wcoltd

"THE FREE-MARKET HAS FAILED!"

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“THE FREE-MARKET HAS FAILED!”

Normal 0 false false false EN-US X-NONE X-NONE by Andrew L. Frazier

 

 

There is perhaps no more divisive topic in economics than the issue of Price Controls. The issue is especially pertinent because it usually comes up in times of economic duress, times in which, the consequences of action or inaction are most immediate. These times are considered by Keynesians to be periods which the “Market has failed”. Only the government, the Keynesians say, can correct the imbalances of a “failed” market.

In order to first consider price controls, we must learn about the conditions which justify them; namely, conditions in which “the market has failed".

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Part 1: “The Market Has Failed”

To the proponent, “Market Failure” is a phenomenon in which the market is not producing things as efficiently as it otherwise could, and so the market must step aside - according to a particular school of thought – and allow the government to correct the imbalances.

Already, by mere suggestion of “Market Failure” the economist in question has met a point of fundamental contention. The market - by definition - cannot possibly fail, retorts the opposition, because the market is an arbitrary term which describes the progression of individual cost-benefit interactions. It is as if saying “the process of evolution has failed”. The problem is, evolution cannot possibly fail, because the surviving specie is by definition the more evolved one. Sometimes the particular specie of animal you like dies out, but that’s not a failure of evolution, it just is merely the impersonality of the process. The process doesn’t care if the particular animal is cute, in so much as it has an effect on the organisms’ ability to thrive and reproduce. The same is true for economics, the market doesn’t fail when a particular company you like goes out of business, to paraphrase again, it’s just the impersonality of the process; or so say the opposition.

The opposition would contend that the free market has no explicit purpose or goal, how then can it fail to reach a goal which does not exist? The issue, say the opposition, generally comes when economists impose their own standards of what the goal of the market should be. Should it, for instance be to make every individual wealthy? And if so, how wealthy should each individual be? How do you define what wealth is? These answers are not as clear as they might seem; indeed, it may be far beyond what any single person can answer. Yet however, it is not too difficult for everyone to answer, In a way, each individual participating in the economy answers these questions through their choice of what goods and services they wish to purchase; in the words of Von Mises “the economy is a democracy in which every dollar has a vote”.

However, to the command economist, these questions do not seem too fickle and complex to answer. How you might ask? Does the command economist simply know what’s best for everyone? The command economist of the mainstream kind that we see today, isn’t concerned with micromanagement, instead he simply bonks the free market machine in order to jumpstart it. According to this school of thought there are at least 4 ways in which a market can Fail.

·        Monopoly and Predatory Pricing - For large businesses, it can become more profitable for companies to work through collusion rather than through open competition. In this case, prices for a given product rise and increase the burdon on the society. Price controls can be set to deter monopoly arbitration.

·        Cyclical fluxuations – cyclical fluxuations can cause conditions that are not conducive to business, such is the case when agriculture has a year in which supply is overly plentiful, the price for the commodities drops, and that drop can make it difficult for some farmers to make money. Price controls, in conjunction with subsidies can allieviate difficulties, allowing for bountiful production even in times of poor harvests.

·        Demerit Costs – Demerit costs exist when people in a society to do not do things for their own benefit, such as drinking or buying drugs. Price controls can be used to deter people from purchasing things which are bad for them. The recent excessive tax increases in cigarettes are a good example.

·        Extranalities – Eternalities are third parties which are affected by an operation which should otherwise not involve them. People effected by pollution are externalities to the plant producing the waste. There can be market externalities as well, for instance when AIG sold credit default swaps and defaulted on them, they caused many retirement funds to loose a large amount of their value. The reciever of the retirement fund is an externality in this case because he was not aware of what his future was invested in and what the implicit risks were. Price controls can be established to deter people from taking excessive risks

 

Part 2: Monopolization

According to the Book “Monopoly Power and Economic Performance” by Edwin Mansfield. The problem of monopolization exists when large businesses find that they can become more profitable by collusion rather than competition. This causes prices for the individual consumer to rise, raising the burden on society.

There is one powerful argument against the viability of this thesis. It is this, to the extent that large business profit from collusion is the extent to which they incentivize new competition and innovation. This is the argument taken by Joseph Schumpeter.

Schumpeter’s thesis is then partially taken down by the Predatory Pricing argument, which says that because of the largeness of the monopoly, the monopoly can temporarily lower prices below what it costs the monopoly to produce - for the sole intention of driving the small competitor out of business.  Tom Woods retorts the Predatory Pricing Argument  in his book “The Politically Incorrect Guide to American History” and shows how entrepreneurs can ingeniously circumvent severely underpriced goods monopolies sell during times of competition. The story goes as follows:

There was a man by the name of Herbert Dow, and Herbert Dow was a smart man, He was able to produce a chemical called bromine for a substantially reduced cost than his competitors. The German monopoly Brokomvention did not like the fact Herbert Dow could do this, so they offered him a warning – they said if he ever decides to sell his bromine in Europe they – Brokomvention - would lower their prices so significantly in the U.S. that he would be put out of business. Herbert Dow was not deterred, he began selling his chemical for .33/lb in Great Britain versus Brokom’s price of .49/lb. So Brokom made good on their promise, they reduced their price in the United States for Bromine to .21/lb – a price which Herbert Dow could not possibly compete. So what did Herbert do? He did something very smart, he contacted his buying agent and ordered him to buy up as much of Brokom’s Bromine as he possibly could. He then took this Bromine and sold it to Europe (where the price was still .49/lb). Brokom, unknowing of this tactic saw the dramatic increase in demand for their bromine and saw that Herbert Dow was still well in business. So the Germans lowered the price to .15/lb and Herbert Dow bought and sold more, then they lowered the price to 10.5/lb until they finally discovered what Herbert Dow had been up to – and promptly raised their prices. But not before making Herbert a very wealthy man!

