Venezuelan President Hugo Chavez who rose to the chair in 1999, and since then been holding power despite the Washington backed coup attempt of 2002, is certainly in news now than ever before. Chavez has always been vocal about his aim of establishing 21st century Socialism in his country. Whatever that means, lets hope the almighty Marxist Praxis does not trust price controls as the economic tool towards that dream.

Venezuela is currently suffering from severe shortages in the supply of various goods, in particular rice. The nation reminds us of the erstwhile USSR in this aspect, as it does in many other perspectives. Only that direct physical force against the masses has not been let loose yet. Venezuela has been reeling under the impact of shortages in the supply of various goods since 2003, and now the crisis has hit rice supply as well. Keeping up with propaganda records, Chavez has launched a propaganda tirade against private suppliers. He has accused private suppliers of hoarding supply of rice. There could be a certain element of truth in it, suppliers could indeed be hoarding supplies to a certain extent. But that’s definitely not where the fundamental problem lies. The causal problem of this crisis lies in price-controls which have grown in size ever since 2003.

I will first explain the economic basics of prices, and then lead into the cause of shortages, inflation and hoarding.

What are prices, and what do they say? The price of a product simply shows how much money you should give up to obtain it. Then, what do you prices say? And why do prices of commodities change so often in markets? The answer is, people are willing to give up different quantities of money for the same homogeneous product at different points of time. This might sound vague, so lets get on with an example.

You are given 3 bags of rice. You have a particular preference scale based on your individual liking, and it shows those immediate needs that you would like to satisfy with the three bags of rice. The first immediate need that you fulfill with a bag of rice is to feed yourself. So, the first bag of rice goes to feeding yourself. You decide to use the second bag of rice to make some cakes. The third bag goes to feed your pet dog. This explains your preference scale. Your highest valued purpose is to feed yourself, followed by making some cakes, and finally feeding your dog.

Now imagine, you have only two bags of rice, and you are to decide what among the different uses of rice you are going to sacrifice. Since you have feeding your pet dog the least important of all uses, you decide to let your dog starve. Now suppose your neighbor has some extra bags of rice in his kitchen and he is ready to sell it to you for some money. How much would you be ready pay for that extra bag of rice which you would use now to feed your dog? You would see if the utility (or use) you gain from that extra third bag of rice is more than the utility you attach to the money you pay to your neighbor for that extra bag. Lets assume you would probably pay $2 to get a third rice bag from your neighbor, and you use it to feed your starving dog.

Lets further assume now that you have only one bag of rice. So you would have to give up on both feeding your dog as well as making tasty cakes. Now again, your neighbor has an extra bag of rice. How much would you be ready to pay for that second bag of rice? The same kind of reasoning as used earlier applies here as well, you would buy the second bag of rice only when the utility you achieve by buying it is greater than the utility you attach to its price. Perhaps you’d be ready to pay $5 to get the second rice bag from your neighbor, to make some cakes.

Now lets go further and assume that you have no rice bags with you. And again, your neighbor has an extra bag to sell. This time too you’d buy the bag of rice only when the utility you gain from the rice bag you buy is greater than the utility that you attach with the money that you spend to buy it. Now, you would be ready to pay almost anything to buy that bag of rice from your neighbor, and that’s because the utility you attach with the bag of rice is your life itself. You would have to starve without that bag of rice.

We have now seen three instances where the price offered to buy an extra bag of rice varies, quite drastically in fact. Economists explain this as the “law of diminishing marginal utility”. Marginal utility of a commodity is the utility that you gain (or lose at times) from an additional unit of the commodity.

This explains why prices change at different moments in the market. When there is excess supply of a commodity in the market, people would have the liberty to use those commodities for less valuable goals, like how you used the third bag to feed your pet dog. So they are willing to pay only low prices. On the other hand, when there is deficit in the supply of a commodity, people are strained to obtain sufficient goods. They are forced to cut down on their frivolous expenses, like your preference to feed your pet dog. The price of the commodity in this case is high. This explains how prices are set in a market.

What the market does is it rations the goods that are available to the most immediate needs by raising prices when supplies are constrained. So, high prices enables everybody to satisfy their most intense immediate demands, while restricting them from using further units of the commodity towards less intense needs.

So when supplies are inadequate, the price of the commodity increases to make sure that the commodity is diverted towards the most urgent needs rather than being wasted in satisfying less intense needs. This means that suppliers would gain lots of profits.

The suppliers then invest this extra revenue to expand their production in order to gain more profits. Note, monopolies might restrain from producing more to maintain current profits, but they won’t be able to do it for long, until competing firms sensing profits enter the business to produce more of the commodity. This increase in supply would cause prices to go plunge. So high prices leading to high profits are market signals to encourage increased production. And this is how the free market deals with the economic problem.

Governments on the other hand have a very different way of dealing with high prices due to insufficient production of a commodity. They deal with the economic problem with price ceilings. The Government sets arbitrary prices to commodities whose prices are “too high”, and it thinks the problem is solved. But that’s exactly where the problem starts. The lower prices leaves no profits to be gained or even sends firms right into losses, and that discourages firms from increasing production. Witnessing lower prices, consumers demand more of the commodity than they would at the genuine free market price level. That is like, if a sack of rice were available for just 50 cents you’d probably buy hell a lot of rice bags and waste them for weird reasons. We have in hand a very critical situation, production of the commodity plunges due to decreasing profits or outright losses, but at the same time people are demanding more of the commodity. This leads to shortages.

This is what is being experienced in Venezuela because of price controls imposed by Chavez’s government.

The other fact to remember is that price controls which are imposed initially on a a few commodities are spread to other commodities as well. In fact governments are forced to spread the price control regime because of their initial mistake of controlling prices of a few commodities. Why does this happen? When the price of a commodity is arbitrarily set low, people are encouraged to demand more of the commodity but since there is not sufficient supply available, goods are sold to people on a first come first serve basis. This could have a very important side-effect. The supplies do not get diverted to the most intense needs because those customers whose demand for the product is extremely important is prohibited from bidding higher prices for the commodity.

So when such needs are not satisfied, consumers search for alternative goods to buy. People who failed to secure rice because of the shortages would try to buy wheat which is not controlled by the government’s price control regime. As more people who failed to get rice start bidding for wheat, the price of wheat skyrockets. And now the government steps in again to impose price controls on wheat as well. And thus, the price control regime keeps spreading and turns into a universal price control system, with no kind of free market pricing to guide production and consumption.

Now coming to the problem of hoarding. First reason why some people hoard supplies is because they are unsure about the availability of future supplies due to chronic shortages. The second type of hoarding is carried out by speculators who expect a higher price for the product in the future when the price control regime collapses, or they might sell the supplies in the black market at prices higher than the government set arbitrary ones. It must be realized that the problem of hoarding is definitely not the cause of the shortage, it is a minor side effect of the real culprit–price controls.

The Venezuelan economy is in the mud, and the price control regime is spreading all over the economy. The system is bound to collapse and cause serious problems to the Chavez government. It should also be observed if Chavez does a Stalin here, to use force against his own people. Reports emanating from Caracas already show the seizure of rice processing units, and also the spread of the price control regime towards other goods like meat, sugar ad other goods. Just another case of price controls bringing disaster.

Venezuela will not be able to reach Socialism because Socialism is an impossible theory, it demonizes the same tools by which pro-Free Market economies achieve efficiency in distribution of resources and satisfies the demand of the market. In the name of achieving more Socialism Hugo Chavez keeps on grabbing more and more power, and this is causing Venezuelan people to lose their Liberties.