Research & Policy Briefs From the World Bank Malaysia Hub No. 56 May 24, 2022 Temporary Price Controls as a Second-Best Option to Control Sudden Spikes in the Prices of Basic Necessities Undral Batmunkh and Tobias Pfutze Given rising inflation, governments around the world may be considering price controls. While inefficient in most cases and often costly, price controls may be warranted under certain circumstances to avoid sudden price spikes in staples, such as food items and fuel. Short-term price controls may play an important role in keeping inflation expectations in check. Such controls need to be carefully designed. In most cases, they should be temporary and limited to goods that make up a large share in the overall consumption expenditure, especially in that of poor households. Direct transfers to poor households and firms, once the relevant digital infrastructure is in place, are a better alternative to alleviate the pain from the price shocks without distorting price signals or subsidizing the wealthy. The Theoretical Case for Well-Designed Price Controls Standard economic thinking views price controls as mostly inefficient because they result either in market shortages or Governments impose price controls for a number of reasons. substantial public expenditures. Moreover, the subsidy will For example, price floors (minimum prices) are sometimes necessarily benefit the well-off as well as poor households. For used to favor certain producers or to protect industries seen as goods such as gasoline, the subsidy may even be regressive strategic. However, the most common practice is the use of (benefit the better-off more than the not-so-well-off) if richer price ceilings (maximum prices) to keep prices of goods households spend a larger share of their income on the good deemed to be basic necessities, such as staple food items and than poorer ones. For that reason, direct cash payments to fuels, low to protect consumers. Basic economic theory poor households are considered a more efficient policy than suggests that binding price ceilings will result in shortages subsidies. A case in point is the approach taken by Indonesia, because producers will not be willing to produce as large a which replaced a costly fuel subsidy with a cash transfer quantity of the good at that price as consumers will demand. program. However, shortages can be avoided through subsidies paid to the producer or to the consumers. In some situations, however, price controls may constitute an efficient market intervention. One example would be an The effect of producer subsidies on shortages is illustrated effort to curb monopolistic market power, the rationale behind in figure 1. A binding price ceiling would result in a shortage as price controls on medicines in most advanced economies. A demand (D) exceeds supply (S) at that price. This shortage can case can also be made for keeping price volatility in check. Cash be avoided if producers are compensated with a subsidy, transfers to the poor are usually very static. So sudden spikes in shifting the supply curve from S to S’. In order to meet demand, the price of staple foods or fuel could still lead to widespread the per unit subsidy would far exceed the difference between impoverishment. Moreover, cash transfers can be inflationary. the price ceiling and the market equilibrium price, resulting in Unexpected bottlenecks in several crucial sectors have been substantial public expenditures. This converts the question of widely blamed for increased inflation during the second half of price control to a public expenditure problem. 2021. Given the concerns that higher inflation can become entrenched, short-term price controls may play an important role in keeping inflation expectations in check. Figure 1. Price Ceilings Can Result in Shortages, Which Can Be Corrected with a Subsidy The Actual Practice of Price Controls in the East Asia and Price S Pacific Region S’ This Research & Policy Brief examines the extent and nature of price controls in developing countries in the East Asia and Pacific (EAP) region as a case study to assess whether or not E1 Pseller they may have played a role in lowering headline inflation. Figure 2 shows the number of price-controlled product E0 subsidy categories for 11 countries in the region in comparison to other P0 per unit emerging markets and developing economies (EMDEs). The Pceiling median number of price controls on food and beverages in EAP E2 is 10, twice as high as the median for EMDEs (excluding the EAP shortage D countries). Similarly, the median number of price controls set on energy-related products is significantly higher in the 11 EAP QS Q0 QD Quantity countries than the rest of the EMDEs. Within the EAP countries, Malaysia and the Solomon Islands have the highest number of Source: Authors’ illustration. price controls on food items, while within the rest of the EMDEs Note: D = demand; E = equilibrium; P = price; Q = quantity; S = supply. Tunisia has the highest number of price controls (40). Affiliations: Undral Batmunkh is a research analyst in the World Bank Macroeconomics, Trade, and Investment Global Practice stationed in Ulaanbaatar, Mongolia. Tobias Pfutze is a senior economist in the World Bank East Asia and Pacific Chief Economist Office based in Kuala Lumpur, Malaysia. Acknowledgements: Aaditya Mattoo provided valuable comments. Objective and disclaimer: Research & Policy Briefs synthetize existing research and data to shed light on a useful and interesting question for policy debate. Research & Policy