Costs and Prices mechanism
Written by Dr Carmelo Ferlito, CEO of Center for Market Education
First published in Asia News Today on 23 January 2023
Economic affairs minister Rafizi Ramli has recently asked owners of restaurants and food stalls why their prices are high despite the lower cost of raw ingredients. In particular, he lamented the attitude of certain operators who still refused to lower their prices.
«Sometimes people get angry when they see that prices of raw ingredients are declining and electricity rates are being maintained, but the prices charged by restaurants and other food outlets remain the same», he said, according to a report by Free Malaysia Today.
Rafizi’s argument seems to be rooted in common sense: if production costs decline, then prices of consumer goods should follow the same path.
However, the idea that prices are determined by the cost of production – although still appealing to many both in economic theory and in the everyday conversation – is misleading, and it does not take into account the great subjective revolution which took place in economic science in the 1870s.
Prices are determined by supply and demand, and supply and demand are made of subjective evaluations. The interaction between these subjective evaluations generates market prices. This is not only true for prices of consumer goods but also for prices of production factors.
Therefore, prices of production factors (cost of production) do not determine prices of consumer goods, but the process works in the opposite way: expectations about future prices for consumer goods determine the emergence of prices for production factors.
An example will help the reader. There is a lot of talking about chicken prices and how they are influenced by rising costs of raw material. The way in which we should think about price formation is instead different; if chicken producers expect chicken prices to be good in the future, they will want to produce more and therefore they will enter the market for raw materials with a higher demand and such a higher demand will push upward the prices for those raw materials. In a nutshell: expectations about consumer good prices affect prices for production factors.
As explained by Prof Matthew McCaffrey (University of Manchester) in an educational paper published by the Center for Market Education: «Consumers’ decisions to buy or not to buy determine the prices of consumer goods, and through these goods, the market prices of all the factors of production used to produce them.
We could say that the value of consumer goods is imputed to the land, labor, and capital used to produce them. These factors only have market value because of their ability to contribute to producing goods and services for consumption» (An Introduction to Value, Cost, and Price, 2020, https://marketedu.me/edu-papers/).
What is the reason for high prices now and why are they not yet moderating? There are several factors at play. The first is a heated demand following the Great Lockdown and the adjustment time needed for the supply to meet that demand. In turn demand is high for a series of reasons:
- The festive seasons.
- More buying as a reaction to the years of constrain imposed by the Great Lockdown.
- Higher employment, which is, in most cases, unsustainable employment, as it was artificially created by the expansive fiscal policies implemented during the great lockdown; we may then expect rising unemployment after the post-Covid and inflation-driven economic crisis that CME already predicted in 2021 (Inflation, Unemployment and COVID-19 Policies: Where Is The Malaysian Economy Heading?, 2021, https://marketedu.me/policy-papers/).
Beyond the tension between supply and demand there is the real source of generalized and persistent price increases: the excess of money into circulation that was created during the Great Lockdown with expansive fiscal and monetary policies, which were implemented without thinking about the high costs they were bringing along.
In conclusion, the fight on rising cost of living cannot be fought with moralizing slogans, but needs a deep understanding of the price mechanism and the reasons beyond price increases. Bank Negara is acting by tightening monetary policy, but this will not be enough; a plan for gradual government spending cuts is of the utmost importance.
At the same time, that fight will not be without costs; inflation should have been avoided in the first place by avoiding the Great Lockdown; now we cannot fight it without implementing contractionary measures.