The South Korean government is now running a pilot program of the delivery unit price indexation system -- an interlocking price adjustment system for the cost of goods delivered, chiefly designed to help protect small businesses when they handle orders from big companies.

But there is a dispute over whether it undermines free market principles, especially concerning artificial price control by the government.

Under the system when there is, for instance, a big change in the price of raw materials, big companies that have made orders should pay more to small and medium-sized subcontractors to reflect the increased cost.

How the system works sounds fair enough, but there is an important reason that the Ministry of SMEs and Startups is spearheading the introduction of the delivery price indexation system.

In South Korea where big conglomerates tend to have a firm grip on major sectors in the market, small enterprises handling orders from those big firms often find it extremely hard to ask for an increase in payment even if they have to pay more to secure raw materials at a higher price.

As the local currency is rapidly losing value against the US dollar and prices soar across a wide range of raw materials, a growing number of small firms are struggling to minimize losses, since the price adjustment system has yet to be implemented across the nation.

Small firms have long been calling for the government to make it obligatory so that they can run their businesses and process orders from big companies without worrying about sudden hikes in component prices.

When the SMEs Ministry started a pilot program, a total of 335 companies including 29 conglomerates expressed their intention to join the program that would reflect changing prices of raw materials in a preset range. Since this system is a voluntary program, the ministry plans to offer policy incentives for all participating companies.

Even though the program is being tested by a state agency, the Korea Development Institute, a state-run think tank, released a report Tuesday arguing that making the price adjustment system mandatory could have side effects.

In the report, the KDI said that linking the delivery unit price to raw material prices in a bid to jointly reduce risks could benefit all parties involved when there is a high level of uncertainty. But making it a mandatory system is feared to undermine its effectiveness, the KDI report said.

“The mandatory unit price indexation system signals the involvement of the government in the price-setting mechanism in the marketplace,” the KDI report said. “As this type of price control can have a direct and huge impact on the market, a cautious approach is needed.”

The underlying reason is that a mandatory price adjustment could distort decisions of market players in a way that generates inefficiency. For instance, big companies could opt for modifying contract periods or adjusting other trade conditions to secure profits. In a worse case, when extra financial burdens appear to be too much under the system, big companies could simply stop placing current orders and manufacture goods by themselves, or start outsourcing orders to foreign subcontractors.

As the system itself works as a state-imposed price adjustment, some companies could find and abuse loopholes, such as quickly passing higher production costs to consumers in the name of following the system.

In response to the KDI report, Kim Ki-moon, chief of the Korea Federation of SMEs, said he strongly disagrees with the idea that the delivery unit price indexation system could bring side effects. “The system is designed to prevent unfair trade practices,” he told reporters Wednesday.

As lawmakers from both the ruling and opposition parties are in favor of revising the related law by the end of this year, the system is likely to be introduced as a mandatory system. Given possible side effects, however, policymakers should closely check how the system works during the pilot period and take a more cautious approach to fix loopholes proactively.