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Saturday, June 4, 2011

The economic and social impact of price controls in Cape Verde

Cape Verde has historically had a very high rate of poverty but has managed to significantly alleviate poverty levels through effective governance and policies for economic growth. Poverty has by no means been completely eliminated - about 30% of the population lives at or below the poverty line.

Protection of the poor has been one element of the economic philosophy that has been especially effective up to the current times. The Cape Verde government established ARE or Agência de Regulação Económica (Economic Regulatory Agency) to control prices for certain products and public utilities such as electricity, water, oil products and transportation.

For example, in the case of water, ARE set the following maximum prices on April 12, 2011 (all prices are in local currency of escudos per cubic meter per month and before value added taxes):
Domestic Use
253.72 for 6m3 or less
359.98 for more than 6m3 but up to 10m3
470.30 for more than 10m3

Business Use
434.13 for 20m3 or less
501.87 for more than 20m3

Industrial Use - 416.96
Tourism Sector - 531.89
Non Profits - 277.92
Water Trucks - 280.12 if supplied to Non Profits
Water Trucks - 449.97 if supplied to Other users

It's a pretty elaborate structure and appears to favor the poor who may be expected to use less water because they live in smaller homes and possess less appliances that would consume significant quantities of water. Large businesses and the tourism industry pay at higher rates.

Cape Verde is not blessed with a vast natural supply of potable water. Much of the water production comes from desalination plants which are built for the purpose.

It is interesting that the mission of ARE is "to promote economic efficiency and financial stability of the regulated sectors to ensure the provision of services of public interest for the benefit of society." This mission is completely contradictory to the reality of the economic and social effects of price controls on free markets. The establishment of maximum prices has the following negative effects:
  1. Chronic Shortages - price caps artificially elevate the amount of demand for a product over and above the amount manufacturers of the product are willing to supply resulting in shortages (here is an example from Venezuela in 2013);
  2. Reduced Quality - manufacturers will cut back on spending needed to deliver product quality in order to attempt to achieve profits;
  3. Reduced Reliability - manufacturers will reduce spending on maintenance of equipment used to manufacture and deliver the product in order to attempt to achieve profits, resulting in less reliability in the delivery of product when machines break down and have to be repaired or are abandoned; in addition, equipment will eventually become outdated as zero money will be spent on new machines or improved technologies;
  4. Loss of Economic Incentive - manufacturers will have little incentive to produce the price controlled product and the more capable manufacturers will allocate their capital and human resources to more profitable ventures;
  5. No Innovation - there will be no incentive for new entrants to bring new innovations or for existing manufacturers to spend on research and development in the controlled industry since they would not be appropriately rewarded for such investments.

In other words, while price controls are well intentioned, the end result is that those who the controls are intended to help are the ones who end up the most hurt by the price controls. In fact, everyone gets hurt - consumers, manufacturers and the government. The ultimate results of price controls are economic inefficiency and financial instability for everyone.

However, there is a counterpoint. When it comes to the basic necessities of life, such as access to potable water, gas for cooking, and electricity to power homes for basic needs, a responsible society cannot leave the poor unprotected. There is a place for limited price controls. Price controls can indeed be an effective social tool at a certain point in the economic development of a nation, for example, a Lesser Developed Country (LDC). It is not that the economic effects are different than described above, but a LDC receives financial aid from external sources (essentially wealthier nations) and that aid is used to subsidize or pay for the costs over and above the price caps. Some but not all of the effects may thus be alleviated. But there will still be inherent economic inefficiency in the sector.

Cape Verde is no longer an LDC, and has recently demonstrated that it is now better able to stand on its own in the ranks of those nations that are classified as Middle Income Country (MIC). Therefore, the government receives loans instead of financial aid. This makes the economic effects of price controls even worse. The  government becomes caught between a rock and a hard place because the economic ill-effects continue unabated causing social dissatisfaction as the population becomes more savvy, while at the same time increasing the financial pressures on government budgets and total debt. It's a classic catch-22 whose effects are being seen in the country today.

So how is this problem solved? The answer is conceptually quite simple - aggressive movement towards the economic efficiencies of markets that have greater economic freedom. In practice, the steps involved might include:
  1. Continued use of tiered pricing structures to protect the poor and small businesses and at the same time discouraging excessive use of energy. But, in addition to the tiered structure for domestic and business use, ARE should explore a peak/off-peak pricing structure for utilities such as water and electricity.
  2. Elimination of most of the artificial pricing bands. In the case of water rates above, is it really necessary to establish separate rates for industrial use, business use, non-profit use, hotel use and so on? It seems scientific but it is not.
  3. Provide major incentives for the allocation of economic resources and FDI to renewable energy and alternative sources of energy such as bio-fuels. Cape Verde's biggest natural resources are year-round sunshine, relatively constant and strong winds, and high seas. Technology in these areas continue to advance at a rapid pace and the cost of these technologies is continuously falling.
  4. Partial privatization of public utilities (provided the cost controls are removed simultaneously). This will inject more capital, management talent and innovation into the public sectors involved.
On the latter two points, the government is already moving in that direction. For example, in addition to urgent calls to privatize the water and electric company, ELECTRA, late last year the government announced a public-private partnership with Cabeólica to provide wind farms on several of the islands of Cape Verde. These are good first steps. There continue to be significant opportunities for private investors in this sector including the area of solar energy. More should be done regarding relief on price controls in order to create the best possible climate for private investors and to restore economic balance.


Anonymous said...

O dia em que o governo de cabo verde apresentar efectivamente uma estrategia seria para estes sectores vitais do desenvolvimento podemos conversar!!! Atè aì é continuar com os banhos de canequinha(onde se pode) e luz de pulgueira!
Aih nos terra!

Anonymous said...

Terrific blog. Really helpful, especially for us living abroad!

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