Download Price Controls in the Indian Economy

Price Controls in the Indian Economy
Do They Hamper Growth?
V C Shah
The two crucial questions which arise in any discussion of the role of price controls in the Indian economy are;
(a) Is the choice of commodities whose prices are controlled rational and justifiable? and,
(b) Do price controls impede the flow of investment resources into the industries whose products are
subject to price control?
An attempt is made here to examine from these two angles the existing controls on prices of manufactured
goods.
THERE is an impression in some
quarters, both in India and particularly in foreign countries, that the
Indian economy is studded with a
number of price controls. Such an
impression is unjustified. This is
evident from the fact that out of the
numerous non-agricultural products
only 17 commodities are at present
subject to price controls. The twelve
commodities whose prices are controlled statutorily are sugar, kerosene,
coal and coke (higher varieties).
woollen yarn and articles, worsted
weaving and hand knitting yarn, iron
and steel (flat products), cotton, fertilisers, cotton yarn and textiles (coarse
and fine varieties) cement, ethyl alcohol
and molasses. The remaining commodities - paper, motor vehicles,
petroleum and petroleum products,
matches and bicycles — are subject
to non-statutory price control.
The story of price controls on agricultural commodities in India is the
same as in the Western countries,
such as the U S A and the Federal
Republic of Germany. There is, however, a basic difference. In the U S A,
for instance, the Government follows
a price support policy for agricultural
products in order to maintain parity
between agricultural prices and industrial prices in the interests of farmers.
In India, agricultural price policy is
designed not only to protect the
consumers' interests but also to induce
farmers to increase agricultural output This analysis is confined to price
controls on the 17 non-agricultural
commodities. It does not attempt to
cover agricultural price policy which
is a challenging topic by itself.
There are two crucial questions
which should be considered in discussing the role of price controls in
the Indian economy. Firstly, it is
necessary to analyse the choice of
products within the framework of
economic justification for imposing
price controls on them. Secondly, one
must examine the impact of the operation of price controls on the flow of
investment resources into industries
whose products are subject to price
controls. This is a very basic question for various reasons. After a l l
price control policy is a short term
measure to meet the problems created
by the shortage of supply in relation
to the demand. But the long run
solution is to equate supply to demand
by increasing the production capacity
of the industry. This is possible only
if the operation of price control does
not discourage investment in the
industry.
Why Price Control ?
The price mechanism in a free
enterprise economy brings about an
optimum allocation of resources given
certain
assumptions. These are (a)
perfect competition in both the pro.
duct and factor markets, (b) perfect
divisibility of all resources and products, (c) absence of direct interdependence among producers and
consumers, i e, absence of any divergence between social benefit and
private gain as well as social cost and
private cost.
In addition, two points pertaining to
the Pareto optimum are worth noting.
The general equilibrium theory is after
all a static theory and therefore fails
to take into account the implications
of dynamic forces in a growing economy — for instance, the concept of
pecuniary external economies and diseconomies.
Secondly,
the
Pareto
theorem does not offer any policy
norms for income distribution. On
account of these characteristics of the
Pareto theorem together with its unrealistic assumptions, the price mechanism left to itself as suggested by the
static equilibrium theory in both its
general and its partial form, cannot
serve the basic objectives of economic
policy. Hence, the need for Govern-
ment interference with the market
mechanism.
In India, price control has been one
of the instruments in the armoury of
the Government for achieving economic objectives and for implementing
the Five Year Plans. Specifically, there
are four objectives which price controls
on the 17 non-agricultural products
are expected to fulfil. These are ;
(a) to protect the interests of the
vulnerable sections of the consumers given the income distribution";
(b) to facilitate investment in
priority industries which are
essential for laying the foundation for rapid economic development of the country;
(c) to prevent monopolistic exploita.
tion by a few- firms belonging
to a single industry, and
(d) to ensure a reasonable degree
of price stability.
