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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:

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.

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    As described in the answer, economic theories are not like the natural laws in physics. The are models that try to describe how economists expect the real world does or should behave. That doesn't make them less useful but this misunderstanding seems to be common among economists.
    – quarague
    Commented Jan 2, 2023 at 17:54
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    @quarague I hear this excuse a lot (usually from politicians) but basically saying "Economics is just too inaccruate" isnt an answer. Especially when so many times the problem that has occurred seems to be in violation of basic econ. And especially when policy makers have no problem using econ 101 when is comes to artificially reducing demand, and thereby reducing prices
    – Amon
    Commented Jan 2, 2023 at 18:35
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    if there is no supply, shortage will happen regardless
    – njzk2
    Commented Jan 2, 2023 at 20:26
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    @Amon I was mostly objecting to the phrase 'known fact'. If instead it would say something like 'economic theory says this is a bad idea (link for the reasons), why do governments do it anyways?' I would be perfectly happy because a priori this allows both the answers a) governments ignore the theory and fail or b) the theory is too simplistic and doesn't apply in this case.
    – quarague
    Commented Jan 3, 2023 at 6:25
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    @JonathanReez it's more complicated than that (which is why you shouldn't have skipped econ 102, 103, 104,...). You may want to factor in the level of elasticity of both demand and supply. (2 examples: if a resource is fully destroyed, you can't buy it anymore. If a resource takes time to re-generate, you can't buy it right away)
    – njzk2
    Commented Jan 3, 2023 at 21:47

8 Answers 8

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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.

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    @Amon Mind you, I wrote "not just due to supply issues". And of course, for oil and gas there is going to a broad range of opinions on what reasonable prices and consumption levels are.
    – Arno
    Commented Jan 2, 2023 at 18:39
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    @Amon: In some situations, rising prices trigger increased demand, pushing prices up further and creating a vicious circle. Price caps can sometimes prevent such situations as described in my answer.
    – supercat
    Commented Jan 2, 2023 at 18:54
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    @Amon You're still oversimplifying. It's very unlikely that the demand will increase in this case. Prices have already increased considerably, leading people to conserve. Much of the reason people will buy more than usual is to insure themselves against further price increases (leading into price and buying panic spirals), which price caps prevent. Keep in mind that in the (very simple!) model where price caps lead to shortages, the shortages are caused by less investment into further production (since there's less revenue incentive).
    – Luaan
    Commented Jan 3, 2023 at 11:34
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    @Amon A typical scenario for the kind of Econ-101 thing is something like this: prices have been increasing over the board, and one of the problems is increasing meat prices. Meat prices are now very high and people can't afford meat. The government steps in and caps the price to keep the goods supplied to poor people. However, meat prices weren't increased by awful producers increasing their profit margins - they increased because (say) oats is more expensive. The price cap on meat means it's no longer possible to profitably produce meat in the current market, and supply drops like a stone.
    – Luaan
    Commented Jan 3, 2023 at 11:36
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    @Arno Yes indeed, the "sweet spot." Real price caps have never been tried. The usual method of reducing demand for food then follows. en.wikipedia.org/wiki/Holodomor
    – Boba Fit
    Commented Jan 3, 2023 at 20:16
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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.


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.

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  • "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." Actually it is: "a condition where the quantity of a product or service demanded is greater than the quantity supplied at the market price." Before those [poor] people die, there is shortage. Not after they die, sure. Commented Mar 14 at 18:41
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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.

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    Why would price controls force the companies to sell their stocked oil? They could simply refuse to sell any until price controls end (hoarding). That strategy even works without price controls: keep your stuff in warehouses until prices rise, speculating that the increased profits after the price increase will offset the storage costs.
    – gerrit
    Commented Jan 3, 2023 at 7:55
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    @gerrit: Actually in Hungary for food with capped prices the grocery stores are obliged to hold as much of them in the selves as they used to have a year ago. In practice when I have to go to the third shop to buy sugar, it doesn't really work out... Commented Jan 3, 2023 at 9:29
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    @gerrit because it allows them to recover some of the cost of that oil. Oil in storage requires maintenance, goes bad... and it is not as, after keeping people without oil for a time, once the supply is recovered they will "compensate" for the time they were without (other than everybody needing to fill their tanks). If anything, if people do not have access to oil they may resort to alternatives (e.g. buy a bike) and consume less of it after supply is resumed.
    – SJuan76
    Commented Jan 3, 2023 at 10:08
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    @gerrit In addition to what SJuan76 said, the point is that the company isn't going to wait for the price to go even higher - there's no expectation the price will rise even more if there's an actual cap.
    – Luaan
    Commented Jan 3, 2023 at 11:57
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    @user2414208, of course it doesn't work out. The whole reason the prices went up in the first place is that those things are more scarce than the previous year. Price increases serve two purposes, to induce more supply AND to reduce demand. If there's a supply shock such that no more supply is possible then the only way to have supply and demand meet is for there to be less buying. This can be done with non-price rationing such as being the first in line, or explicit rationing coupons from the government. It can't be that someone just says the stores have to have a thing. Commented Jan 4, 2023 at 19:47
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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.

