools. In this case, the household might have faced lower marginal

costs of education if electricity tariffs had covered full costs.

The net effect of price control's various possible impacts on a particular

household's welfare is thus extremely difficult, if not impossible, to evaluate. The point

of my paper on this subject, therefore, is not to debate price controls in all their

ramifications. The point is, however, that, in thinking about all these possible issues, the

public should at least be free of the misconceptions about price control's inflationary

effects, because price controls just happen not to lower the price level or the rate of

inflation.

The whole idea of price controls is based on the observation that the common man

in Pakistan is poor and cannot afford all he needs or wants. In these conditions, it should

be clear that if the common man in Pakistan saves some money as a result of the

government's controlling a price, he is going to use this money to try to buy more goods,

rather than just hold on to cash. Presumably, this is the policy-makers' hope. How else

would the common man be better off if he did not use the savings from lower, controlled

prices to buy more goods?

How does this shifting of the common man's spending from the controlled

commodity to other goods affect the overall price level, the average price at which total

CONFIDENTIAL 7

nominal spending power is translated into purchases of real goods? To start with, the

controlled price will be lower, and the extra cash spent on uncontrolled goods will push

those goods' prices higher. However, these are relative price changes, not changes in the

price level.

To determine the effect on the overall price level, one has to determine how the

control of a single price affects total nominal spending power and the total sales of real

goods. Starting with the effect on total nominal spending, it is clear that the common

man's total spending does not change. On the other hand, the shift of sales revenues from

the controlled commodity to other commodities may affect spending. If the seller of the

controlled good is a governmental agency, the government's nominal spending may have

to rise to subsidize the seller for the sales revenues it lost under price control.

Alternatively, the seller of the controlled good could be a private firm, in which case the

government might intend that the loss be absorbed by the firm instead of being

subsidized. In this case, the owners of the firm will either have to divert their personal

resources to meet the firm's losses, or the owners will receive less profit, and in either

case the owners will have to reduce personal spending.

The case is symmetrical with the owners of other private goods on which the

common man spends his savings. This offsets any effect on changes in spending in the

controlled good's industry. However, if the common man tries to shift spending to other

controlled-price commodities sold by government agencies, the agencies will not receive

more revenues since their prices are controlled. (Quantity changes are considered below.)

Therefore, subsidies, if any, will not be reduced.

Thus the expected impact on total spending of controlling a price (i.e., imposing a

control that reduces the price) would be either zero, or in the case that subsidies must be

raised, positive. This possible increase in total spending depends, however, on how the

government would finance the increase in subsidy payments. If government spending is

simply diverted from some other heading, then there would be no change in total

spending. Similarly, if private spending power is diverted to the government by increased

taxation or borrowing, total spending would not be affected. Only if spending is financed

by the monetary authority (money creation) is the higher subsidy clearly an increase in

total spending.

In fact, most of these shifts of spending power from agent to agent are only shifts

and not changes in the aggregate. As will be familiar to the members of the intended

audience for this paper, the impact on aggregate nominal spending must come from (or

be balanced by) a combination of two sources: changes in "idle balances" in a short-term

Keynesian framework or changes in the money supply in a longer-term framework,

Keynesian or classical.

Changes in the money supply are not an effect of price controls, but independent

policy decisions. So, the best chance for price controls to have an independent effect on

the price level is for private loan financing of increased government subsidies to come

partly out of idle balances.

CONFIDENTIAL 8

Thus, we can fairly conclude that the effect of a price control on total spending is

either to leave it unchanged or (under Keynesian assumptions that many economists do

not wholly accept) to increase it as an indirect result of the governmental fiscal problems

it may cause.

Moving to the impact of price control on total production, we may short-cut an

equally tortuous (and conventional) discussion of micro-level shifts to come to the overall

conclusion that the aggregate effect depends on the availability of productive resources

(which is exogenous, like the money supply) and short-term variations in employment of

those resources (which, like variations in idle balances, are usually thought to depend on

expectational disequilibria).

Putting the two strands of analysis together, we arrive at the familiar Keynesian

conclusion that there is no long-term effect of price control on the overall price level, but

that it is at least conceivable, although controversial, that extra governmental spending on

subsidies occasioned by price control could lead to short-term and temporary increases in

the price level, output, or both. Even this conclusion depends on the assumption that

overall government spending passively follows the subsidy bill up and down. If the

government holds to a firm outlay target and substitutes other spending for subsidy

outlays as needed, then this avenue for a price controls to affect the overall price level is

closed also. (This in effect makes a price control identical to expansionary fiscal policy.)

