Prices- how are they formed? Economics fundamentally is concerned with the theory of value; wherein prices play a crucial role. Does the mainstream or marginalist (neoclassical theory) explain the formation of prices? In equilibrium, the forces of demand and supply interact to give the equilibrium prices and quantity purchased and sold. But, in reality, is it so? Does this theory explain the actual working of any economy?
In school textbooks, I remember being taught the law of demand, factors affecting demand and the exceptions to demand. The law of demand conveniently takes into account only one factor, which is its own price. And economists like Veblen and Giffen who tried to discuss demand were sidelined as exceptions.
Thorstein Veblen talked of ‘social factors’ like status symbol, conspicuous consumption etc which affected demand. His book The Theory of the Leisure Class explains how interdependent individuals in an economy are, and how the individual is very much a part of the society unlike the ‘rationalist atomistic individual’ as assumed by the mainstream theory.
In Marshall’s Principles of Economics, he mentions Giffen effect- a rise in the price of bread results in a large drain of resources which force them to curtail the consumption of relatively expensive items like meat; and they consume more of bread as it is still the cheapest food they can get. In India, with more than 60% percent of the populace being poor [Guruswamy and Abraham], Giffen effect is the norm rather than the exception!
This post discusses some of the microeconomic concepts taught across schools and colleges.
I was taught that the central problems in economics were that of scarcity, of unlimited wants and how one chooses the best option. And here optimization (a mathematical apparatus) comes to the aid of economics- in finding the optimum. But are resources really scarce? If resources were really scarce, how could an economy grow? Land, of course is scarce; but the availability of land can be increased through reclamation, deforestation etc. Economics ought to be concerned about wants that are backed by purchasing power; otherwise the theory will be trying to reconcile dreams and scarce resources.
Equilibrium is reached when the demand and supply curves intersect in the graph having quantity demanded and supplied on the x axis and price on the y axis. Joan Robinson (1973) wonders why one uses a metaphor based on space to explain a process which takes place in time.
This approach has for quite some time disturbed me. Why is it that we take ‘equilibrium’ to be favorable? Equilibrium is a thing very commonly found in Physics. One of the meanings is that ‘it is a state of rest’ and this is precisely the meaning economists provide. For, in equilibrium, the quantity demanded will be equal to quantity supplied and all is well. Coming to think of it more, why would a stagnant economy be favorable? What is more frightening is that, we are taught that it is what economic policies should aim at!
Prices, according to the mainstream neoclassical theory are determined based on the intersection of demand and supply; that too in a static set up. Prices, in today’s world is certainly not fixed in the before said manner. The producers decide the price based on the cost of raw materials and other items needed for production, wages and salaries of employees, advertising costs, existing taxes, etc. So this means, prices in an economy has more correspondence to the supply side than the demand side.
What is the significance of the demand side? One of the reasons could be to point out the importance consumers have in deciding the prices in a ‘perfectly competitive’ economy. It would signify consumer sovereignty in such an economy. Again, this belief of ‘consumer sovereignty’ is something one would like to have, but is absent totally.
No student of economics graduates without studying ‘perfect competition’. It is very much entrenched in economic theory as taught today. Why? The answer given is that it is the ideal state for an economy. Or rather, as the name suggests, it is ‘perfect’. Then we are taught about imperfect competitions keeping in mind what is good or ideal-perfect competition.
One of thoughts one could have is ‘why is it considered perfect’. The price is assumed to be given or it is said that the firm is the price taker. Another query would be- is perfect competition possible? The main driving force behind corporations and businesses is money or precisely speaking, profits. Would firms like an atmosphere where they are unable to fix prices and hence unable to earn more profits? It reeks of Orwell’s Animal Farm. Why would there be any competition at all? Aren’t differences that lead to competition? Would there be any incentive to produce or to diversify?
This post ends on a skeptical note. Is the current mainstream economics helping the economy by tailoring productive and progressive economic policies? Is they are not, why are they still being taught as compulsory topics? Is there an alternative approach?
I would like to put forth a question regarding the notion of prices.
50 years ago, one could buy a book for a rupee; but now, a book’s average cost would be about 100. This follows for all other goods and services too. What is that which accounts for this sustained rise in prices? Is it inflation alone?