Front Page Titles (by Subject) Chapter XII: STATE REGULATION OF COMPETITIVE PRICES - The Economics of Welfare
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Chapter XII: STATE REGULATION OF COMPETITIVE PRICES - Arthur Cecil Pigou, The Economics of Welfare 
The Economics of Welfare (4th ed.) (London: Macmillan, 1932).
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STATE REGULATION OF COMPETITIVE PRICES
§ 1. THE preceding discussion seems at first sight to prove that, apart from divergences between private and social net product, State interference, designed to modify in any way the working of free competition, is bound to injure the national dividend; for this competition left to itself will continually push resources from points of lower productivity (in terms of economic satisfaction as measured in money) to points of higher productivity, thus tending always away from less favourable, and towards more favourable, arrangements of the community's resources. We have now to confront this general presumption with the extensive policy of price regulation which was followed by the British, as by most other Governments, during the course of the great European War. I propose first to give a general account of that policy and then to inquire how far, if at all, the experience gained should modify the conclusions reached in preceding chapters.
§ 2. Broadly put, the position was as follows. The war caused in two ways a great shortage in certain things. On the one hand, for munition articles, army clothes and so forth, there was an enormous new Government demand much in excess of normal supplies. On the other hand, for various articles of ordinary civilian use, the contraction of available tonnage and the withdrawal of labour for the army and munition work caused supplies to fall much below the normal. The shortage brought about in one or other of these ways put it in the power of persons who happened to hold stocks of short commodities, or to be able to produce them quickly, to charge for them prices very much higher than usual. When the shortage was due to increased Government demand, the scale of business done by these persons being as large as, or larger than, before, the high prices that they were enabled to charge necessarily yielded them abnormally large profits. When it was due to contraction of supply (e.g. through the withdrawal of labour or other obstacles to output), the gain from high prices might be cancelled by loss due to lessened sales; so that abnormally large profits were not obtained. For a great number of things, however, the conditions of demand are such that a shortage of, say, 10 per cent in the supply causes the price offered by purchasers to rise by much more than 10 per cent. For the sellers of articles of this class the shortage, even when it was due to a supply contraction, often meant abnormal profits. Of course, some of these abnormal profits were more apparent than real, for, if prices all round are doubled, a doubling of money profits will only enable a man to get the same amount of things as before. Very often, however, the money profits were enhanced very much more than in proportion to the rise in general prices. Wherever this happened, certain specially favoured persons were benefiting greatly as a direct consequence of the war. This state of things naturally caused resentment, and suggested State interference.
§ 3. This interference might follow either of two principal lines. On the one hand, fortunately situated sellers might be allowed to charge such prices as the market would bear, thus collecting abnormal profits in the first instance; but, thereafter, be deprived of the bulk of these for the benefit of the Exchequer by a high excess profits tax. On the other hand, the prices they were allowed to charge might be limited by authority to rates at which it was estimated that abnormal profits would not accrue to them. Apart from points of technique and administration, the choice between these two plans makes no difference to the fortunately situated seller. But it does make a difference to the people who happen to need the particular goods or services that he sells. For, whereas under the maximum price plan they are left untouched, under the excess profits plan a special levy is, in effect, placed upon them for the benefit of the general taxpayers. It follows that, where the taxpayers themselves, through the Government, are the principal buyers, or where the public are buyers more or less in the proportion in which they are taxpayers, it does not greatly matter which of the two plans is chosen. But where, as with all the staple articles of food, poor people play a much larger part, compared with rich people, as buyers of an article which is short than they play as taxpayers, it does greatly matter. For, if the State were to adopt the excess profits plan in preference to the maximum prices plan, it would be relieving the well-to-do of a large block of taxation, and throwing it, by a roundabout and semi-secret process, upon the shoulders of the poor. Whatever might be thought of the desirability of exacting a larger contribution to the expenses of the war from relatively poor persons, it was obvious that a device of that kind would never be tolerated. Consequently, over a large part of the field, the excess profits plan could not practically be made the main engine for preventing fortunately situated sellers from making fortunes out of the war. Resort had of necessity to be had to the plan of maximum prices.
§ 4. In the actual working out of that plan, a great number of difficulties emerged, which it will be well to set out in order. The first of these was the difficulty of definition. The same name often covers a great variety of different qualities of article, which it may be extremely hard to disentangle in any formal schedule. When this condition prevails it is impossible to exercise control over prices by general rules, and it becomes necessary to fall back upon the cumbrous device of individual appraisement. Thus, under the Raw Cocoa Order of March 1918, it was laid down that no raw cocoa might be sold except at "a fair value," this fair value being determined by a person authorised by the Food Controller to determine the grade of the various lots of cocoa. A similar plan was adopted at the end of 1917 for controlling the prices of cattle and sheep sold by live weight at market. Obviously, however, this plan could not be employed on a large scale, owing to the vast amount of labour that it involves. Consequently, in general, some modification of it was essential, and some general classification of grades had, in spite of the openings for evasion that this permits, to be, in one way or another, relied upon.
