Why do some European governments still consider price capping despite the fact that price caps lead to shortages?

Question

Context

Due to multiple causes such as the Russian invasion of Ukraine, most European countries have faced soaring prices for essential products. In some cases, the governments decided to impose price caps. The last such case that caught my attention was Austria, which considers price capping (among other measures):

Intervention to achieve price reductions on basic foodstuffs is gaining political momentum as calls for uniform national measures to counter increasing inflation gain steam.

This could be realised either with a reduction of the value-added tax (VAT) or a price cap, according to the social democratic Mayor and Governor of Vienna Michael Ludwig.

Austria seems to come late to this party, as other European countries tried price capping, and it did not work too well:

• Hungarian government scraps price cap on fuels as shortage worsens
• Illegal logging in Romania exploded after government capped the price of firewood (as a bonus to shortages)

Question

Why do the governments still try price caps instead of other solutions such as subsidies, to prevent shortages, in the context of a rather long crisis? It seems to be known that shortages are quite certain when a price cap is issued:

Price ceilings are enacted in an attempt to keep prices low for those who demand the product—be it housing, prescription drugs, or auto insurance. But when the market price is not allowed to rise to the equilibrium level, quantity demanded exceeds quantity supplied, and thus a shortage occurs.

Answer 1

First of all, this is one of the many situations where we have to remember that the Econ101-explanations are based on assumptions that are never going to be satisfied in reality. There rarely is an "obvious truth" in economics which shouldn't be furthered questioned.

If an increase in prices is due to a supply shortage which should be overcome with private investments to increase production, then a price cap is going to make things worse.

But that is a big "if". For example, the record profits currently obtained by many oil and gas companies strongly indicate that the current retail prices for those products are not just due to supply-issues. Moreover, the long-term solution here is to reduce demand rather than increase supply. I am no expert on Austrian food economics, but I wouldn't be that surprised if the price issues aren't about supply at all. A too extreme price cap would certainly cause problems, but it doesn't seem obvious at all that there couldn't be a sweet spot.

And then there is a secondary issue: There is a strong incentive for politicians to be seen doing something about a crisis. So in absence of good options, trying less-good options can be favoured over doing nothing.

Answer 2

You may be confused by the economics definition of a "shortage", which is when "the quantity demanded exceeds the quantity supplied" which means people would like to spend more money and get more stuff, but they can't.

Note that "quantity demanded" means the amount that people will buy taking into account the price. As the price goes up, "quantity demanded" goes down. If food is expensive you don't want to spend all your money on food so you buy the smallest amount you can - and this is the "quantity demanded". If food is cheap you might want to buy lots and get fat. That is also the "quantity demanded". If food is very very expensive you demand zero of it and you die.

You can have a situation where food is expensive and some people simply do not have enough money to buy food, so they choose to go and lie down in a ditch and die. According to economics, this is not a shortage. They did not demand food (they weren't able to) so there is no mismatch between supply and demand, and no shortage.

You can also have a wartime ration type of situation, where everyone is fed, but just barely, and they would like more, but there isn't any, but at least they're not starving. According to economics, this is a shortage, even though everyone is getting fed. You might go to the shopkeeper and say "hey, I have more euros, please give me more bread" but the shopkeeper says "sorry you've already had your bread rations this week." That's a shortage.

Which situation is actually worse? Obviously, they are both bad, but the "shortage" is actually better because nobody dies of starvation.

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If you are particularly left-wing-minded, you might notice that economics implicitly makes a whole lot of assumptions, when it defines that people who cannot buy something because it's too expensive do not count as demand. And you might realize these kinds of assumed definitions enforce a certain kind of economic thinking which perpetuates a certain kind of resource allocation in society. You might also notice that it's kind of weird (and similarly biased) that euros are considered as price, but ration cards aren't.

