Controlling the Market

Listener: 18 February, 1984

Keywords: Regulation & Taxation;

The current debate about controls and the market is not merely a question of ideology. Underlying it are analytic propositions about how markets work. Consider an uncontrolled market which settles on a price of $1 a unit at which suppliers sell 1000 units weekly and buyers purchase 1000 units. Now consider the Government imposing a price ceiling of, say, 90 cents. The effectiveness of the controls will in part be a result of how the suppliers and buyers react.

For instance, suppliers might be willing to sell 999 units for 90 cents, or they might be willing to sell only 500 units, Similarly, at the lower price, buyers might want 1001 units or 2000 units. Thus the amount that buyers want in comparison to the amount suppliers offer – economists call it excess demand – may be very small or very large (compared to total market transactions).

Clearly, the controls are more likely to work if the excess demand is small rather than large, which will depend on suppliers’ and buyers’ responses to prices. Economists measure these prices by ‘elasticities’. My impression is that those who advocate and apply controls and regulations to markets believe that the elasticities favour small excess demands. There may be some justification for this belief in a number of important markets. Anyway, let us concede this, and explore whether it follows that controls will work.

The first thing to note is that a small weekly excess demand may accumulate over a year into a sizeable gap. Secondly, while buyers and sellers may not respond much in the short run, their response may be much greater in the long run. A small weekly excess demand when controls are first imposed may be substantial some time later when everyone learns to adapt. So the first lesson I conclude is that controls will be most effective if they are not applied for too long.

The second problem is that market controls require adherence to laws and regulations. In a law-abiding country such as New Zealand, this may not seem serious. Nevertheless, every time laws are imposed which are considered ‘unfair’ there is a tendency for us to become less law-abiding. I conclude that for economic control to be effective it needs to be widely accepted.

Of course, while the letter of the law may he adhered to, the spirit may not. My impression is that 40 years ago there was not a lot of activity designed to get around controls. The managers of today appear to be more vigorous and ingenious. I suspect one cause is the greater challenge of international markets. Selling in the Middle East, Japan, or wherever, requires a high degree of initiative and innovation. Internal competition and technological change also encourage these skills. Note that a major cost of regulation and control may be skills required for international marketing, technological innovation, and growth being diverted to regulation avoidance.

As the November interest rate measures show, it is not easy to enact in legal form comprehensive and consistent regulations. Many of the most powerful concepts of economics are abstractions from a reality. For instance, so apparently simple a concept as income has some ambiguities. Typically, economic analysis avoids such ambiguities, but lawyers need an additional degree of precision. Regulations, often imposed in a hurry, do not always attain such precision. Nor would I expect them to. But the consequence is that the regulations have to he amended over and over again, as loopholes are identified and the regulations are avoided.

One solution is the dictator’s ‘Thou shall not transact in this market without express (and perhaps arbitrary) approval from the authorities’. Outside the dictatorship, regulations tend to be ad hoc, lack comprehensiveness, and be unfair. Moreover, the continuing amendments and further interventions to correct these deficiencies mean that economic management can drift in the direction of dictatorship. Considerations such as these are the political and ideological objections to regulation.

Nevertheless, some regulations have been successful, and it would only be an ideological extremist who would argue that they should never be used. But when should they be used? Some time ago Norm Thomson, of the University of Adelaide, and I tried to answer the question in our textbook An Introduction to the New Zealand Economy:

‘Instruments which divert the economy from the free market economy are likely to be effective without great loss of efficiency if:

1. the diversion is not great,

2. a maximum use of the market mechanism is associated with them (eg [near] market interest rates for securities in captive reserves, the auctioning of import licences and so on),

3. the costs of enforcement are not high and the means of avoidance are not easy,

4. their application is even-handed and comprehensive (which limits opportunities for avoidance),

5. there is public acceptance of their need, and

6. they are not expected to be effective for too long a period.’

I am not sure that our law-makers have read the book.