Price Controls and Subsidies Distort Markets: Sugar Edition

From today’s Star (excerpts):

Sugar woes

PETALING JAYA: There is an acute shortage of sugar in the country.

Consumers and traders in several states have voiced their frustration in getting supply of the essential commodity, describing the shortage as the “worst so far”.

A check at several grocery shops here revealed that no sugar had been on sale for over a week…

…Fomca secretary-general Muhd Sha’ani Abdullah said it had received complaints in various areas including Kuantan, Muar, Klang and Temerloh since a month ago.

He said the problem was not due to retailers hoarding sugar but the smuggling of the item to other countries, especially Thailand.

Federation of Sundry Goods Merchants president Lean Hing Chuan said the shortage nationwide was caused by manufacturers halving production, adding that its members started noticing the slowdown in April.

“Factories might be slowing down their production to keep their costs down until subsidies for sugar are withdrawn,” Lean said.

It’s hard to describe in words, so here’s the classical theory (Econ 101)in graphical form (I’m learning how to use Paint!):

The vertical axis represents price, while the horizontal axis  represents volume. The “A” (blue) line represents the supply schedule i.e. the volume that producers are willing to supply at any given price. As the price goes up, producers are willing to produce and supply more of a good to the market. The “D” (red) line represents the amount that consumers are willing to buy at any given price. As price goes up, people are less willing to consume a particular good, or equivalently, less people are able to afford a particular good. In either case, demand falls as price rises. P1 represents the prevailing equilibrium price at which demand exactly meets supply, and volume of X1 is transacted between producers and consumers.

So far so good – this is a fairly common sense view of what happens in the market for any “normal” good. The underlying assumptions are of course that there are many producers who are able to instantaneously adjust production according to price and demand, there are no barriers to market entry for either producers or consumers, the market and the price are visible and accessible to all, and there are no transactions costs. You can drop any or all of these assumptions without necessarily detracting from the insights gained from the subsequent analysis.

So what happens when the government provides a production subsidy? Since a subsidy reduces the cost of production, the entire supply schedule shifts to the right and down:

The supply schedule “A” drops to “B”, and a new equilibrium price is established at P2 where a volume of X2 is supplied. In the case of sugar, a production subsidy effectively means greater production, a lower market price, and greater consumption relative to the original market equilibrium. As costs of production are lower, more firms are able to enter the market, and marginal firms (those who would otherwise have gone bust because they are inefficient) are able to survive.

So while we have greater production, it is at the cost of misallocation of resources because of the embedded inefficiency of production that is covered by the subsidy. This can actually be calculated by the area of the triangle between the intersections of the price and volume lines, and the demand curve. That area represents a net loss to social welfare, as the money could have been used for more productive uses, or to reduce government spending and thus the tax burden. To put it in more understandable layman terms, the amount of subsidy required per unit of output will almost always exceed the drop in price achieved.

There are also negative externalities involved which are not covered by the market price or production costs, as excess consumption of sugar leads to health costs through a higher incidence of diabetes and obesity.

What happens when price controls are added to the mix? You get a really, really bad distortion of market price, demand and production:

Let’s say the government puts the price ceiling at P3, which is lower than either the original market price P1, or the subsidy induced price of P2. The retail market price will always converge to P3 – given the demand and supply curves as drawn, the price can never drop below P3, as it is uneconomical for producers to increase supply large enough for the market price to fall lower than that. So at P3, demand zooms to P4 as more and more people can afford to buy sugar, with the concomitant increase in the cost of negative externalities to society in the shape of increasing health costs.

But also at P3, the aforementioned marginal producers are out of the business as even with the subsidy previously given, their cost of production is so much higher. Other producers who could have survived even at the original equilibrium market price are also out of the business, again because their costs now exceeds potential revenues. So we have a contraction in supply to X3 – which means that there will be a permanent excess of demand and a permanent shortfall in supply. The bigger the difference between the equilibrium price (subsidy-supported or original), the bigger the shortfall will be. And the controlled price of sugar in Malaysia is a full third lower than the market price currently prevailing in our neighbours.

The only way for the government to ensure that demand meets supply at price control level P3 is to provide a subsidy that drops the supply curve to the point where the demand schedule meets P3. This is not the equivalent of a price subsidy equal to the difference between P1 and P3, which is what most people think is sufficient, but rather the difference between P4 and P3 which is an order of magnitude higher. Assuming a 45 degree angle for the supply curve, that’s equivalent to double the subsidy level from P1 and P3.

If you add intertemporal lags to changing production output (i.e. assuming a short-term inelastic supply curve), then the level of subsidy would be that much greater, as the slope of the supply curve would be steeper. A subsidy that is less than that provides an incentive for producers to hawk their produce outside the country, as they can gain more revenue for a given supply.

So what you get with production subsidies is an expansion in both supply and consumption, but at the cost of inefficient use of resources and lower productivity. What you get with price controls is much worse, with the spectre of permanently decreasing production and a constant shortfall relative to demand. And as time goes on, the situation deteriorates, as consumers feel “entitled” and as more and more producers quit the industry.

That’s the narrative that’s playing out here in Malaysia today, not just in sugar, but in rice, vegetables, and all the other items that the government cares to cap prices on in the name of consumer protection.