Answer 3

In addition to other answers:

First, "Economics 101" does not speak about times. If Hungary imports all of its oil through a single pipeline and the pipeline is shut, increasing prices will incentivate building a new pipeline, but it won't make it happen immediately. It could help make some previously uneconomical alternatives feasible (e.g. importing oil by truck) but only to a certain extent (where from? how many oil carrying trucks are available? Will they collapse the roads?)

A government might prefer to keep prices low, as rising them offers no real solution. If the situation worsens, the actual solution would be rationing.

Of course, high prices affect demand too, but it usually affects more the poor people and it is unpopular. This is why governments have tried reducing demand by other means (cheap public transport).

Also for a short spell, controlling the prices could be a valid solution. It would force the companies to sell their stocked oil, and while those last it could be useful.

And last but not least, the relationship between governments and big business may be complicated. Big business might have a lot of influence in government, but when the government sees a situation dangerous to itself, it does have its own tools, too. For example, it could be privately telling companies to suck up the losses (or more likely, the reduction of the extraordinary profits they have) in exchange of avoiding future tax raises or other possibilities that the government still has.

Answer 4

There is a multitude of reasons why politicians may argue for price caps:

Populism
Plain and simple: politicians want to be re-elected. Giving the impression of caring about common people is much more important for being re-elected than enacting legislation that actually helps people in the long run.

They do not understand or accept market mechanisms
This reason applies to many left-wing politicians who argue for price caps, be it rent, electricity or food. If one does not believe in basic economic principles or outright rejects them, it is easy to claim that the downsides do not exist or will not be as severe.

Consumer prices might not respect true cost increases
The uncertainty around energy supply lends itself to speculation. There is also no better time to increase prices for your products than when everyone else is increasing prices. An indicator for this can be seen in record high earnings for many sectors. Also, an uncertain situation and exploding prices in inelastic markets, such as energy and food, lend themselves to speculation. A price cap could help to contain speculation.

There are important details
Price caps can come in many forms. A good example of this is the price cap on natural gas agreed on by the EU. It definitely is a price cap, but the actual cap is relative to the price of LNG. The background is that there is only so much pipeline gas coming to Europe, and every government overbidding their neighbor to fill up their gas reservoirs for the next winter is helping no one. Another example of an attempt to keep some of the market forces while capping prices for consumers is the German price caps for natural gas and electricity. These will only apply to 80% of the previous year's usage, with the expectation that people will both switch to a cheap provider and try to save gas/electricity.

Answer 5

In general, if applying first-order Econ 101 principles would suggest that a policy is a bad idea, the policy should be presumed to be a bad idea unless there are particular reasons to expect other more complicated principles to dominate. Here, however, it's not hard to name a couple of second-order factors that might dominate.

Hoarding and bubble speculation are a common second-order effects in which rising prices cause demand to increase rather than decrease. While price caps may or may not be effective at discouraging hoarding directly, they can certainly discourage bubble speculation by reducing plausible upside gains. If prices are rising, and one might hope to buy some quantity of energy for $100 and sell it for $200 (accepting the risk that after buying for $100, ine might end up having to sell for less), having a price cap of $120 would make such a proposition much less attractive, and thus reduce the amount of energy acquired in time of crisis by people hoping to profit from resale in time of deeper crisis. That in turn may free up enough supply to avoid triggering a hoarding cycle.

Answer 6

The reason that econ-101 type reasoning does not give the right answer is because the conditions for it applying do not obtain. This is a fact that has been well known since at least Hayek's Road to Serfdom.

Governments like price controls because they regard their success or failure on a very different basis to what ordinary people do. Governments do not particularly care about shortages. Governments care about what they believe will keep them in power, what will give them more power, what will extend their control over more parts of society. Thus the primary feature of price controls that a government will be concerned about, the metric by which their success will be judged, is compliance.

Prices are signals of information. They indicate the degree to which people desire things relative to other things. Governments desire things that are quite distinct to what run-of-the-mill people desire.

