The Russian state corporation Gasprom has dramatically reduced the supply of natural gas to Europe to punish European states for their support of Ukraine. This affects the price of electricity in Europe, of which a large proportion is produced by gas turbines. Gas is also used directly for heating many European homes.

Even before the cut in Russian supplies, prices of gas and electricity in the world had increased because of high demand after the COVID episode and little supply growth following a period of lower investment. Now, some European national governments have instituted new price ceilings on gas and electricity purchased by households and small and medium businesses.

After meeting on October 20–21, the Council of the European Union formally called for an EU effort to cap the price of gas, including a lower cap on its price in electricity generation, and a possible common cartel agreement to pay lower prices for wholesale gas purchased from producers in foreign countries. The legal verbiage of the Council is indicative of its large and contradictory ambitions. The same document describes one of its goals as

mobilising relevant tools at national and EU level. At the same time, the immediate priority is to protect households and businesses, in particular the most vulnerable in our societies. … All relevant tools at national and EU level should be mobilised to enhance the resilience of our economies, while preserving Europe’s global competitiveness and maintaining the level playing field and the integrity of the Single Market. … The Council … is committed to further reinforce our coordination, in order to deliver a determined and agile policy response.

Political factors will have a decisive influence on whatever legislation the EU ultimately adopts toward these ends. But the current intentions provide a good opportunity to review the economic effects of price caps.

Demand and supply of energy / Recall from economic theory that, on a competitive market, if a price is capped below its equilibrium level where quantity supplied is equal to quantity demanded, the former decreases and the latter increases. A shortage in the technical sense develops. (See “Dispelling Supply Chain Myths,” Summer 2022.)

Some people think that energy products are somehow not vulnerable to this because they are “essential”—that, because energy is so important, people can little moderate their consumption of it. But what is “essential” is a matter of degree. A 2018 working paper by University of California at Berkeley economists Maximilian Auffhammer and Edward Rubin estimates the elasticity of demand (the proportional change in quantity demanded relative to a proportional change in price) for natural gas in California at about –0.2, meaning that a 10% increase in the price will reduce quantity demanded by 2% over a year. The demand for gas is relatively “inelastic,” but a price increase still brings a lower quantity demanded. More recently, in the wake of higher industrial power prices, the Financial Times reported a 30% reduction in the industrial use of energy in the Netherlands for the first five months of 2022. A reduction of the same order by German households was also observed.

To prevent shortages and blackouts, European states imposing price caps for some buyers have paired them with subsidies to producers of gas and gas-produced electricity. Part of these subsidies is financed with taxes on so-called “windfall” profits of energy producers, including non-gas producers such as solar and wind, which have also benefited from higher energy prices as prices of substitutes move together. Of course, energy producers that get their “excess” profits taxed away because their past investments are bringing higher returns than expected will take into consideration this asymmetry between upside and downside risk when planning their future investments.

Crucial function of prices / At the source of the detrimental effects of price controls is the fact that they disrupt the signaling and coordination function of prices. A price is a signaling device that informs buyers and sellers of the relative scarcity of the good (or service) in question.

In his famed 1945 American Economic Review article “The Use of Knowledge in Society,” economist Friedrich Hayek gave a useful illustration of the role of prices. Suppose, he explained (I am adapting his example), that the supply of bauxite (the ore used to make aluminum) decreases because of some events in mining somewhere in the world, or alternatively that its demand increases because, say, the consumption of beer in aluminum cans increases in some country. Aluminum thus has become relatively scarcer, and this fact must be communicated to the producers and consumers of aluminum everywhere, so that the latter be incited to consume less and the former to produce more. An increase in the price of aluminum will transmit this signal and matching incentives to reduce consumption and increase production.

Why socialism doesn’t work / True price signals are so important for prosperity that, in the first half of the 20th century, some socialist-minded economists developed a theory of “market socialism.” These economists were trying to respond to Ludwig von Mises, who had argued that efficient calculations of costs and benefits are impossible under socialism because there is no market-determined price for capital (the means of production, belonging to the government by hypothesis) and for labor services. Market socialists argued that the “Central Planning Board” could determine prices by a process of trial and error, until quantity supplied and quantity demanded is in equilibrium on every market.

Hayek countered that this will not work because the members of the Central Planning Board have no way to collect all the information dispersed across the minds of all individuals in all their personal and business circumstances. Nor can the planners recreate the incentives automatically transmitted by prices. Hence, the shortages or surpluses (unsold goods) typical of a socialist economy.

A binding price cap (one that is below the free-market price) blurs the signaling across the economy of the real cost or scarcity of the affected good and of the real price that consumers are willing to pay. It increases quantity demanded and reduces quantity supplied. It prevents individuals from bidding up the prices of goods and services in short supply. It replaces voluntary market cooperation by coerced coordination through laws and regulations.

Note that breaking by legislative fiat the market for an input (in this case, natural gas) into two different markets, one for electricity and the other one for other goods, will divert too much of the input to the government-favored good (electricity) compared to what this good really costs and to the lower value consumers assign to it (compared to other goods). Here again, in its circumvoluted formulation, the EU’s goal is to have other people’s cake and eat it too: it wants “a temporary EU framework to cap the price of gas in electricity generation, including a cost and benefit analysis … while preventing increasing gas consumption, addressing the financing and distributional impacts and its impact on flows beyond the EU’s borders.”

Price caps and redistribution / Note also that if the state’s goal is to redistribute income, it should do so directly and openly, not confusingly through price controls. If a government thinks that what poor households are willing to pay for gas does not represent its true value for them, a cash subsidy would be the efficient solution. The subsidized poor may not actually want all the gas the government decrees they “need” because they may need something else even more. A price cap, even modulated, is a subsidy that prevents the assisted consumer from making this choice because he is incentivized to buy all the electricity he wants, at least up to an arbitrary amount.

The International Monetary Fund has correctly argued that European governments should provide targeted support to the poor instead of interfering with market prices. Even the EU’s “Regulation on the internal market for electricity” mentions the goal of “enabling market signals to be delivered for increased efficiency.” It’s the same phenomenon we see in America: the rulers, or some of them, pay lip service to markets as they adopt opposite policies.

Optimism? / In October, some evidence appeared that price signals still work despite European governments’ inefficient interventions and their plans for more of the same. Prices of natural gas in Europe had started to decline and were close to, and sometimes below, their levels before the invasion of Ukraine. This is because, on the one hand, the quantity of gas demanded decreased and, on the other hand, other forms of energy (coal, renewables, imported LNG) had partly substituted for gas in the production of electricity. Perhaps we can hope that European price caps will turn out to be non-binding.

In a Financial Times column in late October, economics editor Chris Giles predicted that price signals would continue to feed the reduction of energy prices. “The price signal has done its job,” he wrote. “Advanced capitalist economies are remarkably successful in this regard.”

But there is a minimum condition for this optimism: that European governments don’t muddle price signals even more.

Readings

  • “Natural Gas Price Elasticities and Optimal Cost Recovery under Consumer Heterogeneity: Evidence from 300 Million Natural Gas Bills,” by Maximilian Auffhammer and Edward Rubin. National Bureau of Economic Research working paper no. 24295, February 2018.
  • “Economic Calculation in the Socialist Commonwealth” (1920), by Ludwig von Mises. In Collectivist Economic Planning, edited by F.A. Hayek; Routledge & Kegan Paul, 1935, pp. 87–130.
  • “The Use of Knowledge in Society,” by Friedrich A. Hayek. American Economic Review 35(5): 519–530.