Prices and markets

June 26, 2020


The writer is a senior research fellow at the Institute of Development and Economic Alternatives, and an associate professor of economics at Lums.
The writer is a senior research fellow at the Institute of Development and Economic Alternatives, and an associate professor of economics at Lums.

I WAS in graduate school in Montreal in January 1998 when a number of provinces of Canada and some states of the US, on the eastern side, were hit by a severe ice storm. Hundreds of thousands of people found themselves without electricity for a week or more. And it was the height of winter. At one point, the government of Quebec had contemplated, seriously, that they might have to evacuate entire cities and move the population westward for some time.

In the wake of the ice storm, everything had shut down. Supply chains, for the supply of most goods and services, were severely disrupted while demand, for some goods at least, had increased suddenly. Flashlights and candles were suddenly in high demand. As were groceries. When shopkeepers, who had inventories of candles, batteries and flashlights, raised the prices of these items, there was a tremendous hue and cry in the media about price gouging and hoarding as well as accusations of making unfair profits. The government had moved speedily to ensure ready supplies of food items, but some of the other items became short rather quickly. The question is: were vendors right in increasing the prices of goods whose demand had suddenly increased manifold?

Similar issues have been seen in Pakistan many times. Most recently, we have seen price hikes as a result of Covid-19. Whenever a medicine is described as an important drug for Covid-19 treatment, its price increases manifold; the drug disappears from market shelves. There is immediate reaction, on social media at least, where people call drug sellers hoarders or black marketeers and portray them as unethical.

Prices are an important statistic in markets. They allow allocation decisions to be taken. Markets, based on demand and supply, determine prices. Those who can pay the price get the product, those who cannot pay the price, do not get the good.

Are there limits to how much the price should move when there is a demand or supply shock?

Market- or price-based allocations are not the only way of making decisions about who gets a particular good or service. We can and do have other ways of arriving at allocation decisions. We elect representatives through the one-person one-vote system. We form queues to get on the bus or to obtain tickets or access public health systems. We have rationing systems in some places and for some goods. We even use quotas for job allocations and access to goods and services. We can have need-based systems in some cases too.

Markets, through demand and supply and prices, form an important allocative mechanism. In some cases (auctions), the market system is refined to the point where the product is allocated to those willing to pay the most for the product. In price discrimination systems, we can even try and tailor provisions according to group or individual willingness to pay. Irrespective of these differences, the bottom line is that markets, through demand, supply and prices, allocate goods/services to those who are willing and able to pay market-clearing prices.

When there is a demand or supply shock (increasing demand or restricting supply suddenly), the only way the market can ‘adjust’ is by raising prices, if it is to be cleared. If the price is not allowed to respond when the demand suddenly increases or supply decreases, there will be more customers in the market for that good than what can be supplied, and there will be a shortage. If prices cannot rise to remove the excess demand, we will need another allocation mechanism. Otherwise, the shortage will lead to the creation of a black market.

Are there limits to how much the price should move when there is a demand or supply shock? The problem here is that if the initial decision is to allocate goods based on prices, shocks will move prices depending on the size of the shock, and it is not easy to put limits around it. It is also the case that in some markets, where the number of buyers and sellers is low or there are cartels on one side or the other, the manipulation of supply (hoarding) can also take place, and this can make the price move a lot. The solution for the problem is not very obvious.

Regulatory structures can make cartels illegal and can also try to limit hoarding. But in countries, like Pakistan, where regulatory capacity is weak, this is not very effective.

Can we make distinctions amongst categories of goods and say that prices for essentials (food, life-saving medicines, essential services) should not be allowed to move as much as other goods? This is not easy to do through laws and policies. These have to be achieved through market management. But that requires quick action from the state: something that states are not really known for. It is much easier for the state to just say that they will arrest hoarders or raid the premises where they think hoarding is being done. These are not really actions that are very effective. But they are the ones that are easiest for the state to show and implement.

Managing supply or demand shocks is not easy. In markets, the solution, for the state, if you do not want prices to change, is to change supply as demand is usually not easy to manage. But managing supply in market-driven systems is not a trivial task. For goods and services where allocation is not through market mechanisms, other ways of allocation can work. But for goods and services being supplied through the market, holding prices constant or in a specific range is not easy. And this is true for all states, but especially for those that have limited regulatory capacity. It seems we will have to live with this messy system that sees substantial price changes for goods that face sudden demand and supply shocks. In the case of some goods, and these should be chosen carefully (life-saving medicines, for instance), we can move to other ways of allocating them to those who need them. But that cannot be the solution for the bulk of the goods and services that markets provide. For the bulk, we do not have a solution other than to strengthen markets and ensure general regulation.

The writer is a senior research fellow at the Institute of Development and Economic Alternatives, and an associate professor of economics at Lums.

Published in Dawn, June 26th, 2020