People desire such things as food, shelter (including heat, light, water, etc.), clothing, medicine, transport, etc. These are things that keep people alive and healthy. People who are not so motivated do not live long.

Governments primarily desire to stay in power. Governments that are not so motivated do not stay around very long.

Thus, price caps may meet the desires of the current government, while cruelly disadvantaging ordinary people. Indeed, it is the usual expectable situation.

Price caps on fuel, for example, can be held up as "doing something to help the people." They can also be used as leverage on various individuals in order to wield additional power. Oil companies have huge wealth and so potentially have political influence. A chance to manipulate them with the threat of price caps gives the government additional levers of power. Nice oil company you've got there. Shame if the price of oil were half. But do us this favor and we'll let you keep 90% of the current price. For now.

The favors from the oil companies can be traded with other sociological entities for favors from them. The transit worker's union can be manipulated by agreeing to make driving private cars more expensive, thus pushing more people onto the subways. The agricultural sector can be manipulated by lowering the price of fertilizer (which is heavily affected by the price of fuel). Or at least not raising it as much as anticipated. The building and trades unions can be manipulated with promises of caps on the price of houses (affected by the price of fuel) to supposedly stimulate the house building market. And so on.

Thus we see price controls implemented again and again. And when government A is tossed out to be replaced by government Not-A, why the new rascals ask if they can borrow the notes from the previous rascals. Because the new rascals want to implement the policies that only last week they were shouting about being the most evil and ill considered nonsense.

This is by no means new. For example, in the late 1970s it was the case in Canada. The Liberal govt brought in price controls to "fight inflation." Then they lost an election and the Conservatives were elected. Who immediately implemented virtually identical price controls. Which managed to make things worse.

And so the price controls on fuel require price controls on housing and transport. Which require controls on wages in trades. Which require controls on the next aspect of society and the next and the next.

Hayek told us all of this quite clearly almost 80 years ago.

At some point, one expects that the following motto will be heard: Real price caps have never been tried.

Answer 7

In this particular case the true reason is that...

Talk is cheap

Intervention to achieve price reductions on basic foodstuffs is gaining political momentum as calls for uniform national measures to counter increasing inflation gain steam.

This could be realised either with a reduction of the value-added tax (VAT) or a price cap, according to the social democratic Mayor and Governor of Vienna Michael Ludwig.

...

The Viennese mayor also recommends a partial cap on electricity bills, as proposed by Gabriel Felbermayr, head of the Economic Research Institute (WIFO).

The mayor doesn't have the power to either reduce VAT or introduce a price cap on anything. Nor does the city council have such powers. Only the Austrian Parliament could introduce such a drastic measure, so the mayor can talk all day about how price caps are necessary without being forced to do something about it. Same applies to members of the opposition - they very much enjoy coming up with wild unworkable ideas, knowing all too well they don't have the votes to put them into practice.

If I'm wrong and members of the Austrian ruling coalition likewise support a price cap on basic foodstuffs, you can refer to other answers for a better rationale. But the mayor's words could be safely ignored as they're just empty talk.

Answer 8

In the long run price capping does lead to a shortage because supply is reduced. However, in the short term it mostly reduces the profits of producers who are often unable to reduce or stop production instantly.

E.g. if you're a baker, you most likely have a stock of ingredients (or long-term contracts to get them shipped), as well as expensive assets such as bread ovens. If a price cap on bread is introduced which takes away all your profits, you will eventually go out of business. However, it will still be reasonable for you to keep baking bread at until your flour stock runs out, if you can only sell flour at a bigger loss than selling bread with the cap. And if there's an expectation that the price cap will be lifted soon, you won't sell your ovens for scrap metal right away. You may even have to keep baking bread just to keep ovens in a working state, in order to stay in business and get extra profits once the cap is lifted.

Especially with energy industry making record profits due to the ongoing crisis, price capping make more sense than subsidies to consumers which would boost those profits even more while making inflation worse.