Indeed whenever a monopoly sells below cost of production, it creates excesses in demand, and drives speculation – which can then can become profitable when the price for the same good rises during periods in which there is no competition. Speculation deters any significant arbitrage of this sort.

 

Part 3: Real Cases

For every example in which Price controls were to have said to have worked, there must be at least a hundred in which they did not work. During my study, I could not find a single example in which price controls actually worked to benefit society. Here are just some of the examples. Every example (including those in the textbook), severely criticized the viability of price controls.

 

THE CALIFORNIA ENERGY CRISIS (2000-2001)

The general impression people have of the California energy crisis is that there was, basically, a condition where there was deregulation, and the energy companies took advantage of it and jacked up prices. They might think, like I did, that price controls would be an effective measure against these price gouges.  However, through study, I discovered something very interesting, that price controls already existed during the California Energy Crisis – and that those very price controls were more responsible for the crisis – and the high costs of energy than perhaps any other factor.

The real cause of the Crisis stated by the Federal Energy Regulatory Committee

"...supply-demand imbalance, flawed market design and inconsistent rules made possible significant market manipulation as delineated in final investigation report. Without underlying market dysfunction, attempts to manipulate the market would not be successful."

So basically, because of imposed price controls, energy companies had no incentive to grow with demand, because the market had no way of signaling that increase in demand to the supplier. No energy company bothered to increase the supply of energy through investment (of building a new power plant or installing a new reactor) because there was no incentive for them to do this – and all of this as a direct result of artificially low prices imposed on the system.

Then as the problem of shortages became apparent the legislature allowed for deregulation of interstate energy transactions – a piece of legislation which was poorly engineered and allowed companies like Enron and Reliant Energy who were starving for profits precisely due to the Price control to essentially game the market for it’s own benefit.

 

THE BECHTEL WATER SCANDAL (2001)

               The Bechtel Water Scandal is another such situation where, Imposed price controls would seem to be the solution to the problem, but was in reality was the underlying cause of the problem.

The story most people get from the news goes as follows;

In 1999, Suffering under large debt loads, The Bolivian government was pressured by the World Bank to Privatize it’s water operations. The Bolivian government complied and sold part of its water utility operations in a consortium called Aguas Del Tunari which was partly joined by a company called Bechtel. Soon after operation Bechtel hiked rates up as much as 90% causing an uproar amongst impoverished clients. As a result, the government cancelled the contract with Bechtel.

The Humanists contend that It was right for the government to intervene, they argued that Bechtel had tried to take advantage of these poor Bolivians. It may even be beneficial for the government to impose price controls to prevent another such calamity - However after further study, the real culprit of this injustice was not the privatization of the water supply, but rather the government operation of the water supply.

This case again, while it may seem that the solution to the problem would be price controls, it was actually the underlying cause of the problem. Before the Bolivian government had privatized it’s water operations to Aguas Del Tunari (a consortium in which the government had a majority stake) they were in control of them. The government was running the water system at a loss, and going into perpetual debt to fund the water supply. (this can be seen as another form of price control, where the price can be artificially suppressed) They were so bad at running water operations that by four years time they run up debt of 35 million dollars. Their creditor, The World Bank, was not to happy with the way the Bolivian government was running their water operations and compelled them to privatize the water operations in order for the water system to run at a profit. The reason why Aguas Del Tunari had to increase the rates was to pay back the debts it had inherited under contract. Bechtel, unlike the government, did not have the luxury of running perpetual debts. The price of water was artificially low. The Bolivian citizens were used to paying lower prices than the cost of production for that water, and it should be the government that gets blamed for being so irresponsible.

However the story becomes more ridiculous, because the truth was that the water rates had actually declined for most of the poorest in the city, that was because those people had no running water they had to get their water from tanqueros.  Water from tanker trucks which was both lower in qualtity and rougly 8-10 times more expensive. The reason why water bills went up so drastically was not because of an increase in rate price, but was related to a government regulation which prevented people from pulling water from their wells, it increased the amount of people using the city water supply, so while rates for the poor had declined or only risen slightly, the amount of water being sold had increased.

Previous to Aguas Del Tunari, the government had a regressive pricing policy on their water, since they were taking up greater costs and risks for supplying water to the poorer communities, they had opted to charge them more for their water, so much so that as a result the poorer clients were paying more than 6 times more for the same amount of water. It was actually such a price differential that the rich who were partially comprised of cocaine farmers, were able to pull the water from the city supply and sell it in tanqueros  to supply water to the poor communities. Bechtel suspects that it was this financial incentive that was behind the irrational protesting in Cochabamba Bolivia.