Briefs carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions are entirely those of the authors. They do not necessarily represent the views of the World Bank Group, its Executive Directors, or the governments they represent. Temporary Price Controls as a Second-Best Option to Control Sudden Spikes in the Prices of Basic Necessities Figure 2. Price Controls in East Asian and Pacific Countries Vary by Number and Type. Food & beverages Energy Others 30 26 25 25 20 15 10 10 5 5 5 3 0 China Fiji Indonesia Malaysia Mongolia Myanmar Philippines Samoa Solomon Thailand Vietnam EAP median EMDE Islands mediana Source: Authors’ compilations based on Global Economic Prospects January 2020 and inputs from country economist. Note: EAP = East Asia and Pacific; EMDE = emerging markets and developing economies. a. The EMDE median excludes the EAP countries. Looking more closely at the 11 EAP countries, figure 3 such a negative relationship between price controls and shows the aggregate number of price controls by more detailed inflation does exist. To shed light on this question, the inflation product categories. The figure presents the number of rates in the third and fourth quarter of 2021 were regressed on countries with any controls, the median number of controls in the number of price controls for a subset of countries for which countries that have at least one such control, and the total consistent data on both measures are available. Reliable number of controlled prices in all 11 countries. Controls for inflation numbers are available for 42 countries, of which 5 are petroleum products dominate, for both the number of in the EAP region. The parameter estimates on the number of countries and total number of controls, while only four price controls turned out to be highly statistically significant. countries have price controls on coal, gas, or electricity. For inflation in the third quarter of 2021, each price-controlled Controls on food and beverages are more varied. The highest item is estimated to have reduced inflation over the number of countries have price controls on dairy products three-month period by 0.076 percentage points (the average (milk, butter, and cream) and rice. Relatively few countries inflation for that period is around 1.8 percent). The control the price of fish and fish products. Overall, controls corresponding number of the last three months of 2021 is cover a wide array of products. 0.065 percentage points, but at a lower level of statistical significance. Figure 4 illustrates the third quarter results. The The Brief next examines whether the relatively large five included EAP countries lie entirely below the regression number of price controls in EAP may have played a role in its line, suggesting that some other factors are at play. However, subdued inflation during the second half of 2021, and whether the negative relationship holds at the global level. Figure 3. Prices of a Wide Variety of Products Are Controlled in East Asia and Pacific. Number of countries with price controls Median number of price controls Total number of price controls 40 38 36 35 31 30 26 25 20 17 16 16 15 12 10 9 9 7 7.5 6 7 6 5 5 5 4 5 4 4 5 2 3 0 Petroleum Milk, butter, Rice Various Water Sugar Fish and fish Coal, gas, products and cream cooking oils products and electricity Source: Authors’ compilations based on Global Economic Prospects January 2020 and inputs from country economist. 2 Research & Policy Brief No.56 inflationary pressure in Ulaanbaatar by 2 percentage points Figure 4. Price Controls Helped Tame Inflation at the Global Level, although Not in the East Asia and Pacific Region during these months, it created a lower base effect for the following year when the price was returned to its regular level 6 (figure 5). To limit the volatility caused by this base effect and Inflation Rate in Third Quarter of 2021 5 continue supporting households during the winter months, the price of coal briquettes has been halved since October 2021. 4 Nevertheless, given that the price of coal briquettes remains 3 higher than its level a year ago, it contributed 0.7 percentage 2 point to headline inflation in Ulaanbaatar as of March 2022. As 1 for the price of petroleum products, although it is not completely administered, tax reductions and subsidies for 0 petroleum importers kept domestic prices in check until -1 mid-2021. However, the contribution of the fuel price to -2 headline inflation in Ulaanbaatar quickly turned positive and 0 5 10 15 20 25 30 35 40 45 50 reached 2.6 percentage points by March 2022 amid rising Number of Price Controls global oil prices and the adoption of a new arrangement 95% Confidence Interval Regression Line whereby the domestic price would follow a six-month moving Other Countries East Asia and Pacific average of the global oil price. While the arrangement of a six-month moving average could smooth domestic price Source: Authors’ calculations based on Global Economic Prospects January 2020 volatility and reduce the cost of subsidy under a strict price and IMF data. control option, it is unfortunate that the timing coincided with rising global prices amid heightened geopolitical risks. A Case Study of Energy Price Controls in Mongolia An earlier initiative at price control, which was enacted from It is also instructive to look at a particular case study. In 2012 to 2016, eased inflationary pressures in the short term Mongolia, price control on energy— specifically, coal and but contributed to significant macroeconomic imbalances and petroleum products—had