Prices, Competition and Markets

It has become commonplace in India to point fingers at the central government when prices of essential commodities such as onion or fuel rise. The underlying arguments behind this accusation could be that: (1) the government is expected to maintain price stability and/or (2) the government should socially engineer agricultural markets in a ‘fair’ manner. But, is the pursuit of price stability not the job of the Reserve Bank of India (RBI)? It is true that the RBI cannot do anything to combat inflation when it is caused by a supply-and-demand mismatch in the domestic vegetable market or the international oil market. What the RBI can do is manage inflation expectations, and that is for another post. The present post is motivated by the insightful analyses of Kannan Kasturi on the Indian vegetable market, published in the Economic & Political Weekly and other places. That is, this post takes up the second of the reasons mentioned earlier.

The price mechanism – adjustments made by producers to the selling prices and consumers to the purchasing prices – is expected to allocate the commodities brought to the market amongst the consumers, in accordance with their needs, reflected in their willingness to pay. The prices therefore act as signals for the producers especially. Sellers can adjust quantity in order to affect prices; hoarding commodities is one such strategy. At equilibrium, producers earn a normal rate of profit, which contains a pure rate of return on capital advanced and a return for risk and entrepreneurship. If producers do not make normal profits in time t, they will cut down production in time t+1. During the equilibration process, producers who are unable to earn a normal rate of profit will exit the market. If entry costs are low, new producers will enter the market. Producers who have large financial resources (or access to easy credit) at their disposal are insulated from temporary alterations in demand. Producers who have enough accumulated earnings can shield themselves from such market volatility. In short, a competitive market is one where prices are not distorted (by the producers or by external intervention), no (especially, cultural and social) barriers to enter the market exist and workers are mobile within and across markets.

Of course, the agricultural markets in India are far from competitive. Since more than 50% of Indians derive their income from agriculture, and particularly because of the poverty of the farmers, these markets require government intervention. This is not to say that any form of government intervention will better the situation. Kasturi quite convincingly shows that the fault lies with the supply-side – the agricultural supply chain. This post will not discuss minimum support prices or other input subsidies, such as for electricity, irrigation and fertilizers. Also to be noted is the specific manner in which the agricultural input markets are inter-linked in India, which has been of an exploitative nature. Finally, social and cultural factors (pertaining to caste and gender) are seen to hinder competitiveness in Indian markets, not just in agriculture.

What are the problems with the agricultural supply chain? Kasturi points out the following: (1) Small farmers lack storage facilities in order to gain from the high market prices. (2) The middlemen (those who intermediate between farmers and final consumers), i.e. the wholesale traders and commission agents have the ability to hoard vegetables and consequently they reap the benefits of the high prices they themselves engineer; the Agricultural Produce Marketing Act governs the agricultural markets (mandis) and it is here where all the proceeds from higher prices are absorbed with nothing reaching the farmers. These traders and commission agents are ‘well entrenched in the mandis, having been in the business on average for 20 years’ (3) Agricultural pricing is not at all transparent and the mandi records are of no assistance in this regard.

To sum up, the nature of government intervention has to change, in such a way that is beneficial to farmers. Proper laws are of utmost importance, not just in protecting the interests of the small farmers, but also that of the consumers.  Moreover, intermediaries in any market perform useful functions but laws should be in place which ensures that they do not become monopolistic and exploitative. Agricultural infrastructure such as storage facilities is paramount in this context. A very detailed study of how these supply-chains operate will be of much help in our attempts to combat inflation.

James Steuart, Strange(r) Economists and the Indian Economy

 

Inflation has been portrayed as the biggest challenge faced by Indian policy makers and its Central Bank, Reserve Bank of India, in recent times. The Chief Economic Advisor to the Government of India and Professor of Economics at Cornell University, Kaushik Basu, recently presented his professional views on inflation – understanding and management, at the First Gautam Mathur Lecture on 18 May 2011. This is currently available for download as a working paper at the Ministry of Finance website. Various excerpts from this paper have made its way in some English newspapers and TV media. I will comment on this paper at length on a later date. Reading Basu’s paper makes me wonder whether monetary economists or other policy makers know what India is, who Indians are and what Indians actually do. In more abstract terms, do economists know the structure of the Indian economy? Do they know what motivates Indians? Is it primarily region, class, caste, religion, gender, education, self-interest, compassion, sympathy, fame, status? Although, to be fair to Kaushik Basu, he asks the RBI not to experiment and not to put up a façade of knowledge (which he frequently does). Without having a clear understanding of, what the 18th century economist James Steuart calls, “the spirit of a people”, it is impossible to formulate effective policies. Moreover, the focus on employment generation has completely given way to inflation stabilisation, using sophisticated econometric techniques. Therefore, this blog post revisits James Steuart’s views on how “the spirit of a people” influences economic engineering. In the Indian context, the consequences of monetary intervention might not be those which are depicted in conventional models of inflation.

