The dark side of price caps

The most popular chart of economists? By far, the supply and demand curve. The ascending line shows the quantity offered as a function of price (the higher the price, the more is offered). The descending line shows the quantity demanded, also as a function of price (the lower the price, the greater demand). At the intersection of the two curves (often straight lines for the sake of simplicity) results the market price (p 1) and the quantity sold (q 1).

The diagram may be far from reality in any detail (reality is not static, supply and demand do not run in straight lines, etc.) but the great strength lies in the simplification. Real problems become visible through abstraction. I love such approaches.

With such a diagram, for example, a risk can be shown that may soon occur in Germany.

This week, the German government presented a new 200 billion euros relief plan in response to soaring energy prices. The measures include a cap on gas prices.

Such a price cap seems reasonable at first glance. The high gas prices are crushing private households and companies alike. With a cap, people and companies will be relieved. The difference between the market price and the capped price will be borne – via debt ­­­­- by the state (more precisely, by the taxpayers in the future).

But such a cap could lead to unintended consequences. Germany could run out of gas. The supply and demand chart below shows why.

The gas supply in Germany is currently more or less fixed (hence the vertical supply line). A reduction in the gas price below the market price (from p1 to p cap) means that the quantity demanded rises(from q 1 to q cap).

However, only the quantity q 1 is available. As a result of the price cap people want to buy more gas than is available. Consequently, the state has to ration the difference between q cap and q1. It will therefore have to make specifications on which households and companies may use how much gas.

It is not yet known what the shape of the gas price cap will be in Germany. An expert commission is to be set up. I very hope that everyone involved is aware of the danger of rationing.

The goal must be to keep the market price as a scarcity signal so that people have enough incentive to save gas. This could be achieved, for example, by people and companies receiving a subsidy payment depending on previous gas consumption. The motivation to save energy would remain due to the current high price of gas, while hardships would be cushioned at the same time.

I am excited to see how well the German government understands the economic mechanisms behind a gas price cap and which model of such a cap it will present.

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