A second difficulty, when the problem of defining grades of quality was overcome, resulted from the mere fact that grades were often very numerous. The task of fixing prices directly for a great variety of these might well be more than any authority, at all events in the earlier stages of its operation, was prepared to enter upon. When there were only a few grades, it was comparatively easy, with the help of advice from experts, to do this; but, when there were a great many, it was thought better to rely, not on a schedule of maximum prices, but on a general Order determining the relations between the prices that might be charged in the future and those that had been charged in the past. An example of this plan was the Order of the Ministry of Munitions, issued in August 1916, by which sellers of machine tools were forbidden, except with the sanction of the Minister, henceforward to charge prices higher than they were charging in July 1915.
An analogous difficulty had to be faced when a commodity, about the grading of which, perhaps, there was no need to trouble, was produced under different conditions in a number of different localities, in such wise that a single maximum price would not treat different producers fairly. Here, too, inability to construct a schedule as varied as the circumstances required forced the controlling authority to fall back on the plan of fixing, not future prices themselves, but the relation between future prices and past prices. Thus, in May 1917, an Order was issued that no imported soft wood should be sold at prices above those that ruled in each several locality in the week ending 31st January 1917. This Order was subsequently modified as regards imports from Scandinavia; but with that we are not concerned.
So far it has been tacitly assumed that the maximum price aimed at for any one commodity of a given grade is a single price. For some commodities, however, no one uniform price ruling throughout the year is adapted to the conditions of their production and sale, and a series of maxima is needed. Plainly, a series is more difficult to determine correctly than a single price. Consequently, here again the controlling authority was driven to the method of regulating the relation between future and past prices. Thus, in July 1917, it was ordered that the wholesale price of milk per imperial gallon should not henceforward anywhere exceed by more than 6½d. the price charged in the corresponding month a year before, and that the retail price per imperial quart should not exceed this corresponding price by more than 2d. The same plan was followed in the Price of Coal (Limitation) Act of 1915, which decreed that no colliery company should charge a price exceeding by more than 4s. (afterwards raised to 6s. 6d.) the price charged on a similar sale at a similar date in 1913-14.
Plainly, all these indirect and roundabout methods of control left the way open for evasion and were likely to prove difficult to enforce. Consequently, controlling authorities, as they got a better grip and better knowledge of the conditions of various industries, tried to step forward to the more precise method of maximum price schedules. More and more this became the predominant plan. The producers' and wholesalers' prices of most of the more important articles of food came to be fixed directly by schedule, as were also the prices of most of the commodities controlled by the Ministry of Munitions. For most things it was found sufficient to set up a single schedule. But sometimes different producers' prices were fixed for different parts of the country. For hay, for example, Scotland was given one price, England another. Sometimes, too, a series of schedules were set up to apply to different parts of the year. For potatoes the Order of February 1917 fixed one price up till March 31st, and another higher price after that date; and for peas and beans an Order of May 1917 fixed three prices, diminishing in amount, for sales in June, July and later months. Similarly for wheat, oats and barley, to be harvested in the United Kingdom, the Food Controller, in August 1917, fixed a series of prices rising gradually in each successive two months from November 1917 on to June 1918. A later Order fixing maximum milk prices made a similar differentiation between different parts of the year. It is plain that the direct establishment of maximum prices is, if the appropriate prices can once be worked out satisfactorily, likely to prove much more effective than any roundabout plan.
