So You Want to Know About Economics

by Roopa Pai

A. Rival makes four jugs as usual, and sells it at ₹15 a glass (the formula that worked for her). You make three jugs this time, and sell at ₹20 a glass. This time, however, A. Rival is only able to sell 33 glasses (because there are people who don’t mind paying ₹5 more for a better glass of lemonade, and so buy from you instead), and makes ₹495 (33 glasses @ ₹15), while you are able to sell 25 glasses, and make ₹500. Both of you have some stock left (because you can never predict demand too accurately).

  Lessons learnt:

  ▶A. Rival made less money than she did last time, which means your pricing was more on the mark this time.

  ▶You actually made more money by reducing the price of your good. (Aaaah! That’s why stores so often have those seemingly ridiculous ‘Flat 70 per cent off’ sales!).

  ▶Between A. Rival and you, you made sure the customers at the mela were kept really happy—each customer got what he wanted, at a price he was willing to pay, and there was more lemonade (of both kinds) available in case he had wanted another helping.

  ▶It took a couple of tries to get it right, but by Diwali, A. Rival and you have figured out how much of your goods to stock, and the consumers are happy that they have a choice.

  ▶You know what’s the coolest part, though? It happened by itself, as if by magic, by invisible, untraceable signals that your customers and you sent to each other through your actions. That’s what they mean when they say the market decides the right price of a good!

  P.S.: At the Christmas mela, A. Rival and you use the brilliant ‘Diwali Formula’ again and set out your lemonade stands. But this time both of you sell only HALF of what you sold at Diwali and make a big loss! What happened? Someone set up a tomato soup stall at the far end and took all your customers! Because seriously, who wants iced lemonade on a cold December night when there’s hot soup available?

  LEARN THE LINGO

  Price Elasticity

  How often do you buy a new notebook, priced currently at say, ₹20, for school? How often would you buy it if its price went up to ₹25? ₹30? ₹35? If you said ‘I would buy it just as often as I buy it now’ to all three questions, it means that the price of the notebook would never affect your need (or demand) for it. Whatever they are priced at, you cannot do without school notebooks, so you will just continue to buy them. Economists would say that ‘the demand for school notebook is completely price inelastic’. In other words, your need for notebooks, and your willingness to buy them, does not change with their price.

  Think about something a lot more expensive, and relatively unnecessary, like a pair of Nike sneakers. If the price of a pair of Nikes went up from ₹2000 to ₹3500 (the same percentage increase as the notebook, when it went up from ₹20 to ₹35), you would probably look around in the market to see what other brands of sneakers cost (unless you have very indulgent parents!). Your demand for sneakers doesn’t change, but your demand for Nike sneakers has changed because of the steep price hike. Economists would say that your demand for Nike sneakers is price elastic or that it changes with the price.

  Generally speaking, this is how price elasticity should work. The demand for essential goods (rice, onions, milk, petrol) are more or less price inelastic, while the demand for luxury goods (gold jewellery, cars, houses) and goods which have decent substitutes, are price elastic. If what you are planning to buy is price elastic, you will either simply postpone buying it (in case of a luxury good) until prices fall; or you will buy the cheaper substitute instead (like in our sneakers example).

  But this doesn’t always happen. There are certain goods which go against the price-elasticity-of-demand (PED) logic. One of them is telecom services. Today, telecom services—mobile phone services, broadband services and so on—are considered an essential good. But demand for them is price elastic i.e., the demand for them rises sharply when the price declines, and declines when the price increases. The other good that bucks the PED logic is the demand for ultra-luxury goods, like fine wines, designer handbags and fancy cars, which actually increases as their price increases (making those goods price inelastic), because of various factors, including:

  ▶The Snob Effect: Your status goes up if you have those things, so you don’t mind splurging on them.

  ▶The Bandwagon Effect: Just because more people are buying a particular brand, other people begin to think it’s reliable / better quality / cool, and buy it, even if it is more expensive than other brands.

  ▶The Network Effect: More people today buy (more expensive) smartphones rather than dumb phones, because you can only be on WhatsApp if you have a smartphone, and your entire ‘network’ of friends, family, plumber, boss is on WhatsApp, and you will lose out if you are not.

  ▶The Reverse Effect: People would rather buy more expensive goods than cheaper ones because they believe, for no logical reason but simply because of a ‘feeling’, that something that is cheap must be of lower quality than something that is more expensive.

  Phew! Mind games everywhere!

  A short note on markets—Monopoly, Oligopoly, Monospony

  In a true ‘competitive market’ like your apartment’s Diwali mela, where manufacturers are free to charge what they want and customers have a choice (two lemonade stalls), the market eventually settles at the ‘right price’. But not all markets are free and competitive, and in such markets, things could go very wrong. Here are some examples of non-competitive markets.

  Monopoly: The customer isn’t king. I am!

  A monopoly situation happens when there is only one producer of a good in the market. How does this come to pass? Let’s say this producer was so rich that he could sell his good for way less than the ‘right price’ because he was in no hurry to start earning a profit. Other producers of the same good could not sell so low and therefore lost all their customers. Eventually, they shut down their factories, leaving only the rich guy in the market. Now that he has monopoly, i.e., no competition, this guy decides to price his good way higher than the right price. Customers are now forced to buy the good at this high price if they want it, because no one else is selling it.

