What are the dangers of blanket capping of trade markup when inflation exceeds 5% — the simple explanation for everyone

The idea of ​​introducing an automatic mechanism to cap the trade surplus when inflation exceeds the 5% alert threshold is an extremely electorally tempting economic policy measure, but full of structural pitfalls.

The price crisis will turn into a commodity availability crisis. Photo by Shutterstock

Although at first glance it seems an effective shield for purchasing power, Frames analysts argue, economic experience and European examples show that such a brutal intervention in the free mechanism of price formation can generate severe adverse effects, turning a price crisis into a commodity availability crisis.

The Boomerang Effect: Major Economic Implications

According to analysts, introducing a fixed cap on trade markup (say, a maximum of 20% for processors and 20% for retailers, as was temporarily experienced on staple foods) at an inflationary time creates immediate distortions in the supply chain.

Even worse is the fact that from the statements made by the Minister of Agriculture it appears that this mechanism could be applied to all food products, not only the basic ones.

“The proposal of the Ministry of Agriculture raises a lot of questions. If Mr. Barbu wants to extend such a mechanism to the entire food industry, in an attempt to reduce inflation, we are witnessing a world premiere. It seems like an initiative worthy of the Nobel Prize for Economics. In reality, it is economic ineptitude”says Adrian Negrescu, Frames manager.

According to the analysis, such a regulation risks driving retail investors out of the country, and not just those in the food sector.

The Waterbed Effect

If we start from the premise proposed by the Ministry of Agriculture, the economic effects are easy to anticipate, the analysis shows.

Retailers, in order to maintain their profitability margins necessary to cover fixed costs (salaries, energy, rents), will be forced to compensate for losses from capped products by aggressively increasing the price of non-capped ones.

If oil and sugar have limited addition, the price of detergent, cosmetics or other products in hypermarkets will increase disproportionately.

“It's the classic Waterbed effect, which we've seen before in the economy since the capping of allowances for basic food products was introduced. Even the Competition Council complained about this economic effect with significant consequences in the dynamics of sales and purchasing power”, the Frames analysis shows.

Shortage on the shelf

Moreover, when the regulated price no longer covers the cost of production and logistics (which increases due to inflation), manufacturers or retailers may simply decide to stop selling those products. The phenomenon of empty shelves or rationalization occurs as selling becomes a loss-making activity.

In a tight-margin environment, companies are drastically cutting their investment and marketing budgets. The launch of new products becomes risky, and the quality of existing products may decrease (the phenomenon of skimpflation – reducing the quality of ingredients to maintain the price).

“Romania is not the only country that sought unorthodox solutions, but the models differ radically in terms of results”says Negrescu.

The government in Budapest, for example, has imposed the toughest price ceilings in the EU for food and fuel. The result was disastrous: Hungary subsequently experienced the highest food inflation in the EU (over 40-50% at one point), fuel and sugar shortages, and the bankruptcy of many small traders. When the caps were lifted, prices exploded to recoup the accumulated losses.

Instead of coercive laws, France opted for “Anti-Inflation Quarters”a voluntary agreement in which retailers pledged to keep prices low on a select range of products in return for government pressure on major industrial manufacturers to renegotiate contracts.

Greece has imposed full transparency and a cap on gross profit margin (not final price) in 2021 for essential products. The measure was more flexible, allowing prices to be adjusted according to costs, but prohibiting speculation.

Local companies are the most vulnerable

If it will be implemented in the form announced by the Minister of Agriculture, this measure intended to protect the population could have a boomerang effect for the Romanian capital. The application of such a regulation risks removing precisely Romanian entrepreneurs from the market, who do not have the economic power to allow them to face the negative effects.

“Large retail chains (hypermarkets, discounters) have huge volumes and can negotiate much lower purchase prices from suppliers. They can survive with a small commercial markup (eg 10-15%) due to fast turnover. In contrast, small Romanian stores (traditional trade) have much higher operating costs per product. Capping the addition at a low level would push them straight into bankruptcy, unable to cover their utility and staff costs“, states Negrescu.

According to analysts, in the face of capping the addition, it is not excluded that large retailers will put enormous pressure on suppliers (often Romanian food producers) to lower the delivery price in order to fit into the desired final price. Romanian producers, already decapitalized, risk selling below cost or being delisted in favor of cheaper imported products.

“The automatic introduction of capping the commercial addition at 5% inflation risks turning Romania's economy into a partially planned market, with major risks of blockingj,” Frames' analysis shows.

Although it can provide a breath of electoral and social oxygen in the very short term (a few months), in the medium term the measure erodes the competitiveness of small Romanian companies, reduces the supply of goods and, historically speaking, leads to an even greater explosion of prices at the inevitable moment of market liberalization.

“The viable solution is to leave the market free, for retailers to compete with each other, for there to be real competition in the market, and if there are deals, we have the Competition Council which can sanction. In addition, let's not forget one essential thing – prices are like a rubber band. If you pull too much on it, it breaks, in other words if you price too much, you are left with unsold goods. And manufacturers and retailers know this, proof that they have engaged in a hellish race of promotions and discounts, in attempt to retain their clienteleto make sales in volume”Negrescu also declared.