(a) The consumption of essential
products like sugar, kerosene, coarse
varieties of cotton textiles and molas.
ses is vital to those sections of the
Indian society which are relatively
poor. In a growing economy when
prices of such products
are under
pressure, it is natural that these
vulnerable sections cannot purchase
their day-to-day requirements at marker
prices. Just as during war time essential consumer goods are subject to
price controls and rationing in the
interest of the consumers, their prices
are at present controlled in India in
the interest of the lower income
groups. And the pressure on consumer
goods prices is generated by the strains
and stresses inherent in the process of
accelerating the rate of the growth of
the Indian economy,
(b) Economic planning implies investment priorities. Such priorities
have to be determined because the
market mechanism fails to allocate
the scarce resources in a manner that
would hasten the pace of economic
1097
THE
July 10, 1965
growth of India. The failure of the
market mechanism, in turn, is due to
the divergence between social and
privale cost, as well as social and
private gains. It is extremely desirable that scarce resources, particularly
the basic inputs such as steel, cement
and coal are made available for priority investments in adequate quantity,
at the proper time and at reasonable
prices. This is because the flow of
basic1 inputs to the different sectors of
the Indian economy is essential for
maintaining the time schedule of
various key projects. If the time
schedule is upset, the problem of
phasing the Five Year Plans would
become extremely difficult This is
particularly so in the case of India
because it does not possess the safety
valve of imports to supplement the
deficiencies in the domestic production
of basic inputs. Thus the rationale
behind price controls coupled with
distribution controls on cement, higher
varieties of coal and coke and flat
Source:
1098
Reserve Bank of India.
products of iron and steel industry is
to enable the user industries to purchase them at reasonable prices and
in adequate quantities.
In the absence of price controls,
some of the priority industries requiring cement, steel and coal would find
it very difficult to buy them in adequate quantities and at reasonable prices
in the free market. It is very likely
that cement would be available for
luxurious residential construction in
the growing urban areas whereas
construction of irrigation canals and
dams would be starved of cement.
Everyone, however, would agree that
investment in dams and canals is
more beneficial that investment in
luxurious construction from the point
of view of the society as a whole.
(c) It is true that the number of
producing units in a given industry is
not a necessary and sufficient condi.
tion for considering the industry a
monopoly or an oligopoly. However,
market conditions tend to be mono-
ECONOMIC
WEEKLY
polistic or oligopolistic when the
number of enterprises in a given
industry is relatively small. It is,
therefore, not incorrect to regard
paper, motor vehicles, matches, bicycles, iron and steel, fertilisers, and
petroleum and petroleum products industries as monopolistic or oligopolistic.
This is because the number of units
manufacturing paper and paper board
were 45 in 1964, those manufacturing
motor vehicles were 9, scooters, motor
cycles and three-wheelers 9, and
bicycles 20. There were only four
companies which manufacture petroleum and petroleum products and only
6 producing matches, and two main
private sector units in the iron and
steel industry.
Given the market structure for the
products of each of these industries,
it is not unlikely that they might
follow a policy of administered pricing.
If so, these industries would tend to
exploit the consumers of products such
as paper, motor vehicles, petroleum
THE
ECONOMIC
WEEKLY
and petroleum products, matches and
bicycles. Such a situation would not
be consistent with the objective of
preventing exploitation of the consumers and also concentration of
economic power. The Governments in
Western countries, such as the U K
and the U S A do not allow full free,
dom to the management of an oligopolistic industry to adopt an administered pricing policy. The Government in India would likewise be
justified in becoming a party to the
determination of prices of these commodities.
Theoretically, effective- maximum
price of a commodity produced by a
monopolist or an oligopolist might
lead to increased output and more
efficient allocation of resources. If
the maximum price is somewhere
between the equilibrium price which
would be determined in the absence
of price control and the point of intersection of marginal revenue and
marginal cost itself, a monopolist or
an oligopolist would regard the demand curve for his product as perfectly elastic upto a certain limit. The
new marginal revenue curve upto a
limit (which would also be equal to
the average revenue curve) would be
lower than the original marginal
revenue curve. The producer would
determine the equilibrium output by
equating his new marginal revenue
curve with the marginal cost curve.
Hence there would be higher output
provided the producer had not already
reached the point of production beyond which his marginal cost curve
had become perfectly inelastic.
