So You Want to Know About Economics

by Roopa Pai

  When does the rupee get stronger against the dollar?

  ▶When more countries would rather lend money to India than to the US. See, countries very rarely have enough money to do everything they want to. So they are always looking to borrow money from other countries. Now, the countries that can lend money have only a limited amount of money to lend, so they have to decide which country to lend it to. Obviously, they will pick a country in which their money will grow faster, i.e., a country that offers a higher rate of interest on their investment*. So one way for a country to get more countries to invest in it (lend to it) is to offer a higher rate of interest on their money.

  ▶When the price of the Indian goods that the US is buying goes up faster than the price of the American goods that India is buying.

  ▶When India’s government is stable (no civil wars, no military coups, no dictatorships, regularly-held free and fair elections), and its economy is growing steadily each year (more food being grown, more goods being produced, more services being offered), the US (and other countries) will pick India to lend money to over countries whose governments aren’t so stable or whose economy isn’t growing as steadily. That will help India gain a favourable exchange rate.

  Yup, it’s a long, winding and uphill road to a better exchange rate, but everyone wants it and is working towards it, one rupee at a time.

  Bet you didn’t know that!

  A McDonald’s burger not only impacts your health, but your country’s too!

  The price of a Big Mac burger in your country as compared to another country can tell you how strong your currency is against that country’s! There is actually a semi-serious thing called the Big Mac Index that the Economist magazine came up with in 1986. But before we get to that, let’s rewind a little.

  Remember we spoke earlier about GDP, or Gross Domestic Product (see page 78)? GDP is a measure of how poor or rich a country is. One way of calculating a country’s GDP is by finding out the combined value of all the goods and services produced in that country over a certain time period, say a year. GDP calculated by this method is called nominal GDP. A country with a higher GDP is considered ‘richer’ than a country with a lower one.

  But there are problems with this method. Since each country’s GDP is calculated in its own currency, how do you compare the GDPs of two countries, say India and the US? You do this by converting both their GDPs into some other common currency, usually the US Dollar. How do you convert? By using India’s dollar exchange rate. Let’s say USD 1 = INR 65.

  But we know that India’s dollar exchange rate is largely based on the exports and imports between India and the US (see points 3, 4 and 5 in the previous question). Surely, said economists, the relative richness or poorness of India when compared to the US, and the strength of the rupee compared to the dollar, cannot depend so much on India’s trade with the US. A better way, they felt, would be to figure out how the lives of people in India and the US compared to each others’ in money terms—how much did people in each country get paid for similar work, what could each afford to buy with the money they got paid, did they each have a similar variety of different products available in their countries, and so on.

  So economists came up with another way to compare the relative wealth of two countries (India and the US in our example), and the relative strengths of their currencies. Here’s what they did. First, they put together a ‘basket of goods’ that people in the US regularly use (1 litre of milk. 1 loaf of white bread, 1 kilo of rice, 1 litre of petrol, rent of a single-bedroom apartment, a bus/taxi ride inside a city, a pair of Levi’s jeans, a pair of Nike shoes, a combo meal at McDonald’s* and so on) and calculated the total cost of the things in that basket in US Dollars. Then they put together a similar basket of goods in India, and calculated the total cost of the basket in rupees. Then they created a new ‘dollar exchange rate’ based on the difference between the two costs. This new exchange rate gave a better sense of what ₹100 would buy in India compared to $100 in the US, i.e., how ‘powerful’ ₹100 was compared to $100, in their respective countries.

  This kind of exchange rate, based on the purchasing power of a currency, is called purchasing power parity. A country’s GDP calculated using this method is called that country’s PPP GDP (phew, so many letters!). Although this kind of calculation is not perfect either, many economists feel it is a better measure of the strength of a currency than nominal GDP.

  Here’s a question for you: Do you think the rupee would have a better exchange rate against the dollar if we used PPP to measure it? You can find out through an experiment. Put together your own basket of goods, and find out what each of the things in that basket costs in New York, and what it costs in Mumbai. Then calculate the PPP exchange rate for the two baskets and see!

  Let’s help you get started. A loaf of white bread in New York City costs about $3 while it costs about ₹30 in Mumbai. In other words, $3 is equivalent in value to ₹30. How many rupees is $1 equivalent to then? Dividing both by 3, we find that it is equivalent to (or can buy the same amount of bread as) ₹10! But according to the regular dollar exchange rate, $1 is equal to ₹65! See what happened when we used PPP to compare currencies? The Indian rupee suddenly got six times stronger against the dollar!* No wonder India is the world’s seventh-largest economy by nominal GDP but the third-largest by PPP GDP.

  P.S.: Some countries believe that GDP itself is not a good way to measure the wealth of a nation. India’s neighbour, Bhutan, for instance, has a different measure, called GNH or Gross National Happiness! It believes that how happy its citizens are is a better measure of a country’s wealth than anything else. A British organisation called the New Economic Foundation has come up with another index called the Happy Planet Index, which measures how well a country has taken care of its environment while providing for its citizens. Another popular one is the Human Development Index, which measures things like education level and life expectancy of a country’s citizens along with its GDP.

