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.

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.

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).

On Prices/Values

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.