Category: Prices

(Mis)understanding Inflation

 

The recurrent hikes in fuel prices over the last one year are a cause of concern. For, fuel is a basic commodity and it enters as an input directly or indirectly into the production of all commodities ‘ agriculture, manufacturing and services. About a year back, an ‘expert’ committee headed by Kirit S Parikh recommended a partial deregulation/liberalization of fuel prices. This has eased the financial burden of the government. In addition, economists have posited that deregulation will enable markets to become efficient (subsidies and taxes distort efficiency). In any case, the role of the government has been changing rapidly too ‘ from that of a provider to that of an enabler (to quote our Chief Economic Advisor, Kaushik Basu).

A couple of days back, our esteemed Deputy Chairman of the Planning Commission Montek Singh Ahluwalia told the media that the recent hikes in fuel prices was a strategic move. According to him, the hike in prices of petroleum products would help ease inflation in the long run as it would suck money from the system. This post examines this statement by trying to understand the mechanism of inflation.

INFLATION

Inflation, as we know, refers to a continuous increase in the price level over a period. To make sense of this seemingly simple statement, we must have a clear understanding of the two concepts based on which we understand inflation. It is on the basis of this understanding that policy decisions are made both by the RBI as well as the Central Government to control inflation. The two concepts are:

(1)” Time: the price rise has to be continuous over a certain period.

(2)” Index number: inflation is studied by making use of these special averages

Time

How much time must elapse before we can characterise the price increase in an economy as inflationary’ In theory, economists solve this problem of having to fix the time period by introducing the distinction between short-run and long-run. However, this distinction does not solve the problem, but only adds to the complexity. What do we understand by short-run’ Does it refer to one week, one month, 6 months or one year’ Interestingly, there is no fixed answer to this. The distinction between short-run and long-run shows how creative economists are, although its utility is questionable. Short-run refers to the time during which the variables under consideration do not have adequate time to adjust or settle (at their equilibrium positions). Whereas, long-run refers to a period (point’) when all the adjustments are over and all the variables have settled. How convenient! The long-run will remain a mirage.

Given these unsettled issues, how does our Deputy Chairman of the Planning Commissions confidently maintain that fuel price hikes will ease inflationary pressures’ This statement is meaningless because the long-run is a fictitious concept. Such statements indicate the misplaced confidence economists possess as well as the poverty of economic theory.

Index numbers

Price level is what we examine in theory when trying to understand inflation. In applied work, we trace changes in indices such as WPI and CPI (which is a proxy for the general price level in an economy) in computing inflation. The construction of a good index number is a difficult task. Selection of relevant variables, choice of base year, the kind of index number to use ‘ Paasche, Laspeyre or Fisher ‘ are some of the issues which have to be tackled. A detailed discussion of index number will feature as a blog post in the future.

Ahluwalia, one of our economic planners, maintains that fuel price hikes will ease inflation in the long run. The explanation he provides for this occurring is both logically and factually incorrect. He said that fuel price hikes ‘suck excess money out of the system.’ Firstly, this statement is based on a particular view or understanding of inflation, namely the neoclassical one. Inflation is seen by this group as a result of excess money in the economy. In the words of economics textbooks, which do an excellent job at indoctrination, inflation occurs when too much money chases too few goods. It is this factually incorrect view which dominates academia as well as the policy arena. In fact, it is this view which is widely communicated in the media as well. Several economists have questioned this notion but with limited success. For, if inflation is not a monetary phenomenon, how will the central banks survive’ In any case, this view is not a correct representation of reality because manufactured products and services are not priced on the basis of demand (unlike agricultural prices which are largely demand-determined). [See Who prices the Products’ and On Prices/Values] If the prices increase from non-monetary factors, such as production conditions, expensive labour, from a higher profit margin, corruption or rise in fuel prices, how will removal of money reduce inflation’ In fact, how does one arrive at a benchmark for computing ‘excess’ money’ Fuel price hikes, on the other hand, will threaten the livelihood of both the poor consumers and poor producers.

