What Prices are Made For?
As European countries are shaken by the energy crisis, governments are taking measures to soften the shock while strongly pushing households and companies to adjust their behavior. In France, while measures have been taken to limit the increase in the prices of electricity and gas, the government also has designed a “sobriety plan” encouraging the reduction of the consumption of energy. Most of the plan consists of non-compulsory requests, such as asking people to not warm their homes above 19°C. Other demands are more formal but hardly enforceable (e.g., civil servants are asked to drive slower while at work). In the end, few coercive and enforceable obligations have been decided.
All this is economic nonsense. Governments have a powerful tool at their disposal to drive individuals toward less energy-demanding behaviors: market prices! As any economics student learns in principles of economics textbooks and Econ 101 classes, prices have a double function of transmitting information and incentivizing. They transmit information because any price change indicates a change in people’s preferences and/or the costs of production and/or the availability of the resources, leading individuals to adjust their behavior given this new information. The adjustment works through the incentivizing effect of price changes. A change in prices means a change in opportunity costs, leading people to revise their tradeoffs at the margin. Now, if the prices indeed account for all the relevant information (meaning that there is no externality), including everyone’s expectations about future economic conditions, the behavioral adjustment is optimal both at the individual and collective level. Prices make tradeoffs such that resources continue to be allocated efficiently to agents with the highest willingness to pay possible.
The decisions taken by the French government regarding the huge discounts on petrol prices and the cap on electricity and gas are obviously perturbing the price signal. Prices of petrol are currently somewhere between 30cts and 50cts per liter higher than they should be, and the gap is probably bigger for electricity and gas. As a result, people are consuming too much, as they are not incentivized to revise their tradeoffs. Then comes the so-called sobriety plan with its non-coercive and anyway non-enforceable measures. This is convenient. If something goes wrong, it will be easy for the government to put the responsibility on economic agents for being “irresponsible”. What is irresponsible however is to interfere in such a way with market prices. The underlying hypocrisy makes it even more irresponsible. Independently of the war in Ukraine, we know that we need to change our consumption behaviors not only in the future but now. Interfering with the price system is only adding confusion about the urgency of this necessity.
Undoubtedly, the “yellow vest” experience has taught political officials that it can be very unpopular to rely on market prices – adjusted so that to account for externalities – to bring behavioral changes. This is a constitutive feature of what we call populism: changes must be brought by “people’s will”, a.k.a. the political leader’s authoritative decisions. Market mechanisms are viewed with suspicion because they are seen as impersonal, or even worse as the instruments of shadow actors plotting against the general interest.
So much for the political economy of price interference. Interfering in such a way with prices is bad, period. Of course, many would ask “what should we do, then?”. It is surely not plausible to let the prices rise without doing anything. There is however a very simple solution. Just give people money, and eventually, give more money to the poorer people. Or in microeconomic jargoning, make sure that the income effects of price change are limited while the substitution effects are still operating. In such a way, agents who definitely need to consume energy will be able to do so, while keeping the price signal intact. Sure, it will be costly for public finances, but putting a cap on prices is at least as costly.
Finally, some will object that people will misuse the money that is given to them. Recent empirical research suggests that this fear is not founded. And even if this were the case, the government would be at least justified this time to say that if things go wrong, the responsibility is on each of us.