In no case, however, do we arrive at the conclusion that a price control lowers the

aggregate price level. (The exception to this rule is the Soviet-style system where all

prices are effectively controlled and people have forced savings in the form of money

balances they cannot spend--the famous problem of "monetary overhang".)

Another way to approach this question is a proof by negation. Suppose that a price

control could indeed reduce the overall price level; what conclusions can one draw?

Anyone who believes that the price level will fall and that the common man will buy

more goods and live better should explain where price control should stop. After all, if

price controls do lower the price level and raise total consumption, then why not lower

prices yet further and expand consumption even more? Indeed, by controlling prices at

levels near to zero, the common man in Pakistan could be made as rich as an oil sheikh.

If this conclusion seems unlikely, then there must be a problem with the argument

that price control lowers the price level. Clearly, at some point the resource constraints

for both total nominal spending and total real production make themselves felt. Most

economists feel that we do not have to cut all controlled prices by half to make these

constraints felt, but that they are with us all the time, and that in effect, "There is no free

lunch".

6. Alternatives to price control:

One of the reasons that governments invoke price controls is to ensure that goods

and services are sold at a „fair‟ price. In a situation with numerous well-informed

consumers purchasing from multiple sellers who can develop a reputation for high or low

quality, the free market works well. The market price is „fair‟ due to the competition

between innovators and between buyers. However, there are occasions when entrants are

CONFIDENTIAL 9

discouraged or the information available to one or more parties is poor. In such cases,

government may impose price controls in an effort to protect citizens from exploitation.

This might occur if patients had to choose drugs without the help of physicians, for

example. In such a case, patients might need government protection from high prices for

the wrong medicine. Our modern healthcare system largely removes this concern by

employing informed physicians, pharmacists, and formulary committees who affect drug

choice.

Early Puritan communities, described in Hugh Rockoff‟s book Drastic Measures:

A History of Wage and Price Controls in the United States, abandoned detailed wage and

price controls shortly after imposing them in 1630 and 1633 because they were

ineffectual. Subsequent laws against “excessive” prices were more vague and, according

to Rockoff, aimed to prevent “sales influenced by fraud, ignorance, or short-run

monopolies… rather than lowering the equilibrium price in a particular market.” His

interpretation is that the Puritans faced underdeveloped colonial markets and so

“competition could not be relied upon to regulate prices and protect consumers.”

A market failure, such as lack of entry, can be mitigated with the right price

control, at least in theory. The difficulty lies in the execution. Typically, no entity is well

informed enough to be able to exactly identify the imperfection, choose the correct price

to rectify the situation, and then provide ongoing adjustment and enforcement.

Competition is a better tool than price controls for protecting consumers; the Puritans

appear to have realized that and gradually ceased using them. As Rockoff writes, “One

would expect that as markets grew; producing a smoother flow of information…the need

for regulation would have decreased. Indeed, that seems to have happened.” More

typically, governments try to fix the bad effects of price controls with subsidies to the

discouraged activity.

In the case of the pharmaceutical industry, these subsidies go to research and

development. A subsidy could restore the free market outcome by lowering the cost of

research. Again, however, the difficulty arises in choosing the level of the subsidy,

deciding whether and how to award it to for profit corporations, and avoiding inefficient

lobbying and corruption. In practice, these are very difficult issues to manage in a way

that benefits consumers.

1. Lowering Prices Through The Market

The private sector has found several successful methods for reducing the price

paid by a buyer. In most cases, government can use similar techniques to get a low price

for prescription drugs without disrupting the competitive market.

a) Buying in bulk

The most common approach is to take advantage of scale. A buyer representing a

large volume of market transactions can negotiate for a better price by threatening to

backward integrate or to move its business to a competing supplier (if the product is not

patent-protected). Moreover, a large buyer provides efficiencies to the seller. Lower

transaction costs (one invoice, one negotiation, one shipment), guaranteed volume, and

economies of scale create cost savings for the supplier that the two parties can share. The

CONFIDENTIAL 10

private sector provides countless examples of this approach; for example, big

supermarket chains pay lower prices for packaged goods than corner stores because of

large-scale central purchasing.

