“We economists don't know much, but we do know how to create a shortage. If you want to create a shortage of tomatoes, for example, just pass a law that retailers cannot sell tomatoes for more than 2 cents per pound. Instantly you will have a tomato shortage. It's the same with oil or gas,” said Milton Friedman, a libertarian and Nobel laureate in Economic Science (1976).

Friedman’s remark reflects a contradiction between normative and positive economics. The first describes a decision of normative economics involving a value judgement to control retailers’ prices. The latter describes and explains economic process and predicts, without making a value judgement, a shortage as the undesirable outcome of price control.

The contradiction is pertinent to the recent cooking oil shortage in Indonesia. Normative economics justifies a government decision to control price based on value judgement to protect consumers, while positive economics predicts a shortage as the unintended outcome. Effective market intervention through price control should combine those two basic economic approaches.

The price of cooking oil has been escalating since October 2021. To reduce and stabilize the price, since Feb. 1, 2022, the government has enforced a domestic market obligation (DMO) and domestic price obligation (DPO) for crude palm oil (CPO) and olein on cooking oil producers and a retail price ceiling (HET) for cooking oil.

Conceptually, the measures should run well. Producers of CPO and olein must obey the DMO and DPO, otherwise they cannot export CPO and cooking oil. The price at the producers’ level would drop after raw material costs fall and reduce prices at the distributors and retailers’ level. Consumers can buy cooking oil at the HET of Rp 11,500 (82 US cents) per liter for bulk, Rp 13,500 for simple packaging and Rp 14,000 for premium packaging.

The HET is a price ceiling to prevent price from exceeding a certain fixed maximum, but empirically it has distorted the market. Prior to the imposition of the HET, supply and demand for cooking oil had always been in equilibrium, following the escalating international CPO price, and cooking oil is available everywhere.

Most consumers kept buying CPO-based cooking oil at any price because other types of cooking oil – such as domestic coconut oil or imported olive and canola oils – sold at higher prices. The demand for CPO-based cooking oil is inelastic because there are virtually no cheaper substitutions.

It was only after the price skyrocketed and set off a nationwide controversy over how the cooking oil price could rise steeply in the world’s largest palm oil producer, that the government intervened in the market. However, soon after the intervention, the supply of cooking oil decreased but the demand increased, resulting in excess demand and empty shelves in supermarkets.

A shortage occurred and prices exceeded the HET in many regions. Limited stock led to consumers queuing only to buy 1-2 liters of cooking oil and some people traveling long distances to where cooking oil was available. Consumers must spend a similar amount or even more on cooking oil compared with before the HET. For those in queues, the actual price of cooking oil, which included the cash paid and the time spent waiting in line plus travel costs, is higher than it would have been if the price had not been fixed at the HET.

The shortage as a positive economics prediction should not delegitimate price control as a normative economic decision. Indeed, price control prevents free market mechanism from working to ensure sufficient supply to meet demand. However, when the market price of cooking oil is uncontrollably elevating, consumer welfare is deteriorating. It is a market failure.

The intervention to fix market failure could turn into government failure – an inefficiency which would not exist in a free market – if the shortage cannot be relieved.

Meanwhile, the compliance of producers and distributors depends on normative economics decisions based on profit maximization as the value judgement. Then, if positive economics predicts that compliance with a price ceiling will reduce profit, the lower profit must remain acceptable for business continuity.

The government claims that the shortage and price above the HET is due to the price adjustment at producer and distributor levels. Yet, market operations to help consumers buy cooking oil at the HET are uncoordinated and sporadically performed by local governments, private and state-owned companies. As of the end of February, cooking oil prices varied at or above HET levels, and supply was limited and unpredictable. When stocks run out during high demand, retailers miss the opportunity to serve consumers and gain profits.

To be effective, a price ceiling requires a specialized agency to procure sufficient stock for adequately refilling market supply. The government has yet to employ such an agency, notwithstanding the State Logistics Agency (Bulog), which is in charge of food supply and price stabilization. So far, Bulog has performed only limited cooking oil market operations on its own initiative.  

The House of Representatives has suggested the government give a special assignment to Bulog. Indeed, Bulog can be assigned to procure bulk and simple packaged cooking oil from producers at producer price (production cost under a DPO scheme) and sell the oil at the same price plus a government-fixed margin to retailers, who then sell the oil at the HET to consumers. Bulog can also distribute its stock through market operations to quickly address any shortage.

Bulog procurement must be substantial, say 30 percent of 630,000 tons monthly production to be able to drive the market equilibrium price to the HET. The Palm Oil Plantation Fund Management Body (BPDPKS) can finance Bulog working capital and Bulog repays BPDPKS with its sales receipts. It is a business-to-business scheme between BPDPKS, Bulog, producers and retailers.

In a nutshell, the government (relevant ministries), must focus on overseeing its market intervention measures and employ specialized agencies to deal with the market participants in the cooking oil value chain. 

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The writer is a managing partner at Trade-off Indonesia economic and business advisory services. The views expressed are his own.