Market Analysis

Reality Check: You Get What You Pay For

It's safe to say everyone likes a good deal, but government subsidies often turn out to be more than we bargained for.

It's safe to say everyone likes a good deal. From inventory liquidations to blow-out sales, a large part of consumerism is based on the idea we're walking away with a good or service for less than it's worth to us. But as the season's fury of high capitalist consumption revs into a post-holiday sales binge, it seems appropriate to remind shoppers, "You get what you pay for." Usually uttered after the purchase of an inferior polyester sweater with prancing reindeers that dissolves after one wash, the saying is also a powerful statement of the free market pricing mechanism.

Students of capitalism know the proper price of a good is the one freely agreed upon by two willing and able parties based on the natural machinations of supply and demand. Anything precluding prices from freely expressing the conditions of supply and demand interferes with the efficient allocation of resources. Unfortunately, prices are artificially distorted quite often, giving good reason to be wary of the deal that was too good to be true.

Look no further than Iran for proof. Its government subsidizes gasoline—service stations in the country sell the fuel at 1,000 Iranian rials a liter, or about 42 cents a gallon. A subsidy can take many forms—grant, tax break, trade barrier—but it's generally some form of financial assistance from the government. In many ways, they're little more than government-induced charity.

But just look at their effect on prices! The cost in Iran compared to the rest of the world is eye-popping. Imagine if US consumers were able to fill up their tanks for less than fifty cents a gallon. And you think SUV sales are high now! Perhaps Iranians would consider themselves the luckiest people on the planet for such an altruistic government.

The unfortunate reality is once people grow accustomed to something they tend to start thinking of it as a right. The unintended consequences of Iran's gasoline subsidies were made apparent this summer, after the government announced rationing to ease demand pressures. Citizens rioted, burning at least five filling stations in Tehran.

What happened? Subsidies interfered with the pricing mechanism, keeping gasoline well below its true market value. This is basic economics—prices should rise along with demand. But artificial caps kept it from happening. Predictably, such policy led to overwhelming demand for gas. If the government had let the free market pricing mechanism work unencumbered, demand would surely have been much lower.

Unless corrected, government-induced imbalances will only cause further problems. Folks will get creative in circumventing the problem or even profiting from it themselves. Shortages, hoarding, black markets and even violence often follow. The irony in this case: Iran holds the world's second largest energy reserves. Their problem isn't a shortage of resources, merely poor policy by the government.

Usually such government manipulation is justified under the guise of "social stability." At one point, Iran's government deemed its actions prudent for the good of society and changing such policy now would result in undue harm. Putting aside the flawed logic, there is some truth to that. A move by Iran to end the subsidies and thus dramatically increase the price of fuel would surely have social and economic repercussions. But it would be better than the alternative—adding ever more layers of government intervention to fix problems it created in the first place. It's far better to suffer the short-term pain and let the market adjust.

We're not just picking on Iran. They are hardly the only place to suffer from subsidy inefficiencies. One can find cases in virtually every industry and country, from Western capitalists to centrally planned regimes. Despite all the evidence to the contrary, politicians across the globe continually implement policies that obstruct the free movement of prices.

We struggle to find many markets that enjoyed long-term benefits from interference with the pricing mechanism. Capitalism works so well on its own we rarely notice it. Only when it is tampered with it do we truly appreciate how powerfully efficient it is. Alas, markets don't work in a vacuum. Winning votes or maintaining power remains an acceptable substitute for sound economics. Apparently, that really is a deal too good to be true.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.