Sir James Steuart (1713-1780) published An Inquiry into the Principles of Political Oeconomy in 1767 which was and has been overshadowed by Adam Smith’s Wealth of Nations published in 1776. Steuart acknowledged the importance of devising context-specific economic policies. However, we must realise that context-specific economic policy is not antithetical to general economic theories. In other words, proposing economic theories and models of a general nature is not inherently a problem; but, when applied blindly, they cause havoc, which is often supressed in very clever ways. Steuart writes:

“Every operation of government should be calculated for the good of the people. . .that in order to make a people happy, they must be governed according to the spirit which prevails among them” (p. 21).

An ignorance or lack of understanding of this “spirit” can have disastrous consequences. We see some of them in the worsening urban-rural inequality, falling of inflation-adjusted per capita incomes in interior villages [EPW, 2011], agricultural distress and forced migration [P Sainath, The Hindu, 2011]. One of reasons why such skewed policies are implemented is because of the rationale provided by “pure economic theory”, which Basu seems to praise for its scientific rigor and [semblance of] truth. To be clear, “pure economic theory” is something which Steuart was against because it assumed a certain “spirit” and claimed to be universal thereby neglecting important specificities and characteristics pertaining to individual economies.

For Steuart, “the spirit of a people is formed upon a set of received opinions relative to three objects; morals, government and manners: these once generally adopted by any society, confirmed by long and constant habit, and never called in question, form the basis of all laws, regulate the form of every government, and determine what is commonly called the customs of a country” (p. 22). That is, education, religion, region, caste, gender, etc would significantly affect the “spirit” of India. Also, important characteristics such as the percentage of Indians employed in agriculture, in unorganised manufacture, in self-employment, in rural areas, using informal sources of finance, who are socially poor (less than 100 rupees a day), who actually invest in stock markets, who read English newspapers and so on affect the outcomes of economic engineering. Not paying heed to these significant characteristics is the same as formulating an inappropriate policy. Let me highlight once instance. The RBI conducts Inflation Expectations Survey to estimate how the expectations of the Indian populace change over time and this result forms an input into monetary policy making. Despite this, the RBI did not survey any Indian living in rural areas; they seem to neglect and forget the fact that the main producers live in rural areas and their chief occupation is agriculture! This certainly deserves to be questioned. Policies should not be formulated “at any point which regards the political oeconomy of a nation, without accompanying the example with some supposition relative to the spirit of the people” (p. 23). If the “spirit of the people” is not taken into account, as the example above indicated, such policies could prove to be harmful. This also calls for greater dialogue between economists and other social analysts (sociologists, cultural theorists, political scientists, anthropologists, social workers, etc) when engineering nation-wide socio-economic policies. Hence, Steuart writes that “in every step the spirit of the people should be first examined” (p. 25).

Often, the attitudes of policy makers indicate how much their academic knowledge is irrelevant for practical economic and social problems. The reliance on “pure economic theory” is nothing but an intellectual looking, mathematically replete and made-difficult-to-understand version of free markets, because efficiency and rationality are our new gods! As Keynes writes in his preface to The General Theory, “the difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.” Today, these “old ideas” are not only fashionable and ‘scientific’ (and often unsuited to India), but they are also communicated relentlessly to the new generations through schools and universities. In conclusion, it is scary to realise that India’s policy making is done by those who are “strangers” to the Indian realities. Steuart warns us that “when strangers are employed as statesmen, the disorder is still greater, unless there be extraordinary penetration, temper, and, above all, flexibility and discretion” (p. 27).

(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!

 

 

Economic Survey of India 2010-11: A Critical Look

The Union Budget is presented based on the Economic Survey conclusions and recommendations. Therefore, the Economic Survey becomes a crucial document to examine and interpret. This time as well, the hands of its architect remain quite visible. Like the previous attempt, there is an increased use of economic theory – game theory, mechanism design, rational choice theories, etc – which provide support to various policy recommendations. According to this economic architect, all solutions are to be found in incentives. If the right incentives are provided, then economic and political governance will be smooth like that of the most competitive market. Agreed! What commonsense and insights from various social processes tell us is that individuals have heterogeneous preferences and what is an incentive for one might be poison for another. This blog post will examine some of these suggestions in detail (from Chapters 1 and 2 of Economic Survey 2010-11). In particular, the suggestions examined below will be those which have been favoured or disregarded based on arguments drawn from (neoclassical) economic theory.