A slightly more subtle point of relevance to the pharmaceutical industry is that a

buyer with significant volume can often get an even lower price by helping its supplier

increase market share. Insurance organizations can agree to educate or encourage

physicians to prescribe a certain drug. In return for altering market share in the provider

network, the drug manufacturer offers the provider a lower price.

b) Foster Competition

A buyer can explicitly foster competition where none exists. For example, several

large corporations in the Detroit area recently began funding a small, low-cost airline

named Pro Air that operates out of that airport. The Detroit airport is otherwise

dominated by Northwest Airlines, which charges relatively high prices due to the lack of

competition. General Motors, Masco, and Daimler-Chrysler each pay Pro Air a fixed sum

of money per month in exchange for a certain number of flights for their employees. This

gives the start-up airline stability and causes its competitors to realize that it cannot be

driven out of business. By encouraging the entry and survival of a low-cost competitor to

Northwest Airlines, the companies save both on the flights their employees take on Pro

Air and also through any price reduction Northwest undertakes in response to the

competition.

c) Information

Another way to obtain lower prices through the market is for an independent

organization to provide information on the competing alternatives to individual buyers.

Using this information, an informed consumer can identify the product that best fits her

needs and can demand a discounted price when purchasing a different product. Many

large corporations take this approach with health plans for employees; the employee may

choose among a set of approved plans and the corporation provides ratings or a scorecard

to help employees compare the plans. The ratings cause plans to compete for customers

on the price and quality dimensions.

2. Taxation

Tax reform is perhaps the most pressing economic policy step needed in Pakistan.

However, income taxation seems almost to be ruled out of discussion and the public

views any increase in commodity tax rates as inflationary. Even a programme to equalize

taxation of internal and international transactions is handicapped by charges of being

inflationary, despite the fact that this programme involves lowering international trade

taxes while it raises internal taxes.

This is perhaps the clearest case of the public and economists holding opposite

points of view, since economists generally believe that financing government outlays

through tax revenues contributes less to inflationary pressure than borrowing does. Where

the government's tax or sales revenues substitute for borrowing, they reduce pressure on

credit markets. Since monetary authorities tend to relate monetary policy to "credit

conditions", they are likely to react to reduced pressure on credit markets by expanding

CONFIDENTIAL 11

aggregate credit less, thus tending to reduce future inflation. This would not be the case if

monetary authorities worked like strict quantity theorists, but strict quantity theory is a

luxury that even monetary authorities can rarely afford.

CONFIDENTIAL 12

Final Word:

The imposition of price controls on a well functioning, competitive market harms

society by reducing the amount of trade in the economy and creating incentives to waste

resources. Many researchers have found that price controls reduce entry and investment

in the long run. The controls can also reduce quality, create black markets, and stimulate

costly rationing. In the case of pharmaceuticals, the most damaging area is likely to be

the reduction in innovation, which will harm all future generations of patients. Although

policymakers know that price controls can be very harmful, they continue to have strong

incentives to legislate low prices for themselves. This often leads to the adoption of more

sophisticated price controls. The government pegs its price to some reference price in the

economy rather than choosing a fixed number, or sets its price a fixed amount below that

of other customers. These schemes destroy welfare by inserting a new incentive into what

would otherwise be a well-functioning market; either the price to non-government

customers is higher or the price to poorer customers rises. More generally, the reference

price chosen by the government rises because of the price control, not because of a

change in the underlying forces of demand or supply.

The overwhelming evidence against price controls naturally leads to consideration

of other methods of lowering purchasing costs. The private sector uses a number of

methods that are both effective and consonant with a market economy. Such approaches,

when used by the private market, are much less damaging to economic welfare than a

government price control.

CONFIDENTIAL 13

Essential Readings:

Price Control And Prevention Of Profiteering And Hoarding Act, 1977

The Problems of Price Controls By Fiona M. Scott Morton Yale University

2001

Reading Material A Price Controls by Hugh Rockoff

Reading Material B Food Insecurity in Pakistan

Reading Material C Devolution Plan in Pakistan Context, implementation

and issues By Saad Abdullah Paracha Open Society Institute, Budapest –

Hungary International Policy Fellowship Program August 2003

Reading Material D Implementing Price-Control Mechanism By Aamir

Hakeem

Does Governance Contribute to Pro-poor Growth? Evidence from Pakistan

by Rashida Haq and Uzma Zia Pakistan Institute of Development

Economics, Islamabad Institute of Development Economics, Islamabad

PAKISTAN PIDE Working Papers 2009:52