Sunday, January 13, 2008


There is a detailed discussion over suddenly observed commodity price increases where food prices are exposed in particular. The Economist recently wrote about the future of food prices. Agreeably, the Economist correctly diagonosed that changing conditions of world supply and demand will inevitably result in higher consumer food prices as input and wholesale prices have increased substantially. What is the anatomy behind the price level? What features affect price dynamics? What is the driving wheel of price escalation? How firms take/make prices? What's the effect of elasticity? Why monopolies are bad and competition is good?

Supply, Demand and Equilibrium

As first, prices are determined in general equilibrium by matching supply and demand. The latter are shaped in the opposite direction. Consumers want to maximize the quantity at the possibly lowest price and suppliers want to sell the products at the highest possible prices to increase total revenue. In economics, we say that demand curve is a negatively sloping price function. Individual demand curves merge into market demand curve where all individual demand curves are aggregated into a single market demand curve. On supply side, supply curve shows the relationship between two basic entities in economic analysis - quantity and price. The curve is positively sloping as supplier are willing to sell larger product quantity at higher product prices. What actually affects demand and supply?

Demand in primarily affected by consumer preferences, prices of substitutes and complements, income, population size and future price perception. On the other hand, supply is subject to production technology, prices, costs and future price assumption as well. A reasonable question is how prices emerge. They emerge from market behavior. Consumers have to give up their slice and suppliers have to give up their portion. When the anti-correlated interests come together, the equilibrium point is formed up. At that point, the interest of both sides is satisfied.

How market structure affects the level of prices?

In the course of economic theory in analysis, market structures play a fundamental role. For example, a local monopolist charges higher prices than prefectly competitive supplier. Oligopolies are based on prisoner dilemma and game theory and set implicit barriers to future market agents. In Chamberlain's model of monopolistic competition, there's hardly any entry barrier but products and services are highly differed. Every economist dreams about perfect competition. In it, the price equals marginal cost.

Often, it is said that perfect competition exemplifies social optimum. The model of perfect competition is based on four basic assumptions: (1) homogenous products, (2) prices taken as given, (3) maximum mobility of production means and (4) perfectly informed consumers. One could question what the fourth assumption really means. The answer to this question opens a new concept - elasticity of supply and demand. In the model of perfect competition we assume that consumer behavior is highly sensitive to single relative price increases. For example, if there are two local grocery stores and the first raises the prices of milk by $1 USD, a rational consumer would trade a slice of its purchasing power with the same product supplied by another company. In a discussion about perfect competitive markets, we say that prices are like information signals. They work as means of communication by sending the information to suppliers of how to coordinate the economic activity and estimate future perception about market behavior and prices.

However, if market structure is incomplete, the market behavior is different. In oligopolistic model, few companies control their real market share. Prices are therefore not the outcome of a spontaneous order of competition but the result of an incomplete market structure. In case of few companies dominating the retail market, the question of firm's price policy will produce a prisoner dilemma. In Nash equilbrium, each players sets a strategy as the best response to another player's strategy while possessing the knowledge of other players. These strategies include cost structure and all possible outcomes regarding the settlement of prices shown in the payoff matrix.

Firms always set the prices that maximize their overall utility by attempting to examine the possible behavior of competitors. Probably the most important quest in incomplete market structure is that final prices are not set on the basis of marginal cost but on the basis of marginal revenue. That is because firms in incomplete market structures are not price takers, but price makers. In this case, the price elasticity of demand is not infinite because the curves of demand marginal revenue are negatively sloping while marginal cost curve is positively sloping. In a graphical analysis, the price is settled at the point where marginal cost equals marginal revenue. And there is gap between between the point where the price is settled and the slope of demand curve. In such a situation, firms maximize their utility by raising the consumer price in a vertical line with demand curve.

The question is, why demand curve is negatively sloping? It is because few companies dominate the market and the outcome is that consumer behavior is modified according to the actual choice. The price elasticity of demand varies between 0 and 1. Firms signalize this clearly. 0,81 price elasticity coefficient of demand means that if a price of A is raised by one percent, the demand for A declines by 0,81 percent. In this case, the supplier faces a 0,19 percent gain if his company raises the price by 1 percent. It is said that in such a complex situation, the price elasticity of demand is inelastic and because of an incomplete market structure, firms have a sizeable space to control price settlement as consumer lack the choice such as in perfect competition.

Monopolies, prices and welfare

One could argue that there is a tradeoff between the quality of consumer products and perfect competition. In a theoretical terminology, the higher the level of market competition, the lower is the level of product differentiation. The fact is that each price is the outcome of particular allocation of scarce resources. It is usually not difficult to answer why monopolies are bad. Monopoly companies do not produce at the lowest possible cost. They do not advance technological improvements to speed-up the growth of productivity. They also do not offer the best possible quality and do not consider the essence of succinct allocation of resources. A monopolist is a pure price maker.

He settles the price at the cross of marginal revenue and marginal cost. Given the negative slope of demand curve, he produces a deadweight loss corresponding to inefficiencies in production and his allocation mechanism. The overall outcome is that monopolies do not maximize the individual welfare. There is absolutely no exception to that rule in case of natural monopolies where average and marginal cost curves slope negatively. Policymakers are often exposed to the dilemma of how to regulate natural monopolies such as railway companies. Often they want to nationalize the company.

They also want to regulate its rate of return. If such policy decision were implemented, the monopoly would face a bottom-line pressure and zero profits. If privatization and competitive initiative were launched, the natural monopoly company would have less incentive to discriminate with the prices and its price policy would be approaching closer to the competitive model.

Competitive Markets, Elasticity and Inflation

Government policies often intervene the market to maximize the best possible outcome on the consumer benefit. For example, there are two ways to reduce smoking. (1) The first option is to launch anti-smoking campaign and try to influence smokers' decision to stop smoking. In this case, the demand curve would move left while the price of cigarettes of remain the same, ceteris paribus. (2) The second option is to impose a tax on tobacco company which produces cigarettes. In this case, the supplier would add the tax to his price and set a new consumer price of a pack of cigarettes. In this case, only the size of demand would be reduced and the equilibrium point would be changed by moving up the demand curve.

The last question is referring to the actual situation regarding food prices, demand elasticity and inflation. First, inflation is a monetary phenomena arising from the situation where money fund is larger than the fund of goods and services. The settle the equilibrium point, the level of prices goes up to catch the balance with current quantity of money circulating in the economy.

The important thing to realize in the question of how competitive market structures really are is the degree of flexibility and demand elasticity. If the demand for particular good or product is inelastic, the situation gives a sign that market structure is quite incomplete. Monopolies exhibit its market power by adding mark-ups to the marginal cost after particular shocks. The more inelastic demand, the higher the size of particular mark-up. Food market has been accountably exposed to the mark-ups. In Slovenia, the structure of supply-chains is known for a substantial degree of inflexibility.

Consequently, every single shock emerging from global conditions of supply and demand for food is transformed into the mark-up above the marginal cost. The outcome is not beneficial for consumer welfare as the combination of inelastic demand, false structural policies, incomplete market structures and non-competitive supply-chains is abused for the escalation of prices. That is why various cosmetic attempts do not reduce the extent of paricular shocks. In sum, the principles of competition codified in the competitive law are the only possible way to prevent the abuse of market power that stakeholders possess.

Rok SPRUK is an economist

Copyright 2008 by Rok Spruk

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