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    +1 for populism. This is the primary reason that any politician considers price caps. Politicians support price caps because it makes it look like they're "doing something" to people who don't understand how economics work and it makes them more likely to be re-elected in the short term, even though it's usually bad for the population in the longer term. The goal of politicians is to stay in power. Not all means of doing so, even in a democracy, are actually helpful to the people, especially in the shorter term.
    – reirab
    Commented Jan 3, 2023 at 20:41
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    " every government overbidding their neighbor to fill up their gas reservoirs for the next winter is helping no one. " worse, it was helping the very country that Europe is currnently trying to punish for a certain "special military operation". Commented Jan 4, 2023 at 15:11
  • @PeterGreen I didn't think Europe was trying to punish the USA (where it is buying lots of overpriced gas from) for its wars in Yemen and Palestine? Commented Jan 4, 2023 at 17:49
  • Pushing up the price of pipeline gas means more money for russia. Commented Jan 4, 2023 at 17:51
  • @PeterGreen I thought Europe had contracts for a fixed price and probably also fixed quantity, which Russia broke. Commented Jan 5, 2023 at 0:35
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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.

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    That's assuming most people are buying to resell. In reality most people are buying out of need, and if that product is cheap (because of a cap), people buy in hoards, which just offsets the people who would buy for reselling (who can still buy those cheap products in hoards). The basic econ applies either way. The actual best way I believe is when individual stores place buying limits on items (this isn't perfect, people can come in with their friends/family)
    – Amon
    Commented Jan 2, 2023 at 19:06
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    @Amon: The aformentioned second-order effects sometimes play a big role in markets sometimes a slight role, and sometimes no appreciable role. Price caps are often a bad idea, and may well be a bad idea in this case, but--contrary to what Econ 101 would predit--they're not always a bad idea. If many people have bought energy assets on speculation, they way want to hold off on selling them until prices peak. Using a cap to force a market peak may cause holders of such assets to liquidate them, thus freeing up the associated resources.
    – supercat
    Commented Jan 2, 2023 at 19:13
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    @Amon: Price caps are best in situations where they are announced in advance and discourage prices from reaching the cap, and can be very destructive if they are set at a level below the minimum point to which the supply and demand curves can adapt themselves. I like to view an economy as something like a ball rolling around a shifting textured landscape. In situations where a ball could get caught in either of two low regions, one of which is more desirable than others, a price ceiling may prevent the ball from falling into the bad one. Although it's all too common...
    – supercat
    Commented Jan 2, 2023 at 20:10
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    ...for the "ball" to get trapped between the a rising landscape and the ceiling, that doesn't mean there aren't times when the ceiling causes the ball to end up in a better spot than it otherwise would have.
    – supercat
    Commented Jan 2, 2023 at 20:11
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    @reirab: Have I not made it adequately clear that price caps are generally a bad thing? Bubble-induced demand can in turn induce hoarding, and because price caps may serve to prevent bubbles, they may also prevent hoarding that would have been triggered by bubble-induced demand.
    – supercat
    Commented Jan 3, 2023 at 21:07
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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.

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    "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" - and what will keep them in power is making life better for ordinary people. Why would ordinary people re-elect a government that keeps making their lives worse? Commented Jan 4, 2023 at 17:51
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    That's a pertinent question. Why do you think people keep voting for governments that do things that are drastically and obviously bad for them?
    – Boba Fit
    Commented Jan 4, 2023 at 18:21
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    @user253751 To answer your question in the context of the broader question, when people can't find the thing they want to buy, they don't blame it on the price cap, they blame it on the producer. Even if the thing that makes life harder for people is the direct result of a government policy, it only hurts the politicians if the people recognize that fact. Commented Jan 4, 2023 at 19:34
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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.

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    Please note that this mayor is head of one of the constituent states of Austria, not a mere municipality. That said, this is still mostly just applying pressure on the federal government, which may have similar plans in any case.
    – Chieron
    Commented Jan 3, 2023 at 22:56
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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.

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    At least in Hungary there's price cap on (some very specific) food, so it's not just about fuel. Given that the Hungarian food price inflation is the highest in the EU, I'd say it backfired spectacularly. First of all, the cap is only on some specific articles, so the shops raise the prices of everything else to compensate for their losses. The grocery stores were also hit by some extra tax, so they increased their prices even more to cover that tax. Commented Jan 3, 2023 at 9:37
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    Also the price caps are handled arbitrary (e.g. the removal of the fuel price cap was announced less than 30 minutes(!) before they were abolished at 23:00), so there's a certain amount of uncertainty, anything can be capped any time at any price - and the grocery stores increase their prices to cover this uncertainty. Commented Jan 3, 2023 at 9:40
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    @user2414208 I'm absolutely not saying that one can't have a spectacular economic failure with ill-designed price caps, just that well-thought price caps could be useful sometimes. Commented Jan 3, 2023 at 10:12

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