What does our planner mean when he talks of the ‘system” A closed economy’ An open one’ Will the money not still be circulating in the economy even after the fuel price rise’ Without clarifying the above mentioned issues, the statement made by the Deputy Chairman of the Planning Commission holds no ground, however scientific it might sound! Such statements only reinforce the arrogance of economists and the poverty of economics!

 

 

Who prices the products’

Recently, Indians have witnessed an escalation in onion prices followed by a hike in fuel prices. Price rise is a phenomenon which affects all sections of the society in varying degrees. Earlier, through the work of Michal Kalecki, a Russian economist, this blog showed the difference between cost-determined and demand-determined prices. The current post examines how products are priced. Majority of the arguments in this post is taken from the book Smart Pricing, authored by Jagmohan Raju and Z. John Zhang published in 2010.

Textbook economics teaches us that it is demand and supply which determine prices. Are the prices of vegetables, rice, chicken, train travel, milk, bread, toothpaste, parathas, etc determined in a similar way’ When price changes are attributed to demand and supply, it means that prices are taking their ‘normal course’. In other words, price movements arising from demand and supply are considered as normal as the law of gravitation. Economic theory ascribes the term ‘invisible hand’ to denote demand and supply factors which cause prices to alter. However, as repeatedly pointed out in this blog, manufactured goods and producer/consumer services are not priced in the market via bargaining. As Raju and Zhang rightly point out, ‘Price setting is a tangible process with a tangible outcome ‘ a dollar figure. The process of arriving at that number might not be tidy, but it cannot be so mysterious that it does not involve any human intervention. Someone, somewhere must make a concrete, numerical decision about the price of a product or service’ (2010, p 2). Further, they argue that ‘the market does not set prices. Marketers do. All the prices we observe in the marketplace do not just spring out of an autonomous, impersonal market. The managers’ hands in setting those prices are entirely ‘visible,’ regardless of whether such interventions are acts of expediency or strategy’ (Ibid, p 11-12).

According to Raju and Zhang products are usually priced based on three approaches: (1) cost-plus based, (2) competition based and (3) consumer based. An overwhelming majority of U.S. Companies use this approach to set prices. Here, the mark-up is determined by the company’s targeted internal rate of return on investment or by some vaguely defined industry convention. Competition based pricing is the second most popular approach and is considered to be strategic. In this approach, the prices are fixed taking into account the prices of similar products in the market. In the case of consumer based pricing, the company tries to determine how much each consumer is willing to pay and then accordingly fixes a price. All the above mentioned approaches indicate that price fixing is a conscious and deliberate action carried out by the company or individual producer.

In microeconomics textbooks and in the media we find statements which ascribe price rise to demand-supply factors. The group of individuals ‘ the capitalists, the brokers, the intermediaries etc ‘ who cause the prices to rise with their actions are completely absent in this account. The book by Raju and Zhang therefore is a must read for all economists who wish to understand how products are actually priced in today’s consumerist society.

Reference

Raju, Jagmohan and Zhang, John (2010), Smart Pricing: How Google, Priceline, and Leading Businesses Use Pricing Innovation for Profitability, Pearson Education: New Jersey.

Economics: The Study of Commodities

The study of commodities has been central to economic theory. Mercantilists considered gold, a commodity to be wealth. Later economists argued that an increase in commodities, both agricultural and manufactured, implied an increase in wealth. The increase in the production of commodities is still the most widely used indicator of economic growth/progress. This indicator is none other than the real GDP. In 1985, Amartya Sen published a book titled Commodities and Capabilities. In this work, Sen challenges the dominant view in economics regarding the role of commodities, i.e. he maintained that an increase in commodities cannot be taken as the sole factor in assessing economic development. Sen emphasised the importance of examining capabilities, which subsequently led to the creating of the Human Development Index (HDI). This post discusses the rationale behind economists’ obsession with commodities. It also examines Sen’s critique of commodities and how his (Aristotelian) concept of capabilities differs from it. This post concludes by arguing for a strengthening of classical economics, which studies the production, distribution, exchange and consumption of commodities, for the considerations of ethics can be easily integrated into this approach.