Zimbabwe (2007)

               In 2007 Zimbabwe had been suffering from severe inflation caused by the government printing press, and the government-mandated elimination of a large portion of Zimbabwe’s productive workforce. In order to counter inflation, the government decided to physically impose price restrictions on the sale of certain goods. It led to complete disaster. Within a matter of days the national supply of food was completely gone. The producers - being forced to produce at a loss - were unable to maintain production, and long term shortages began to arise.    

Indeed, price restrictions in which the price of a good is artificially low, the result is unfailingly a shortage. Examples just from the textbook include the Energy Crisis in the 1970’s in which the U.S. government tried to reverse the trend of rising gas prices by implementing price caps on the sale of gasoline. It resulted in rationing, which contained with it it’s own series of problems including counterfeiting of the rations and black market transactions.

 

Part 4: Cyclical Failures

               In 1929 after a sharp decline in the stock market, the price of agricultural commodities fell sharply, while the price of industrial goods remained relatively flat. The increased relative costs of industrial goods made it difficult for farmers to purchase equipment to maintain their farms. In order to help the farmers, the government established price controls to bring the price of agriculture goods back to parity to the cost of industrial goods. However, this did little good to the farmer because the artificial rise in prices facilitated a commensurate drop in demand, and a reduction of exports, which fell greater than commensurately with the rise in price. So while farmers could charge more for their goods, the amount of goods they were able to sell dropped in proportion, so in the end they were no better off.  However the people who purchased these commodities were less well off, since they had less food to eat.

Price controls can be justified by arguments of intention. If people are having to pay exorbitant prices – at the same time business are reaping massive profits, they say, a government would be justified in establishing price controls. However, it is never asked how to conditions of market failure come to pass - Is it just a natural outgrowth of the free market system? Or is it the result of a previous intervention?

In the Austrian School of thought the market price is established as the price of maximum utilization, proper compensation is defined by market prices, or market demand. When a government decides to impose its own standards of what proper compensation should be, it often distorts the market, which then lead to unintended consequences.  For example,  If a government were to impose artificially low prices for a certain good, what happens is the producer of that good is forced to sell for a loss, and that producer will no longer produce, then shortages arise. Ironically, this causes the price to go even higher, because the only way to receive these products is by paying exorbitant prices on the black market - prices which contain both a higher price due to the increased scarcity and a premium to offset risk of government insubordination.

Alternatively, the government can impose price floors, preventing the price from going down further. However, Artificially imposing too high a price causes illiquidity in the market, the good is there – perfectly consumable, but no one can buy it because the price is too high.  The consumer isn’t the only one who suffers, the farmer who wants the good sold can’t for the simple reason that the government won’t let them. Imagine a situation in which there is the shopkeeper at a market, who is desperately in need of money, and a customer who has some money but is desperately in need of food, and yet, they cannot make the transaction – even though the shop keeper is perfectly willing to part with the good at the lower price, and the customer is perfectly willing to consume it, they cannot reach that agreement, all because of this imposed price control. Of course in the real world these insane policies are impossible to enforce which is exactly what happened during the great depression – and is why the government then decided to plow under fields. They thought that if they reduced the supply, the price would go up – they were right, but why do that? they actually used tax payer resources to destroy perfectly consumable goods! How is that beneficial to anyone?

This just goes to show that sometimes the scientific foresight of complex theories can cloud our perspective of what is right in front of us. Sometimes people do their greatest damage when they have the best of intentions.

Part 5: Demerit Costs and Externalities

Demerits

            Demerits are perhaps the most controversial from of government intervention. The thesis of the intervention proposed is usually ethical in nature. To prevent the people from harming themselves. However, the result is usually antithetical to the intention. 

               Demerits are generally this notion that you cannot make choices for yourself, a good example of this is prohibition, where price controls were imposed via excessive taxes. These price controls did not work and only proliferated black market operations, operations which fueled organized crime and gang violence.

Externalities Argument

The government may intervene in a variety of ways, but there is generally one constant, to save the system from poor externalities. As a result of some free-market wrongdoing some innocent fellow has been mal-affected. So, the politician says he must saved from this unfortunate circumstance.

However, what this particular politician fails to realize is that in the act of saving this particular individual the government has created another externality. Namely, anyone who pays taxes for these solutions - or pays for goods which have increased in price due to price controls are externalities of Government Policy, and as a general rule, those externalities resulting from government policy tend to be greater in both size and severity of affliction, than the supposed externalities the government are trying to free from harm.

 

Conclusion

            If you accept the notion that the free market establishes prices as the most efficient utilization of resources, then by that admission alone, you must admit that establishing price controls can have nothing other than a net detrimental effect.

The Keynesian/Humanist does not address the issue of economics in totality, rather, only looks at the explicit benefit rather than the implicit harm. The Austrian theory is more complete in this sense because it concludes that the implicit harm must exist from first principles. This can be seen as the Keynesian underestimating or ignoring altogether the opportunity costs of their actions.