So far we have only taken account of industries so simply organised that the producers sell a finished product direct, without any intermediary, to ultimate consumers. In most industries, however, there are several stages between the original material or service and the finished product in consumers' hands. This fact gives rise to further problems. The conditions of demand for any finished product being given, when an artificial price is fixed for any material or service used in the course of making and selling it, the price of the finished product need not be lowered correspondingly, but it is in the power of other persons in a line between the provider of this material or service and the finished product to add on to their charges the equivalent of whatever has been knocked off the charges of the regulated sellers. Thus, if the price of coal at the pit-mouth were reduced by State action, and nothing else were done, the only effect might be that dealers in coal could buy more cheaply while retaining the old price of sale. Again, if the price of cattle were forced down, and nothing else done, retail prices might remain unaltered, while butchers and meat dealers gained enormously. Yet again, if freight-rates on imported materials were kept artificially low by Government action, the various people who use these materials in their industries might get the whole benefit. Nor is it merely possible that this might happen. In general it would happen, except in so far as the people, on whom a power of exaction was thus conferred, deliberately from patriotic motives, or from fear of popular resentment, decided to forgo their advantage. In order to prevent this, the fixing of maximum prices at the earlier stages of production had to be coupled with control over the profits which manufacturers or dealers at a later stage may make by adding further charges on to these prices. One way in which this control was exercised was by limiting the percentage addition that might be made by any seller in the line. In May 1917, for example, it was decreed that no timber from Russia should be sold at an advance of more than 10 per cent on the purchase price; and in September 1917 a schedule of prices for fish was fixed as between fish-curers and wholesale dealers, and other sellers (with the exception of retailers) were prohibited from adding more than 10 per cent on to the scheduled prices. More usually it was not the percentage, but the amount, of addition that was limited. Thus, under the Cheese Order of August 1917, first-hand prices of various sorts of British-made cheese were fixed as from the maker, and it was provided that no dealer other than the maker should add on to them more than the actual charge for transport plus, in general, 6s. per cwt. In October it was provided further that retailers should not add on to the prices actually paid by them more than 2½d. per lb. In the same month the prices of the various sorts of leather were regulated on the same general plan. In like manner the price of horse and poultry mixture was controlled, in November 1917, by an Order forbidding the maker to charge a price exceeding the cost to him of his ingredients by more than £1:10s. per ton; and the amount that other sellers might add on was limited to 1s. per cwt. on sales of 6 cwt. and more, 3s. per cwt. on sales of from 3 to 6 cwt., and so on. In meat a variant on this plan was adopted, in the first instance, on account of difficulties due to the custom among retailers of obtaining different proportions of their profit from the sale of different joints. In an Order of September 1917 it was laid down that no person shall in any fortnight sell meat by retail at such prices as cause the aggregate price received by him to exceed actual costs to him by more than a prescribed percentage (20 per cent or 2½d. per lb., whichever shall be less). In August 1917 a rule on similar lines was laid down for retailers of bacon and hams.
It is evident that plans of this kind for controlling the charges to be made at the later stages of a commodity's progress to the consumer suffer from the same sort of disadvantage that roundabout attempts to control producers' charges suffer from. They are liable to evasion. Consequently, the controlling authorities sought, as they became more masters of their work, to evolve some more satisfactory arrangement. One stage in this evolution is illustrated by the Butter Prices Order of August 1917. In that Order it was laid down that retailers should not add to the price of butter sold by them more than 2½d. per lb. above the actual cost of it to them; but it was provided further that local Food Control Committees might prescribe a scale of maximum retail prices in accordance with the general directions of the Order (which includes rules about maker's, importer's and wholesaler's prices), although conformity with that scale should not relieve any retailer from the obligation not to add on more than 2½d. per lb. A slightly more advanced stage is illustrated by the plan adopted for regulating the retail prices of coal. The general principle was laid down that retailers should not add on to their own purchase price more than 1s. per ton over and above the costs of actual handling and dealing with the coal (including office expenses apart from the trader's own salary). But this principle was not left, as it were, in the air. It was provided that local authorities, after consultation and inquiry, should work it out and apply it in the form of a definite list of retail prices applicable to their district. Yet a further stage is reached when the controlling authority itself fixes lists of maximum prices at more than one point on the way from production to consumption. The Potato Order of September 1917 was of this type. Maximum prices were fixed for growers; wholesale dealers were forbidden to sell in any week at prices that yielded them more than 7s. 6d. a ton beyond their total costs on all purchases of potatoes—costs which varied with the transport conditions of different districts; and an elaborate scale of retail prices was fixed, which related the permitted price per lb. to the price per cwt., including price of transport, that the retailer had actually paid for different classes of potatoes. The final stage is reached when definite schedules are fixed throughout—for producer, wholesaler and retailer equally—by the controlling authority itself. This was the arrangement to which the Ministry of Food steadily progressed. It was definitely attained in regard to British onions, most sorts of fish, beef and mutton, fruit for jam and jam, peas and beans, and hay, oats and wheat straw. Lest, through imperfect knowledge, the special circumstances of particular districts should have been neglected in the construction of these scales, a safeguard was sometimes provided in the form of a rule empowering local Food Committees, with the sanction of the Food Controller, to vary the maxima in their district. This provision was introduced into the Order of January 1918 fixing maximum prices for rabbits. In like manner it was provided in an Order of September 1917, that, where the Food Controller or a local Food Committee was satisfied that, by reason of some exceptional circumstance, flour or bread could not be sold by retail at the official maximum price "so as to yield a reasonable profit," a licence might be issued, either for the whole or for a part of any Committee's area, permitting higher prices to be charged. The Order of January 1918, fixing a schedule of maximum prices for most kinds of fish, was made subject, as regards retail prices, to similar local revision, as was also the Milk Prices Order of March 1918. A like power of varying local retail prices, with the sanction of the Food Controller, was accorded to the local Food Committees under the Potato Prices Order of September 1917.