Economics as a distinct form of inquiry begins with the works of Sir William Petty in the 17th century. Petty was interested in assessing the comparative wealth of England and Ireland. Some of the indicators he chose were the number of houses and population. The idea behind this being that a surplus of food results in more population and therefore more houses. Having a large population was considered to be beneficial to the state. His successor, Richard Cantillon, an economist par excellence, pointed out that wealth of a state is reflected in the quantity and nature of commodities it produces ‘ necessities, comforts and luxuries. This brief historical excursus is to point out the nature of economic inquiry, which is essentially an analysis of quantities and prices. Examples of quantities are employment, income, exports, investment, money supply, etc. Examples of prices are WPI, interest rates, foreign exchange rate, commodity prices, share prices, etc. That is, an analysis of commodities is an examination of quantity and price at the same time. Therefore, an analysis of commodities subsumes an examination of their production, distribution, exchange and consumption. Production includes the structure and relations of production; distribution pertains to the process and mechanism through which the incomes/surplus from production is divided among its participants; exchange refers to the mode and institution through which commodities are sold; finally, consumption illuminates the channels through which consumption of commodities aid production in the next period and how production in the current period aids current consumption. Thus, classical economists such as Petty, Cantillon, Quesnay, Smith and Ricardo were interested in the theory of production, distribution and exchange of commodities. Their interest was motivated by the need to find out ways of improving the general well-being of their respective societies.

According to Sen, the kind of analysis posited above looks at opulence as the sole indicator of economic development. A shift in economic analysis came about in the 1870s with the emergence of marginal analysis, independently developed by Jevons, Walras and Menger. Terms such as utility, choice, scarcity, margins, etc made inroads into economics. In fact, standard microeconomics texts are nothing but a combination of Walrasian and Marshallian economics. In any case, the maximization of utility began to be seen as the objective of individuals, for attaining economic progress. The internal justice of free markets was imbued to this form of economic analysis. Based on utilitarian principles, the maximization of utility by individuals was seen as a way to improve human well-being and welfare. This conception of development, according to Sen, emphasised the role of utility.

Both the above mentioned analyses, according to Sen, deal with ‘the relation between commodities and people’ (p. 1). The former approach argues for more commodities which leads to more production, which raises the incomes of the people and hence their consumption. The latter analysis points out that ‘more is better’ and hence availability of more commodities imply more utility. The idea of ‘more is better’ is intricately connected with their idea of economics, as a science of choice. Economics, for marginal/neoclassical economists, refers to the allocation of scarce resources amongst alternative uses, as Lionel Robbins points out. For Sen, both these analyses are limited, since they do not address the heterogeneity in the capabilities of different people, which leads to ‘a confounding of the state of a person with the extent of his or her possessions’ (p. 16). It is precisely this argument of Sen developed in his 1985 book which widened the scope of mainstream economics. I write mainstream economics because for classical economists, economics or political economy formed only one way of looking at growth/progress/development. For classical economists, as pointed out earlier, an analysis of production included the state or condition of the producer. The best example of this form of theorising can be found in Marx, the last of the early classical economists. However, with the advent of marginal analysis, the analyses of the structure of production took a backseat. The sphere of exchange came to the forefront and along with it the explanation of the formation of all kinds of prices and quantities through the apparatus of demand & supply.

It is interesting to note that the idea of capabilities has been intrinsic to classical economics. As mentioned earlier, an increase in the production of commodities translates into an increase in income generated. In contrast with neoclassical economics, the economic processes is visualised in a circular way as opposed to a one-way street. One needs to look into the structure of production to find out to whom (which class) this increase in income accrues (theory of distribution). However, the manner in which Sen develops his capabilities approach is rooted in mainstream/neoclassical economics ‘ via the sub-domain of welfare economics (See Benicourt 2002 and Omkarnath 2007). Although, Sen deserves credit for bringing back humanitarian concerns into the discourse of neoclassical economics. Omkarnath further points out that the capabilities approach rooted in the Walrasian tradition is static in nature, for it mainly concentrates on the formation of capabilities. Whereas, classical economics has numerous insights on the relation between capabilities and commodities. This sort of analysis calls for a careful examination of the structure of production, distribution and exchange present in various economies in the classical political economy tradition, which has more scope for including social, cultural and political factors as well as ethical concerns.