  Monopolies are created in other ways too. Sometimes, governments themselves become monopolies. The Indian Railways, for instance, is a monopoly. Unlike taxi services, which anyone can run, no one but the Indian government can offer railway services from one place to another. So whatever the state of the trains or the stations, or whatever price a train ticket costs, everyone simply has to put up with it.

  Sometimes, it is just circumstance that creates a monopoly—like you and your lemonade stand in the Thar Desert in May.

  Oligopoly: Let’s keep this between ourselves.

  An oligopoly is somewhat like a monopoly, except that instead of just one producer, there are a limited number of producers of a good. Or there are several producers, but only two or three of them have most of the ‘market share’, i.e., most of the customers.

  Are oligopolies good for the customer? Yes and no. Let’s say there are only three producers. On the one hand, each of them has to be careful not to raise prices too much above the right price because customers will then just go to the other two. Also, none of them can sell an inferior quality good, because if he does, his customers will go to the other two. In both these cases, the customer benefits. But there is also the possibility that these three producers will sit together (forming what is called a cartel*) and jointly decide a price for their good which is higher than the right price. This is great for them, because they will make a lot more money than they would have otherwise, but the customer will again be in a monopoly situation of ‘no choice’, and be forced to cough up the high price if she wants the good.

  For instance, in the Independence Day mela, if there were no other cold drink stalls around, and you and A. Rival had jointly decided that she would charge no less than ₹20 a glass and you would charge no less than ₹25 (for your better quality lemonade), any customer who wanted a cold drink would have been forced to pay at least ₹20 a glass. You would
have made more money than you deserved, simply by ‘cartelising’ in an oligopoly situation. The customer would have been fooled into believing she had a choice, when in reality she was being looted.

  Monospony: The customer is queen.

  Here’s where the tables are turned. There is only one customer and many producers, all of whom want her money. In this reverse monopoly situation, the customer is truly queen. She can decide what price she will pay for a good, confident that one producer or another will agree to provide it at that price rather than losing her custom.

  As you can see, this is equally bad for the market. If the customer dictates the terms, the producers will not even make as much money as they spent on making the good or providing the service, and will eventually stop making it, which is eventually bad for the customer, too.

  Monopsonies are not a fantasy. They actually exist. Let’s say a coal mining company sets up shop in a remote forested area. People who live in the villages around have hardly any source of employment. They tend their small fields, collect firewood and honey from the forests, and sell them at a faraway town. The new coal mine promises a steady job, and more money than they can hope to make otherwise. Therefore, everyone wants to work in the mine. This is a monopsony situation—there is only one customer (the owner of the coal mine) and several producers (the villagers) who want to sell their good (in this case, their labour) to him. Since the customer is all powerful in this situation, he can pay the villagers very little, way below what he would have paid in a non-monopsony situation and still have enough labour for his mine.

  As you can see, none of these three situations—monopoly, oligopoly, monopsony—is a good thing. To make sure they don’t happen, governments have all kinds of rules and regulations in place. But governments also have to be careful—too many rules upset producers, who will then be reluctant to put their money into manufacturing goods, but too few rules harm consumers. Yup, it isn’t easy being the government!

  BIG QUESTION 2

  Guess what! The Residents’ Welfare Association of our locality cancelled the Holi mela this year! Apparently, someone (who didn’t even attend the mela, by the way!) complained that there was too much litter in the park after the previous mela. And someone else complained that the music disturbed his son, who was preparing for his Grade 12 exams. But that’s just not fair to us producers, is it?

  Yeahhh. It’s terrible how unfair it all is to you. Not! What is unfair is how often producers and consumers of a good do not realize how their actions affect the silent bystander, who is not even involved in what’s going on but has to suffer the consequences of those actions. In the case of the mela, everyone inside was thinking of their own benefit—you and every other producer was only thinking of how to sell his product and make as much money as possible, and every consumer was only thinking of how her money could be spent so that she got maximum value out of it. Neither was thinking of the impact of their actions on people and things outside of themselves.

  Economists call this kind of impact an externality. If the impact is not a favourable one for the bystander, like in the case of the people who complained about the mela, it is called a negative externality.

  What if the impact is favourable? Let’s say an NGO raised money (you didn’t contribute) and cleaned up the filthy lake next door. Instantly, the stink that used to fill your house every time you opened your windows disappeared, and without you lifting a finger. You have just benefited from a positive externality. Or let’s say your parents decided that you should be vaccinated against chicken pox, even though it was not a compulsory vaccine like the polio vaccine or the DPT one. This is a positive externality for the friends you hang out with—they now have a smaller chance of getting chicken pox themselves, since you are protected against it!

  In the case of the mela, the bystander suffered a ‘cost’ (an afternoon of noise, a messy park) because of your actions; in the second (the lake clean-up), the bystander (you) gained an unexpected ‘benefit’ (hurray! no more stinky house!) from someone else’s actions; in the third, the bystander (your friend) benefited from your responsible action of getting yourself vaccinated.

