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On Prices/Values

Posted by Alex M Thomas on 11th August 2009

Economics, rather Political Economy attempted at providing a coherent theory of value. Economists such as Adam Smith, David Ricardo, Karl Marx, etc are associated with a ‘theory of value’. Currently, in economics, ‘value’ is not discussed in courses of relevance. However, students are exposed to value theories such as labour commanded, labour embodied and so on.

This post is the second in the series of posts ‘On Prices’. This posts attempts at clarifying concepts such as values, prices and costs of production. Note that all prices which are mentioned in economics textbooks (microeconomics, introductory economics, principles of economics, etc) pertain to relative prices or long-run prices. That is, they do not talk about market prices. The reason for this is because it is assumed/believed that market prices tend to fluctuate or hover around these relative prices. In other words, given a particular technology, these relative prices, in some sense, reflect the interrelationships in the economy. Hence, these natural/normal proces are studied in order to understand the workings of a capitalist economy.

Let me start with what is usually taught in various economics and management institutes across the world and even in higher secondary schools. Prices are determined by the interaction of supply and demand. This implies that an excess dmand leads to a price hike. Let us look at an example: Suppose I go to a toy shop and ask for a Meccano set and immediately, another customer asks for the same set. But, the shop has only one Meccano set. Will the price of the Meccano set increase? Is such an explanation intuitive or common sensical? This example talks of an isolated case.

Economics is interested in the formation of a spectrum of prices at the level of the economy. Interestingly, macroeconomics has nothing to offer on price formation. Often, or rather everywhere in the world, economics is taught as microeconomics and macroeconomics. The interdependence and interrelationship present in any economy is inadequately addressed. The closest one comes is probably through the ‘circular flow’ diagram which highlights the role of the firm as well as the households. In this diagram, the complex and strutural interdependence is oversimplified to that of a 2-way interaction between the firm and household via labour market, capital market, etc and the state is shown to play the role of a facilitator. The interrelated production structures goes unnoticed or is seldom mentioned. Why is this important?

How can prices be determined? (The dominant factor will be mentioned.)

1) Demand & Supply – The prices which are determined in this way are the prices of vegetables and fish, prices of shares in the stock markets, price of real estate, etc. In some sense, these prices can be said to be supply determined. For, these commodities are more often subject to variations in supply than in demand.

2)Costs of Production – An alternative view which is present in the literature is that the prices of commodities are prices according to the prices paid to the means of production as well as adding a certain percentage as profit. According to Kalecki, the percentage depends on the monopoly power of the firm. What if the firm’s final product is an input for another firm? Will this affect the price of the product? This aspect is often forgotten in economics.

This forgetfulness is strongly associated to the lack of importance mainstream and even some heterodox economic theories gives to interrelationships in the production structures in an economy. To have a glimpse into this, one needs only to look at an Input-Output table.

If we assume (correctly) that production structures in a capitalist economy are interrelated then we can conceptually distinguish goods/services into – Basics and Non-Basics. [Sraffa 1960] Basic goods are those goods which directly or indirectly enter into the production of every commodity in the economy including its own. An obvious example would be foodgrains because they are needed for labourers and labour is required in all activities. And a tax on a basic good will have cascading effects on the prices of all the goods in the economy.

I shall quote Sraffa to point out the significance of accepting and studying interdependence.

The exchange-ratio (or relative prices) of non-basics is “merely a reflection of what must be paid for means of production, labour and profits in order to produce them – there is no mutual dependence.” [p 8, Sraffa 1960]

“But for a basic product there is another aspect to be considered. Its exchange-ratio depends as much on the use that is made of it ….” [pp 8-9, Sraffa 1960]

It is because of these issues that Sraffa uses values/prices than costs. Also, Sraffa knew that in an economy, “costs of production cannot be measured independently of, and prior to, the determination of the prices of products.” [p 9, Sraffa 1960] To conclude, dan we therefore think that Sraffa’s analysis is similar to the neoclassical analysis of price using demand and supply?