  You can come up with your own economic index to measure a country’s wealth. Like the MDD (Masala Dosa Deliciousness) Index, the MYTVD (Most Yelling On TV Debates) Index, the CSHOMYWARTIL (Crazy Stuff Happening Outside My Window Any Random Time I Look) Index.

  India will be World No. 1, hands down, on all three!

  *The CPI has only recently begun to be used to calculate rate of inflation in India. The more traditional way of calculating it is the WPI, or the Wholesale Price Index.

  *Imagine if this had happened in India, where our largest denomination currency note is ₹2000. You’d have to take a barrow-full of notes to buy a loaf of bread!

  *If you’ve studied Simple Interest at school, you know that Amount = Principal + Interest; that is, the amount (A) that you pay back to the lender is the sum of the amount you borrowed (P) plus the simple interest (I), where I = P * rate of interest * time. Clearly, when the rate of interest is higher, I is higher too. So countries would prefer to lend to a country that offers a higher rate of interest, so that they get more money back.

  *They couldn’t use the Big Mac in this particular basket because the Big Mac is a beef burger and McDonald’s doesn’t serve beef in India!

  *If you check out the Big Mac Index for July 2016—http://www.economist.com/content/big-mac-index—you find that the price of the Big Mac equivalent in India, the Maharaja Mac, is around ₹160, while the price of a Big Mac in the US is around $5. In other words, $5 and ₹160 are equivalent on the Big Mac Index, which means $1 is equivalent to ₹32, not ₹65, at least as far as Big Macs are concerned. Which is different again from the loaf of bread equivalence. Because each item in the basket of goods will give you a different dollar-rupee equivalence, only the TOTAL costs of the baskets are compared to give a more accurate PPP.

  WHAT YOU AND I THINK ABOUT WHEN WE THINK ABOUT ECONOMICS (A.K.A. MICROECONOMICS)

  The ancient Greek mathematician, physicist, inventor, engineer and astronomer Archimedes—the same guy who ran through the streets nake
d, screaming ‘Eureka!’—once boasted, ‘Give me a lever long enough and a fulcrum on which to place it and I shall move the world.’ Archimedes, who did not invent the lever but was the first to explain how it worked, was of course talking about an actual lever, like a crowbar. And however unlikely it seems that one man can move the earth, scientists agree that it can be done, given the right conditions.

  Economics has levers too (even though they look nothing like crowbars). And unlikely as it may seem, it is individual men and women, who make small buying decisions with their limited amounts of money, who actually influence the demand for goods, the supply of goods, and the prices of goods in the global market, and operate the levers that keep the economies of their countries, and the world, running. Or not. Yup, as an individual consumer, you have that kind of superpower!

  In fact, your actions are so important to economists that they created an entire branch of Economics just to study them. That branch of study is called Microeconomics.

  Here are four questions—and answers—that will introduce you to the kinds of things economists talk about when they talk about Microeconomics.

  BIG QUESTION 1

  I am thinking of setting up a lemonade stall at the Holi mela in the park near my house. What price should I sell each glass for?

  So your mum hasn’t said that you should just give it away for free, because trying to make money out of people is somehow a bad thing? Great, you have a mum who thinks exactly like the market! Here’s what the market says: Whatever has gone into the production of your good (in your case, lemonade)—raw materials, time, labour and skills—it is only fair that you should get an amount of money in return that is equal to their combined value.

  But how in heck do you put a ‘money value’ on time and effort and skills? By extension, how is the right price of anything, including a glass of lemonade, determined?

  The answer to that is quite complex, even bordering on the mystical. Even economists find it difficult to explain these things well. But there has never been a shortage of theories.

  A price for everything and everything at a price

  What actually decides how much a thing* costs? Here are some theories that people have played around with.

  Theory 1. It depends on how much work has gone into producing the thing.

  One of the first theories about how a good should be priced was the Labour Theory of Value, which was floated around the time that our friend Adam Smith was writing his famous book. It said that the price of something was a measure of how much work had gone into making it.

  Let’s say, that at your Holi carnival, you put a bunch of lemons, some sugar and salt, a jug of water, a knife and a long-handled spoon on a table in your stall and called it ‘Lemonade (with some assembly required)—₹10 a glass’. We’re betting it won’t be the hottest seller at the mela. However, if you made the lemonade yourself and set it out in a jug, with plenty of ice and a few sprigs of mint floating in it, people will actually pay ₹10 for a glass. What has added value to your offering? The fact that you put in some work—labour—to make it. This is what the Labour Theory of Value said, anyway.

  But is the price only based on how much work went into something? Consider this. Let’s say you have a competitor, A. Rival, who also has a lemonade stand on the other side of the mela. A. Rival used some super-efficient lemon-squeezing device, and a mixie to powder the sugar, and therefore got her one jug of lemonade made in fifteen minutes, while you spent forty-five minutes squeezing lemons by hand, hand-pounding the sugar, and going to the store to get a bunch of mint leaves to float in your pitcher. If the amount of work (and time) that went into producing something decided its price, your lemonade should sell for ₹30 while hers sells only for ₹10. Try that pricing and see what happens. Most likely, A. Rival will sell out while you sit around swatting flies.