  You see how the actual ‘cost’ of something is not really its price? The price of a good (see previous section) is decided by ‘market forces’ like supply, demand, quantity and perceived value, but it doesn’t take into consideration the good and bad impacts (or costs) of the making, selling and using of that good. But that cost is very real. In the case of the mela, the organizer lost the ability to host the next mela—and make a ton of money—at that park, because of the negative externalities caused by the first one!

  What are the most common ‘negative externalities’?

  ▶Air pollution: Car manufacturers and users may not often think about this, but the air pollution their machines are responsible for causes severe health problems for the bystander and the environment.

  ▶Smoking: It causes health issues to bystanders who simply inhale the smoke.

  ▶Open garbage dumps: One of India’s biggest and ugliest problems, which not only spread disease but also impact tourism. Who wants to go on holiday to a filthy, stinky country?

  ▶Unrecyclable plastic bags: They choke lakes and drains and cattle intestines.

  ▶Pollution of lakes and tanks: Toxic, untreated sewage that impacts aquatic life-forms in terrible ways and endangers human and animal lives around it (while the factory bosses, who live elsewhere, are not affected).

  What can be done to minimise negative externalities?

  Governments do a bunch of things—they make laws, impose fines on factories that pollute and stores that hand out plastic carry bags to customers, levy ‘green taxes’ on vehicles*, ban smoking in public places, organize door-to-door garbage collection so that no one has a reason to dump their garbage on the street, and so on.

  But none of us needs to wait for the government to do these things. Just being mindful of our actions can minimise negative externalities both for ourselves and for everyone else.

  For instance, if the Mela Organizer (MO) had thought about the negative externalities his event was likely to cause, he could have taken steps to keep them to a minimum. He could have:

  ▶Ensured that the music was played at a low volume, with the speakers turned away from the houses around.

  ▶Hired a cleaning crew to pick up litter through the day, so that the mela ‘left no trace’ by the next morning. Never mind the bystanders, even visitors to the mela would have had a better overall experience if the place had been clean.

  ▶Placed big bright litter bins all over, so that more litter went into them than on the ground.

  But of course, it isn’t only about being mindful. Cleaning crews and litter bins cost money, and where is the money to come from? It would only be a foolish and short-sighted MO, however, who would ask such a question. A smart one would realize that it is actually in his own best interest to ensure that negative externalities are kept to a minimum. He would figure out creative ways to raise money for the cleaning crews from the mela customers themselves.

  Here is one idea that we came up with for our MO.

  He could charge stall owners a ‘Clean Mela Fee’, and use that to pay the cleaners. Of course, as a good stall owner, you would have whined and complained about the extra charge, but the smart MO would appeal to your greedy, selfish, profiteering heart with convincing arguments. He would remind you that more customers are likely to visit a clean, litter-free mela. He would tell you that a clean place, like cool weather or a scenic landscape, makes people feel a sense of well-being. Happy people, he would go on to say, are likely to hang around longer, and spend money more easily, than people who are uncomfortable in their surroundings. By this time, you are begging him to accept your Clean Mela Fee.

  Can you think of any other ideas for our MO?

  Now, you’ve gone and paid up your Clean Mela Fee, but as a sharp entrepreneur, you want to recover that money from your customers. After all, it is t
he customers who are doing the littering (which is why your MO is hiring a cleaning crew in the first place). It is also customers who are benefiting from the clean environment that you are creating. Surely, they should pony up a little too! Ummm, okay, but it is you who is making a profit at the end of the day, not them.

  Still, if you think that you will be more motivated to participate in the mela if there is a chance you can recover your ‘Clean Mela Fee’, there are ways to do it.

  Here are a couple of ideas.

  Price each glass of lemonade a couple of rupees higher than you were going to, and hope that customers will still buy your lemonade at the higher price.

  Put a donation box and point people towards it gently. This way, you keep customer contribution voluntary, and make them feel good about themselves (when they contribute) and warm towards you.

  Bet you can think of several more yourself!

  Either way, you ensure that everyone involved in the mela—organisers, producers, consumers—do their bit towards making sure that no one is made to suffer through their actions.

  In the end, really, good Economics is all about good manners, and concern for other people and the environment. If you think about how you can do business so everyone wins and not just you, it is very likely that your business will do very well indeed. Plus you will have the satisfaction of being a ‘socially and environmentally responsible entrepreneur’. What’s not to like about that?

  LEARN THE LINGO

  The Tragedy of the Commons

  In 1833, English economist William Forster Lloyd wrote a little pamphlet about the problem of overgrazing on the ‘commons’ in England. ‘Commons’ was another word for the pasture that was open to every cattle-herder in a village to graze his animals on. The pamphlet was titled ‘The Tragedy of the Commons’. Lloyd said that since the pasture belonged to everyone (and therefore to no one), the selfish ones among the herders would graze their cattle to the maximum, until eventually the pasture itself would get depleted and be of no use to anyone.