In brackets, Sraffa writes “one might be tempted, but it would be misleading, to say that ‘it depends as much on the Deamnd side as on the Supply side.’” [p 9, Sraffa 1960]

References

1) Kalecki, Michal (1971), Costs and Prices, in Selected Essays on the Dynamics of the Capitalist Economy 1933-1970, Cambridge University Press, pp. 43-61.
2) Sraffa, Piero (1960), Production of Commodities by Means of Commodities, Cambridge University Press.

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Posted in Adam Smith, Classical Political Economy, Economic Philosophy, Economic Thought, Economics, Inflation, Neoclassical Economics, Perfect Competition, Piero Sraffa, Political Economy, Sraffa, Sraffian Economics | 3 Comments »

Is any 'economics' being taught?

Posted by Alex M Thomas on 12th December 2007

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.

Scarcity

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

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

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.

Perfect Competition

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?

Conclusion

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?

Posted in BA Economics, Consumerism, Economics, Education, India, Institutes of economics, Market Theory, Neoclassical Economics, Perfect Competition | 25 Comments »

On Perfect Information

Posted by Alex M Thomas on 3rd July 2007

Four persons A, B, C and D have to share Rs 4 among themselves in units of one rupee. First A proposes a distribution and all of them, including A vote on it. If at least 50% of those voting agree with A, the proposal is accepted. If not, A loses her voting rights and B gets to propose a distribution and all except A vote on it. Once again B’s proposal is accepted if at least 50% of those eligible to vote agree on it. If not, B also loses her voting rights and C gets to propose and so on to D. Assume that each person prefers more money to less and will always vote against a distribution in which she gets zero. What distribution would A propose?

This is a sequential game. It is one in which players make decisions (or select a strategy) following a certain predefined order, and in which at least some players can observe the moves of players who preceded them. If no players observe the moves of previous players, then the game is simultaneous. [Game Theory.net]

This is also one of perfect information. If every player observes the moves of every other player who has gone before her, the game is one of perfect information. [Game Theory.net]

In the sequential game with perfect information, A will propose 3 for himself and 1 to D. This will be accepted by both A and D. D will accept anything more than 0; the reason being that, if all the proposals are rejected and the 4 rupees come in Cs hand, he will take all 4 for himself and since he will will vote for himself, the proposal will get accepted.

In such a game, the one makes the move first will have undue advantage.

On Perfect Competition

This market environment is extensively studied in Economics and is considered as a “Perfect” environment especially on the basis of efficiency.

This write up explains the concept of perfect competition succinctly.

Is such an environment favourable for all ? Competitive markets emphasise the importance of having perfect information as a pre requisite for a competitive equilibrium; one which is also Pareto Efficient.

The consumption decisions taken are sequential in nature. The consumer decides to purchase the commodity or service keeping in mind the price; which has been fixed earlier keeping in mind the consumers preferences. The outcome will always favour the producer (In a perfectly competitive market) as he makes the decision of pricing first.

On Pareto Efficiency

An outcome of a game is Pareto efficient if there is no other outcome that makes every player at least as well off and at least one player strictly better off. That is, a Pareto Optimal outcome cannot be improved upon without hurting at least one player. [Game Theory.net]

Conclusion

If the objective in an economy is Pareto Efficiency, then it can be achieved by a competitive market. But, it does not take into consideration equity in distribution. For example, in the game mentioned above, an allocation which leaves A with all the 4 rupees is Pareto Efficient, because in order to make someone better off, A has to be made worse off.

In India, the objective is to reduce Poverty and make growth more wide spread rather than growth being segregated in nature.

The idea that we cannot achieve the ideal state of perfectly competitive market equilibrium might seem pessimistic. Some economists insist upon holding the capitalist system to a standard of competitive equilibrium. Failure to meet this standard constitutes a “market failure” that warrants government intervention.[MacKenzie 2006]

So, is a market environment with perfect information desirable?

Posted in Consumer Theory, Economics, Game Theory, Markets, Pareto Efficiency, Perfect Competition | 5 Comments »