  Yeah, so, no go. Still, the Labour Theory of Value stuck around for almost a hundred years, because it is (still) true that labour is definitely one part of what determines the price of something.

  Theory 2. It depends on the ‘intrinsic value’ of the thing.

  Some economists believed that everything has an ‘intrinsic value’, a value that it has simply by being itself. That, they said, would decide what its price would be. But is that true? If nobody wanted to buy gold, would its intrinsic value—that of being a shiny metal imprisoned in rock—count for anything? Coming at it from another angle, would you say a bitter powder made by roasting and crushing little brown seeds had much ‘intrinsic value’? And yet, people all over the world pay a lot of good money for coffee! So the theory of ‘intrinsic value’ is basically bunk.

  Theory 3. It depends on how rare (or common) the thing is.

  Could it be that something is more expensive because it is rare, while something else is cheaper because there is plenty of it? That is somewhat true, but it is also true that people would be unlikely to pay money for something just because it is rare. If you were selling your (quite terrible) kindergarten art projects—they are very rare!—at your stall instead of lemonade, do you think people would be queuing up to buy them? What if you were selling pangolin poop? See?

  Theory 4. It depends on how much money the greedy manufacturer wants to make with the thing.

  So basically, the manufacturer decides a random price and the hapless, held-to-ransom customer coughs it up if he wants the thing. Right. Here’s a suggestion: why don’t you try it and see if it works? Fix a random price, say ₹75, for a glass of lemonade, and see how many people (besides your grandmom) step up and buy a glass. We would guess zero. The thing is, customers are (a) not stupid; and (b) do not have limitless amounts of money to spend.

  Yeah. None of these theories were quite satisfactory. So economists were forced to come up with a new one, which has served us well so far.

  It is called the Law of Supply and Demand, and it believes that it is the ‘market’ that decides the ‘right’ price of something. According to this law, there are four factors involved in the decision.

  These four factors push and pull each other in all directions, until the movement settles at the ‘right’ price. But the right price is not fixed. It changes with time and circumstances because of many reasons. The price of your lemonade, for instance, may go up because:

  ▶The cost of raw materials (lemons and sugar) goes up.

  ▶The cost of production goes up, i.e., you are now in Grade 10 and you have less time for melas, so you have to make an extra effort to have the lemonade ready.

  ▶The demand for it goes up because there is less of it available (maybe your competitor ditched lemonade and moved to sugarcane juice, which got spoilt in the heat, sending everyone to your stall).

  Similarly, the price may go down because of a variety of reasons.

  The ‘perceived value’ of a good also changes with circumstances, which in turn affects the price. At the Holi mela, with your competitor, A. Rival, also selling lemonade, customers may only be willing to pay ₹10 a glass, which makes ₹10 the ‘right’ price. But let’s say these customers are lost in the Thar Desert (with a full wallet to boot!) one afternoon in May, and you are the only lemonade stall in sight (which makes you a monopoly, see page 119). In that situation, these very same customers may be willing to pay as much as ₹500 a glass (you extortionist, you!) because your lemonade is now perceived as a ‘lifesaving drink’ rather than ‘a nice way to encourage a young entrepreneur’.

  So basically, according to the Law of Supply and Demand, the market will eventually ‘settle’ at the right price, under the circumstances, whatever they may be.

  That’s all very well, But can you trust the market to settle at a fair price? Let’s see.

  Situation 1: Holi Mela

  You have sold out your stock of lemonade (two jugs, or 20 glasses, @ ₹10 a glass), hurray! You have made ₹200 in all. People came back for more, but you were all out (because you didn’t anticipate demand correctly). Your competitor, A. Rival, also sold out her sto
ck of lemonade, although the verdict was that your lemonade was much better than hers.

  Lessons learnt:

  ▶Your lemonade sells, and so does A. Rival’s.

  ▶You must make more lemonade next time.

  ▶You must charge more than A. Rival, since people feel that yours is better.

  Situation 2: Independence Day Mela

  Brimful of confidence, you make four jugs of lemonade (40 glasses), and price it at ₹25 a glass this time. A. Rival has four jugs too, but she is charging only ₹15 a glass. Because everyone agrees that your lemonade is better, a few customers come to you even though you are charging more (the ‘perceived value’ of your lemonade is higher). But many decide they would rather spend the extra 10 rupees on something else, and go to her stall instead. She sells out, making ₹600. You sell only 15 glasses, and make only ₹375. Plus you’re left with 2.5 jugs of lemonade that no one wants.

  Lessons learnt:

  ▶A. Rival knows that her lemonade is not as good as yours, so she will always price it a little lower, knowing that there will always be many people who won’t want to spend more than ₹15 a glass.

  ▶You know that your lemonade is better, and there will always be a few people willing to pay a little more for it, but not too much more.

  ▶Both of you know that you underpriced your lemonade at Holi.

  Situation 3: Diwali Mela