It is plausible that in the Indian
conditions, effective maximum prices
of products like paper, motor vehicles,
iron and steel, matches and bicycles
may not have the effect of increasing
their output. This is because producers in these industries arc likely to
be operating their plants at full capacity in the sense that they would have
stretched output to the point beyond
which marginal cost would have
become inelastic.
(d) Price control policy has also
another important objective to fulfil,
viz, maintaining a reasonable degree of
price stability. If prices of sugar,
kerosene, coarse varieties of cotton
textiles and molasses which enter into
the cost of living of the masses of
India are not controlled, it is very
likely that trade unions would be
under pressure to push up the wage
rates. If trade unions were to succeed in raising the wage rates to
compensate the working class for rise
July 10, 1965
in cost of living, industrial development would suffer. In other words,
India would experience the familiar
cost push inflation which countries like the U K and the U S A have
faced in the post-war period. Since
cost push or for that matter demand
pull inflation is not desirable for economic growth of either a developed
or an underdeveloped country, the
Government of India is justified in
resorting to price controls of these
essential consumer goods.
Again if steel prices, for instance,
are not subject to price controls, the
cost of production of a number of
industries consuming steel would rise.
Just as steel prices in the U S A are
extremely Important for maintaining
stability of the American economy,
they are equally important not only
for the stability of the Indian economy
but also for its growth,
The analysis thus indicates that the
choice of commodities subject to price
controls can be justified on economic
grounds. The policy is consistent with
the objectives of maintaining reasonable degree of economic stability,
preventing exploitation of vulnerable
classes of the society and mitigating
the effects of imperfect market structure.
The important question that now
remains is whether the price control
policy has created conditions for the
long run solution of the problem of
shortage of certain commodities, In
other words, the policy should be
scrutinised from the point of view of
its impact on the flow of investment
resources into the controlled industries in order to raise their capacity
consistent with the requirements of
other sectors of the economy. One
should, therefore, examine the basis on
which price of a commodity is fixed
by the Government.
Formula for Fixing Prices
The Government fully recognises
that the efficiency of an enterprise
depends to a great extent on its price
policy. It believes that prices charged
by an industry should provide sufficient resources to that industry for
its expansion. The price policy should
also enable an industry to attract new
investment for its growth. In other
words, the prices fixed by the Government should yield a reasonable
margin of profit — reasonable in
terms of enabling the industry to
build up adequate reserves for expansion and reasonable in terms of attracting new capital by offering a handsome
rate of return
investors.
to
the
prospective
It seems that the Government has
followed the cost plus principle in
fixing prices for the 17 commodities.
Such a principle is a necessary but not
a sufficient condition for making price
control policy adequately flexible for
ensuring a reasonable rate of return
to the investors in industries subject
to price controls. For this purpose,
the Government has to estimate the
cost of production including replacement of plant and machinery at
current or prospective cost. ' It should
also determine a rate of return which
is consistent with the degree of risk
and uncertainty inherent in an industry
whose product price is to be fixed, in
comparison with the degree of risk
and uncertainty in other industries.
Another important aspect of price
control policy is to determine relative
prices of multiple products manufactured by a single industry, in such a
way that the structure of production
would be in conformity with the pattern of demand for the multiple pro.
ducts over a period of time. This
calls for projection of the pattern of
demand for industries like iron and
steel and petroleum and petroleum
products. If the relative prices fixed
by the Government fail to reflect the
changing pattern of demand in a growing economy, the structure of production could become distorted. Such a
development particularly in the case
of a basic industry would have very
adverse effects on the rate of growth
of the economy.2
The formula evolved by the Tariff
Commission is by and large followed
by the Government, while fixing prices
of various products. The formula,
generally, provides for 12 per cent
before tax return on total 'capital
employed'. It may be useful to examine
the implications of the formula in
terms of the maximum rate of return
that it may determine.
Let,
Rc
Po
Pb
Ro
Rb
- Po Ro +
Pb Rb
= proportion of o w n e d
capital to total capital
employed.