Hitherto attention has been confined to commodities that come into the consumer's hands in much the same form as that in which they leave the hands of producers. Further complications are introduced when we have to do with raw materials that are worked up into elaborately finished articles. Here, owing to the various parts which the raw material plays in different types and grades of finished goods, it is not generally possible to fix schedules of prices beyond the raw material. Consequently, for two important articles, boots and clothes, an ingenious roundabout plan was adopted. An attempt was made to induce or compel manufacturers to devote a considerable part of their plant to making "standard articles" to be sold at prices calculated on a basis of conversion costs, in the hope that the competition of these articles in the market would indirectly keep down the price that it was profitable to charge for similar articles that were not standardised. In boots, manufacturers were ordered to devote one-third of that part of their plant which was engaged on civilian work to making "standard boots." In clothes, no fixed proportion of plant was forced into making standard goods, but manufacturers were tempted to take up this kind of work by relatively favourable treatment in the matter of the quota of raw wool allowed to them. In cotton goods, though the price of raw cotton was artificially controlled, no corresponding control of the finished commodity was attempted, the argument being that cotton manufacturers were sufficiently burdened by having to provide a special levy to pay benefit to workpeople thrown out of work by the reduction in the number of spindles and looms that might be operated.
§ 5. The foregoing account of the difficulties encountered and the expedients employed in the exercise of price control suggests a question of some theoretical interest. It is plain enough that, in the earlier stages of control, practical considerations make it necessary to begin at the producer's, rather than the retailer's, end; for the local differentiations needed in a retail schedule are generally much more serious and require much more knowledge to allow of their being fairly made. As has been shown, however, as the controlling authority became more expert and got a better grip on its industries, it tended to make price schedules all along the line from the producer to the final seller. Thus, in the end, retail maximum prices often were fixed. The point in doubt is whether, when this has all been arranged, there is any real need to continue the earlier stages of control. Will not maximum retail prices be reflected back all along the line, and so automatically stop "profiteering" at earlier stages? The view that this will be so seems to have guided the work of some of the Ministry of Food's controls. For example, the prices of turnips and swedes were regulated by a rule that nobody might sell them for more than 1½d. per lb., and the price of chocolates and sweets by a rule that nobody might sell them for more than 3d. per oz. and 2d. per oz. respectively. In general, however, it was thought better to maintain price schedules at the earlier stages, separate from, and adjusted to, the retail maxima. In a world of pure competition it does not appear that this would really have been necessary. If the retail maxima were rightly arranged, everybody in line would automatically be forced to charge prices that yielded them about the ordinary rate of profits. The artificial restriction upon retail price would act in exactly the same way as a fall in the public demand for the commodity sufficient to counteract the shortage of supply. It is probable, however, that this adjustment would not, in real life, be made without a certain amount of friction, and that some of the traders affected might be in a position to exercise quasi-monopolistic pressure against particular shopkeepers or others who happened to be mainly dependent on them. Consequently, when schedules of maximum prices for the earlier stages had already been worked out, to drop them, in the hope that the retailers' schedules subsequently superimposed would by themselves achieve the whole of the ends desired, would probably have been unwise.
§ 6. We have now to consider the broad analytical problem which these expedients of war time suggest. What exactly is to be said of the relation between the kind of price regulation that was then attempted and the size of the national dividend? The great upheaval of the war had caused the existing distribution of resources to be uneconomic, in the sense that the value of the marginal net product (social and private alike) of those employed in making certain specially scarce articles was abnormally high. Apart from outside interference abnormal values of marginal net products mean abnormal returns to the investor; and these abnormal returns tend to draw resources from occupations of relatively low productivity to those occupations of greater productivity in which they rule. When prices are cut down by law, the value of the marginal net product of any given quantity of resources in any occupation is, indeed, necessarily cut down also, because we have defined this value as the marginal physical net product multiplied by the realised price. Plainly, however, this definition tacitly assumes the realised price to be identical with the demand price. When these two are artificially divorced, our definition must be changed. The values of the marginal net products of resources, which it is to the interest of the national dividend to make equal everywhere, consist in the marginal physical net products multiplied by the demand prices. When this is understood, it is evident that an artificial reduction of price, while lowering returns in the industry affected by it, leaves the true value of the marginal net product of any quantity of resources invested there unchanged. The desirability, from the standpoint of the national dividend, of a transference of resources is thus unaltered, while the principal influence tending to bring it about is weakened. To put the same point in more general terms, any external limitation imposed on the price of an article produced under competitive conditions (i.e. otherwise than by a monopolist) must lessen the inducement that people have to make that article. Normally it is just through high prices and high profits that a shortage of anything corrects itself. The prospect of exceptional gain directs free resources into the industry which makes the thing that is short. Cut off this prospect, and that increase of supply, which the interest of the national dividend demands, will be checked, and checked more severely the greater is the cut made from the "natural" price.