significant but varying implications costs to the Central Bank of Mongolia. Under the Price for price volatility. As of March 2022, headline inflation had Stabilization Program, the central bank provided soft loans accelerated to 14.4 percent nationwide and had reached 15.8 amounting to 5.3 percent of GDP (MNT 17 trillion, equivalent to percent in the capital of Ulaanbaatar. The higher price of coal US$632 million) to key producers to ensure sufficient supply of briquettes and petroleum products contributed 3.2 percentage key products including meat, flour, fuel, and construction points to that rise. From December 2020 to March 2021, the materials. While the program is estimated to have eased the administered price of coal briquettes in Mongolia was reduced supply-related factors of inflation (headline inflation declined by 75 percent as part of the measures to support households from around 15 percent in 2012 to around 8 percent in amid strict mobility restrictions related to the COVID-19 mid-2013), together with the other quasi-fiscal measures, it pandemic. While the temporary price reduction eased the contributed to rapid credit growth, increased demand for Figure 5. Despite Pandemic-Era Controls, Price Rises in Energy Added to Inflation in Mongolia 20 Price contribution of petroleum products Price contribution of coal briquette 16.6 15.8 Annual inflation 14.8 15 Central bank’s inflation target 10 Percent 5 0 0.7 0.7 0.7 0.67 -2.1 -1.4 -1.4 -2.1 -2.1 -2.1 -5 Oct Nov Dec 2021 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2022 Feb Mar Jan Jan Source: National Statistics Office, Bank of Mongolia, and World Bank staff estimations. Note: Central bank targets inflation at 6 percent within a band of ±2 percent. 3 Temporary Price Controls as a Second-Best Option to Control Sudden Spikes in the Prices of Basic Necessities Figure 6. Price Controls Enacted in Mongolia before the Pandemic Eased Inflationary Pressures in the Short Term but Contributed to Significant Macroeconomic Imbalances and Costs Change in nominal exchange rate of MNT/US$ 70 18 Credit growth 60 16 Annual inflation (right axis) 14 50 12 Percent Percent 40 10 30 8 20 6 10 4 0 2 -10 0 Source: Bank of Mongolia and World Bank staff estimations. Note: MNT/US$ = Mongolian tughriks to US dollars. imports, depreciation of the nominal exchange rate, and higher inflation. If inflation expectations are not well anchored, demand-driven inflationary pressures in the years that this may result in a permanently higher rate of inflation, with all followed (Doojav 2020).1 In fact, credit growth accelerated to the associated efficiency costs—including those stemming nearly 60 percent (year on year) in 2014. As demand for from the contractionary monetary policies needed to bring imports exceeded exports, the nominal exchange rate prices back down to previous levels. depreciated by 79 percent during 2013–16, the central bank’s foreign exchange reserves declined from US$4.1 billion in 2012 That said, caution needs to be exercised when to US$1.3 billion in 2016, and inflation reached 15 percent in implementing price controls. They run the risk of incurring high mid-2014 (figure 6). Moreover, according to KPMG (2018), efficiency costs due to price distortions and may lead to one-third of the price stabilization program was recorded as unaffordable fiscal costs. In the absence of subsidies, they can loss for the central bank. Finally, several administrative flaws, lead to severe shortages and possibly the emergence of black including weaker transparency and scrutiny of only a narrow markets. Except in monopolistic situations, they should not be group of debtors, also impaired implementation, KPMG used to fix prices below their long term, or average, equilibrium concluded. market price. Price ceilings should be set at levels that prevent sudden temporary price spikes but that are nonbinding (that is, Discussion and Conclusion above the market price) in normal times. They should also be limited to goods that make up a large share in the overall The bottom line is that while inefficient in most cases, under consumption expenditure, and especially in that of poor certain circumstances price controls may be warranted to avoid households. In any case, direct transfers to poor households sudden price spikes in basic necessities. Two considerations and firms, once the relevant digital infrastructure is in place, stand out. First, with the exception of gasoline, most such would alleviate the pain from the price shocks without products, like staple foods and cooking fuels, make up a larger distorting price signals or subsidizing the wealthy. share in the consumption basket of poorer households than richer ones. An abrupt and large increase in the prices of these products would thus hit poor households particularly hard, throwing them deeper into poverty. In the absence of highly dynamic social protection programs, price ceilings, while costly Notes to the public purse, constitute an effective measure of protection. 1In addition to the Price Stabilization Program, the central bank engaged in other quasi-fiscal activities totaling MNT7.2 trillion Second, since such goods make up a large part of the overall (US$3.9 billion using an average exchange rate or 32.6 percent consumption basket, sudden price spikes will feed directly into of GDP) during 2012–16. References Doojav, G. 2020. Development Path of Mongolia. Ulaanbaatar: Admon Print. KPMG, 2018. “Bank of Mongolia, Special Review of Quasi-Fiscal Policy Activities,” Ulaanbaatar, Mongolia. 4