Fiscal policy

Economic Survey 2010-11 assures the reader that India has recovered from the global financial crisis because of the high growth rates. For all practical purposes, this information indicates that we can now call for fiscal consolidation or lowering of the fiscal deficit. The usefulness of the government is over; let market forces function peacefully now without any government intervention!

“With clear evidence of economic recovery in 2009-10 as indicated by the Advance Estimates of the GDP, the Budget for 2010-11 resumed the path of fiscal consolidation with a partial exit from the stimulus measures.”

It is at the same time interesting and worrying to see this sort of rhetoric. Such rhetoric rests on the following premise: the opportunities for investment are limited (read: scarce) and the entry of the government will crowd out private investment. Surprisingly, this neoclassical idea, which is much promoted in our academic textbooks, fail to point out the fallacy of composition on which this argument is based. This argument does not recognise the interdependence in an economy. Wages generated from government jobs are not only used to purchase goods and services from the government sector. In fact, the wages and salaries generated by the government sector are spent in consuming goods and services produced by the private sector. It is certainly time policy makers understood the benefits of crowding in effects of government intervention. The expenditure, one should look for, is mainly in social services – education, health and employment.

Agriculture

Agriculture has been identified to be critical for macroeconomic stability and growth; although services sector is our potential growth engine. This can be read as: agriculture needs to grow at a level which will enable (the favourite word of the economic architect) the service sector to grow. Agriculture is carried out by majority of our fellow Indians (around 60 %) and it provides us food and raw materials. Our economic architect argues:

“The rise in prices of agricultural produce would in part help incentivize production; the moot question remains what proportion of the rise accrues to the producer and what proportion gets appropriated by middlemen. The creation of more direct farm-to-fork supply chains in food items across the country would be critical in incentivizing the farmer with higher producer prices and at the same time would lower the prices for end-consumers.”

Why are middlemen always blamed? Are they not the ones who aid production? Who exactly are these middlemen? Be that as it may, what is clear is that the middlemen have often more power (economic and social) than the actual producers. Majority of the farmers are forced to sell their product immediately after harvest owing to debt obligations. In addition, the (small) farmers do not benefit from the price rise because they do not have adequate storage facilities. As a matter of fact, even the Government only stores certain food grains in its godowns. Vegetable and fruits are not procured by the government. The undue emphasis placed on incentives by our economic architect is of concern. For one, production can only be carried out if the farmers have sufficient capital to purchase inputs. In India, the phenomenon of inter-linked markets is common in agriculture. That is, the same person provides credit as well as inputs to the farmers, thereby enjoying a very strong bargaining position over the farmer. Now, when our economic architect recommends FDI in retail food because they incentivise production, he is being blind to the production conditions of Indian agriculture. This can exacerbate the plight of the Indian farmer by making him/her subject to the contracts of the foreign firms. In this scenario as well, the farmer, owing to his/her weak bargaining power will never be able to enjoy higher prices. But yes, this could mean a lowering of prices for our urban consumers!

Inflation & employment

The subject of inflation has been dealt with in great detail in Chapter 2 of the Economic Survey 2010-11. In recent times, inflation has affected both the rural and urban consumers. However, as we know, the effect of inflation on the consumers are not equal in magnitude. Consumers who have very less income will be deeply affected by inflation. For instance, the small and marginal farmers are severely impacted when prices rise. Given this plight, the following statement by our economic architect is indeed baffling:

“It may be mentioned that food price inflation during the last financial year was mainly driven by high inflation in pulses, cereals, and sugar due to bad monsoon. The rise in the purchasing power owing to the rapid growth of the economy and inclusive programmes like the Mahatma Gandhi National Rural Employment Guarantee Act (MNREGA) partly might have contributed to the upward trend in inflation.”

First of all, the above statement indicates an inadequate understanding of inflation. Secondly, what about the rising purchasing power of the urban consumers or the employees of BPOs. What makes our economic architect point fingers at those who barely manage a living? If the beneficiaries of NREGA were surviving by barely subsisting before NREGA, their purchasing power would not have risen so much post-NREGA to contrbute, as our economic architect suggests, to inflation. In fact, such statements indicate a gross misunderstanding of inflation, a lack of knowledge of how rural India operates and a insensitivity towards subsistence and livelihood in general.

Conclusion

It is high time that we seriously examined some of the tenets of conventional (neoclassical) economic theory. Today, a lot of students and professors of economics world over are questioning the premises and logic of neoclassical economics. However, we find neoclassical economics still domination in various forms, such as new institutional economics, mechanism design, law and economics, microeconomics etc. Given that some of the foundations of economic theory are in question, it is surprising to see how much our economic architect bases the policy recommendations on such apparent scientific and objective truths!