§ 7. In the special circumstances of the Great War this injurious tendency of price limitation was largely counteracted by other influences. For the State itself, in many departments of industry, took over the task of allocating resources among different occupations. It built up munition works, controlled shipbuilding, and urged on agricultural production by the promise of land, tractors, and labour drawn from the Army. Thus, though price regulation might weaken the directive force normally exercised by economic motives, the task of direction was taken over by another and more powerful agency. No doubt, had prices in any occupation been artificially pushed down so low that profits to the "representative" firm fell actually below the ordinary money level, capital and labour would have gone elsewhere in spite of government pressure. But, of course, prices were not artificially pushed down to this extent in any occupation. On the contrary, complaint was often made that they were left high enough to yield abnormally large profits, not merely to firms that could fairly be regarded as "representative," but even to those very weak and inefficient firms which, in the ordinary course, would have been making losses and decaying out of business.25 On the whole, therefore, we may conclude that, as things were, in view of the abnormal activity of the State, and, it should be added, of the effectiveness of appeals to patriotism, price control in the peculiar circumstances of the war probably caused very little damage to the volume of the national dividend.
§ 8. It would, however, be a great error to infer from this that a general permanent policy of control, designed to prevent groups of producers from reaping abnormal profit on occasions when the conditions of the market give them power to do so, would be equally innocuous. People, in choosing their investments, take account of these ups and downs, and, so far as their judgment is correct, place their resources in such a way that, on the average and on the whole, the marginal yield works out about equally in different occupations. In these circumstances it is obvious that any general State policy of cutting down prices in any industry below the competitive level, on occasions when the conditions of demand and supply would enable that industry to obtain exceptional profits, must, in effect, penalise it as compared with stable industries. For, if, in a hilly district where the average level of peaks and valleys is the same as it is on a plateau, the tops of the peaks are removed, the average level there will, of course, be reduced below that of the plateau. The discouraging effect of this differential action cannot be made good by any direct manipulation of production by the State. For here we have to do, not merely with a tendency for free resources to go elsewhere at the time when the régime of price control is at work, but with a tendency that operates continually and checks the general flow of resources that would otherwise seek investment in building up the permanent equipment of the threatened industry. If, for example, this country adopted a general policy of forbidding farmers to charge high prices when they have power to do so on account of a bad world harvest, this would check investment in British agriculture; because people expect bad world harvests from time to time and look to high prices then to set against low prices in bumper years. While, therefore, on the one hand, our analysis does not imply that the policy of price limitation adopted in the abnormal circumstances of the war worked injury to the national dividend, on the other hand, the experience of the war gives no ground for doubting that a general permanent policy of price limitation, in non-monopolised industries, would produce this effect. This conclusion is, of course, subject to the considerations set out in the preceding chapter. It is subject, too, to the qualification that, if maximum prices are fixed so high as to leave all ordinary sales unaffected and merely to protect an occasional weak purchaser from exploitation by unscrupulous dealers, they will not interfere with the way in which resources are distributed between different uses, and will not, therefore, injure the national dividend. Moreover, if State interference to prevent any group of producers from making excessive earnings in good times were balanced by interference to prevent them from making abnormally low earnings in bad times, the net result, though it would necessarily involve a redistribution of their production between good times and bad, would not necessarily involve a contraction in the aggregate amount of their production.
[25.] It might have proved practicable to fix prices at a considerably lower level if the good and bad firms had been formed into a kind of pool, and the objective sought been normal profits for the pool as a whole. Professor Taussig has pointed out that, before an arrangement of this kind could be worked, very serious administrative difficulties would have to be overcome and an elaborate system of detailed costings set up (Quarterly Journal of Economics, Feb. 1919). Besides this technical objection, there is the further more general objection that efficient management in individual firms would be very greatly discouraged, since it would reap very little reward.