= proportion of long term
borrowed
capital
to
total capital employed.
= rate of return on owned
capital.
rate of interest on long
=
term borrowed capital.
1099
July 10, 1965
RC
=
profits 'before tax as
percentage of total capital employed.
Let us assume that Rc
= 12 per
cent. It the long-term borrowed capital
can be raised at 8 per cent rate of
interest and if the ratio of owned
capital to borrowed capital is 1 : 1 .
the formula would yield a ceiling of
16 per cent before tax return on
owned capital. With a higher ratio
(owned capital to long-term capital) of
1 : 2, the ceiling on the rate ef return
(before tax) on owned capital, according to the formula, would be 20 per
cent.
In the case of priority industries,
Indian companies in which public are
substantially interested and whose
ratio of owned capital to long-term
borrowed capital is 1:1, would ar present bear an assregate tax incidence of
45 per cent so long as profits before
tax on owned capital would not exceed
20 per cent. If, however, such companics in the priority industries are
entitled to various tax concessions and
if the ratio of their owned capital to
long-term borrowed capital is 1:2, the
tax incidence would be lower than 45
per cent. Thus the ceiling of 20 per
cent return on owned capital determined by the formula, would yield a
maximum net return (after tax) of
more than 10 per cent.
Incidentally, it may be noted that
industries subject to price controls
except the consumer goods industries
are regarded as priority industries
emit led to tax concessions including
the proposed special development rebate introduced in I he Budge! for
1965-66. Hence, industries producing
basic inputs have scope for earning a
net rate of return of more than 10 per
cent on owned capital.
From the long run point of view,
the crucial question is whether investment resources are diverted from
controlled industries to non-controlled
industries. This is indeed a very
difficult question to answer. The reason
is that for this purpose, it is necessary
to determine the optimum differential
rates of return in various industries
according to the degree of risk and
uncertainty prevailing in the different
industries. If the actual differential
rate of return in a given industry is
below the optimum differential that
would bring about equilibrium of investment resources in the economy, one
can easily draw the inference that
additional capacity in such an industry
would not be created.
1100
THE
In the absence of data on the optimum differential rates of return, it may
be useful to turn to the profitability
ratios estimated by the Reserve Bank
of India. The Table shows that in the
case of industries whose products are
subject to price controls, gross profits
as percentage of total capital employed
did not exceed 12 per cent except in
the case of matches during the three
years 1960-61 to 1962-63. Similarly,
gross profits as percentage of total
capital employed in other industries
were not appreciably higher than 12
per cent except in the case of woollen
textiles, mineral oils and medicines and
pharmaceuticals. Again, profits aftertax as percentage of owned capital in
the industries subject to price con.
trols varied between 3.5 to 13.4 per
cent. The same profitability ratio for
other industries except woollen textiles,
medicines, pharmaceuticals ranged between 4.4 per cent to 14.7 per cent.
The behaviour of dividends as percentage of paid-up capital declared by the
controlled as well as non-controlled
industries was more or less similar to
that of other profitability ratios. Subject to the limitations of these profitability ratios, one may, therefore, infer
that there does not exist wide divergence between rates of return in various industries, which may justify investment in the non-controlled indus-
ECONOMIC WEEKLY
tries at the cost investment in industries subject to price controls.
The analysis indicates that it may
not be proper to blame entirely the
price control policy for lack of Adequate expansion, if any, in same of
the industries whose product prices are
fixed by the Government. Even if
these industries are capable of raising
financial resources, additional capacity
may not be created at a desired rate
because of bottlenecks in the supply
of essential inputs which they require.
It is, therefore, necessary to find out
in the case of each individual industry
whether the difficulties in obtaining the
required inputs both indigenous and
imported or the price control policy
is responsible for any lag in the growth
of the industry.
Notes
1
This implies that the controlled
prices should be changed whenever
cost of production changes. Such
a flexibility is evident in the upward revision of controlled prices
of some of the products, such
coal and steel.
2 This point is very well stressed by
the Raj Committee. See Report
of Committee on Steel Control,
Government of India, October
1963, pp 13.14.