The economics of... price caps
The history of price caps is a history of failures. Whether statutory bread prices or rent freezes – good intentions are usually followed by the power of economic laws.
This economic law goes as follows: Prices result from supply and demand. Suppose the price is forced to be set below the market-clearing price, for this now lower purchase price, demand will be higher and supply lower. It is simply more attractive to buy more of something when the price is low and less attractive to produce such things.
Price caps, therefore, lead to harmful side effects. Apartments are not being built, and long queues form in front of bakeries.
Now there is an entirely new type of price cap, and it will be fascinating to see whether it will work. The EU, G7 and Australia had agreed on a price cap on Russian oil. It came into force on Monday (5 December 2022).
The measure means only oil sold at a price equal to or less than $60 per barrel can continue to be delivered.
This sanction aims to restrict Russia’s revenue while ensuring Moscow keeps supplying the global market. But there are two significant challenges to overcome.
First, price caps tend to collapse. The lower price leads to a gap in supply. This scarcity regularly lets illegal markets pop up because many people are willing to pay more. Since Russian oil is delivered to a global market, it might be difficult to make sure that everybody will follow the sanction rules.
Second, the lower price, as said, increases demand. If the supplier (in this case, Russia) can meet the increased demand by expanding production, then the desired effect of the sanctions could be lost. Then Russia would earn less per barrel of oil sold but with similarly high revenues from more oil sold. To hit Russia hard, the price constraint must be followed by a quantity constraint.
What is the G7, the EU and Australia doing to overcome the problems?
They are trying to cut off routes for all Russian oil selling for more than $60 a barrel. Companies based in the EU, G7 countries and Australia will be banned from providing services enabling maritime transport, such as insurance, with oil above that price. These countries offer insurance services to 90 per cent of the world’s cargo.
So the sanctioning states have – as a group – major power. But they are not omnipotent. Russia can limit or stop oil supplies (which is not in the spirit of the sanctioning countries). And Russia will try to find insurance solutions itself and has already started buying up ships. That can also be done by those states that want to continue buying Russia's oil at a price above $60.
Only time will tell if the sanctions will be successful. In any case, there was a long oil tanker jam at the beginning of the sanctions this week. Around 19 crude oil tankers were waiting to cross Turkish waters. The reason: Authorities in Ankara demanded insurers promise that any vessels navigating its straits were fully covered. At least for the start it is clear that the sanctions are not a toothless tiger.
Onwards,
Johannes Eber