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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.