Price controls on essential foods: partial business and regulatory impact assessment (BRIA)

Annex B: Economic intuition underpinning the effects of price controls in a competitive market

In economic terms, a binding price cap can be understood as transferring some ‘economic surplus’ from producers, suppliers and retailers to the consumers purchasing the capped goods, while potentially reducing overall economic efficiency.

Illustrative diagrams are provided below to illustrate this point which define the prevailing market price (P*) for a given food and the price set under a binding price cap (Pc) using formal economic theory.

Where price caps (Pc) are set below the prevailing market price (P*), the expected effect is to lower the prices paid by consumers for targeted goods.

In practice, food retail markets are complex and not perfectly competitive. Retailers may respond with offsetting adjustments elsewhere. This could include:

• price increases on non-capped goods
• absorbing cost pressures or passing pressures down the supply chain
• changing the product mix, quality, or availability

As a result, impacts on the average cost of a shopping basket (one containing a mix of capped and non-capped goods) may be neutral or ambiguous. Benefits depend critically on which households consume the capped goods and how far capped prices sit below the market price that would otherwise prevail.

These diagrams are intentionally stylised and are intended only to illustrate the underlying economic intuition.

In the figures 1B and 2B, consumer surplus is the difference between the maximum amount consumers are willing to pay for a good and the price they actually pay. It represents the benefit consumers receive from being able to purchase a product for less than the value they place on it.

Producer surplus is the difference between the minimum price producers are willing to accept for supplying a good and the price they actually receive. It represents the benefit producers receive from selling a product at a price above their minimum acceptable price.

By way of illustration, if a consumer would have been willing to pay £1.50 for a loaf of bread but purchases it for £1.20, the consumer surplus is £0.30. Similarly, if a producer would have been willing to supply the loaf for £0.90 but receives £1.20, the producer surplus is £0.30.

In a competitive market, the market-clearing (equilibrium) price (P*) balances supply and demand, generating both consumer and producer surplus. A binding price cap set below the equilibrium price (Pc) transfers some producer surplus to consumers purchasing the capped goods by reducing the price paid for those goods.

Economic theory suggests that price caps may also reduce total economic surplus (the sum of consumer and producer surplus) by weakening the price signals that help coordinate production and consumption decisions.