References

Benicourt, E (2002), ‘Is Amartya Sen a Post-Autistic Economist”, post-autistic economics review, issue no. 15, September 4, 2002, article 4. http://www.paecon.net/PAEReview/issue15/Benicourt15.htm

Omkarnath, G (2007), ‘The Formation of Capabilities’, Indian Journal of Human Development, Vol. 1, No. 2, pp. 389-399.

Sen, Amartya (1985) [1999], Commodities and Capabilities, Oxford University Press: New Delhi.

Utility in Microeconomics: Outdated’

This post clarifies the concept of a utility function, which occupies a very significant position in neoclassical microeconomics. Advances in neuroeconomics and related fields of behavioural economics is constantly challenging the conventional assumptions of microeconomics. This post takes up one such insight by Stephen B Hanauer which was published in Nature in March 2008.

A utility function can be understood in the following way:

U=f(x,y,z) where U is the utility derived from the consumption of x, y and/or z. Alternatively, a utility function transforms combinations of various goods into a single value. Note that x,y and z refer to ‘quantities’ of goods/services consumed.

Suppose, consumer A has the following utility function: U=x+y+z; arbitrary values of x,y and z would result in the following values of U.

x y z U
0 0 0 0
1 0 0 1
10 10 0 20
6 6 8 20
0 10 10 20
10 10 10 30

That is, microeconomics teaches us that the utility of the consumer is determined by the quantity of goods consumed. An common assumption is that ‘more is better’, which implies that the consumption of more goods gives the consumer more utility. The point to be noted is that microeconomic theory teaches us that utility is strictly a function of quantities. The question posed in this post is whether utility is ‘only’ a function of quantities. What happens if utility is also a function of prices’ At this juncture, we need to recollect the objective of utility functions. From the utility function, we derive indifference curves and marginal utilities. Utility or use value of the good or service forms the basis of the demand function, which along with the supply function determines the value/price of a commodity or service. Thus, the use value was employed so as to arrive at the exchange value/relative price of the commodity.

What happens if utility (or experienced pleasantness) is influenced by ‘changing properties of commodities, such as prices” That is, can neoclassical microeconomics accomodate the following utility function:

U=f(x,y,Px,Py)

And research in behavioural economics and related areas suggest that prices exert a significant influence on utility and hence on choice and demand. However, if we accept such a utility function, it can no longer be used to explain exchange values/relative prices. Another implication is that prices are no longer determined by the interaction of demand and supply. And the statement that ‘consumer is the king’ no longer holds. Also, producers can adjust prices in such a way as to affect consumers’ utilities. We know that high prices are often associated with better quality and hence higher utility.

x y Px Py U
0 0 10 10 0
10 10 10 10 200
10 10 5 10 150
10 10 4 4 80

The above table can be explained by the following utility function: U=x.Px + y.Py

In this case, a higher price gives more utility to the individual. The maximum utility is when x=y=10 and Px=Py=10.

The other extreme case is when high prices are detested by the individual. For instance, consumers with low incomes will get more utility from consuming goods which are priced less. Their utility function could be represented as follows: U=x.-Px + y.-Py

In which case, the consumers utilities based on the previous values of x,y,Px and Py will be 0, -200, -150 and -80. And the consumer’s utility is maximum when he/she consumes x=y=10 when Px=Py=4.

Empirical evidence suggests that utility is equally influenced by prices of commodities as well. Does this threaten the core of neoclassical microeconomics’ This is problematic because neoclassical economics assumes the following to be given: 1) tastes and preferences of individuals, 2) endowments of goods and 3) constant technology. It if from these ‘givens’ that prices and quantities (demanded and supplied) are arrived at through the mechanism of demand and supply/competition/market forces. How can we include the recent findings pertaining to consumer utility and satisfaction in a consistent manner’

‘Update

The link to the reference was embedded in the authors name. However, because of the comment by Dr. Thomas Alexander, the reference is prrovided below. Also,I acknowledge him for bringing this article to my notice.

Hanauer, S (2008), ‘Experienced Pleasantness,’ Editorial, Nature Reviews Gastroenterology and Hepatology 5, 119 (1 March 2008).