Article by Mita Chaturvedi, Deputy Editor.
What does the term free-market mean to most of us? To some, the free market is a blessing while others look at it as a curse. Many talk about how owing to the now general disdain for free markets, it is easy to forget the economic miracles they have conjured. For one, choosing the supply of goods becomes hassle-free when markets simply respond to price signals. This very mechanism is mentioned by Paul Seabright- an economist- in his book, ‘The Company of Strangers.’ He talks about how a shirt is made in Malaysia using German machines and cotton from India. Despite including all these individual markets, no one in particular is in charge of supplying these shirts. Seabright notes that having such an ‘agency’ -of sorts- would do nothing but make the smooth flow of demand and supply more complex. As a direct parallel, many talk about how the self-corrective nature of Adam Smith’s so-called Invisible Hand is “beautiful, and thus seductive,” but not practical in real life economies.
While it is next-to-impossible to spot a free market outside a textbook, the belief that the invisible hand will sort things out remains. This bring us to an important question- how steady is the invisible hand- or in other worlds, how practical is this belief for a typical market.
Demand and Supply
Demand and Supply– the very foundation stones of economics. As rudimentary as they may seem, these two are extremely significant when it comes to the economics behind consumer spending. After all, it is primarily Demand and Supply that sets equilibrium prices and quantities in an economy with market settings.
Despite being called the most efficient way to set market equilibrium conditions, an economy may not wish to completely rely on the market settings of Demand and Supply to set equilibrium conditions for a number of reasons, for instance- some would try to decrease prices to make them more affordable while others would want to increase them to reduce consumption. However, is this method of setting market conditions exceptionally efficient? To answer this, let’s talk about these controls a little more and with respect to market settings.
In economics, market settings are used for two prime reasons: price settings and wage settings. Price settings use the seemingly simple forces of Demand and Supply to fix equilibrium prices and quantity. Wage setting, on the other hand, uses the same forces to fix equilibrium wages and labour supply- as in, wage setting helps set daily wages based on the vicinity’s labour demand and supply. Similar to commodity markets, equilibrium wages are set where labour demand is equal to labour supply. The way prices and wages alter supply and demand, and vice versa, is known as price and wage signalling, respectively. Such signalling takes place, as per the invisible hand theory, without any intervention. Think of it as the economy being on some form of autopilot.
Not following these automatically changing settings usually involves the mechanism of price controls set by the government. Price control comprises of price flooring and price ceiling- the former involving prices set above equilibrium price (for instance, in the case of setting minimum wages) and the latter being prices set below equilibrium price (often in the case of rent controlled apartments). More specific instances of where price controls have been used would be- the government placing a minimum price of Rs. 500/kg on pepper imports, in 2017, to protect it from declining prices due to a surge of cheap pepper imports from other countries. Similarly, an example of price ceiling would be the rent controls (or rent limits) on housing offered in Delhi by the Delhi Development Authority (DDA). Such controls help individuals and families from low income strata to be able to afford such housing.
While this method of setting prices and wages does seem- at a first glance- to be more convenient and overall better, given the increase in wages and reduction in prices, it does lead to the creation of deadweight loss. Deadweight loss refers to the loss of economic efficiency, or the loss of total welfare. It is the excess burden, created due to loss of welfare, to either the consumer or producer. We see deadweight loss here due to the reduction in supply from producer’s- owing to the aforementioned increase in wages and reduction in prices.
We see this take place in the above diagram as well. As shown, it is easy to observe the loss of consumer surplus (CS) and producer surplus (PS) due to the added price ceiling. This leads to the grey area being welfare that doesn’t go to either the producer or the consumer anymore- i.e. lost welfare. Hence, we call this area the deadweight loss (DWL). Imagine a market for apartments with a price control as shown in the above diagram. The reduction of rent would lead to demand for housing (the blue line) exceeding housing supply (the red line). Due to this, we observe the loss of efficiency and owing to this inefficiency, price controls can also lead to consumer’s making mistakes in consumption.
One very important source of such a mistake would be asymmetric information in the market. Asymmetric information refers to a state where there is unequal knowledge between the parties involved, i.e. one person/party knows more about something than the other party. In our context, this would mean that in spite of the government placing price controls, many consumers may not be aware of such schemes provided by the government. This may be due to several reasons ranging from lack of education to a poor communication system. Such asymmetry would lead to consumers not using the controls provided to them, further deteriorating sales for producers who have set their prices lower and wages higher. This mistake can be easily redeemed through market settings. This would involve the government lifting or relaxing the price controls in order to permit market forces to set prices and wages closer to the equilibrium price and wage.
Regardless of the previous argument, it would not be right to say that a market setting can completely fix all the mistakes that consumer’s make. For instance, if solving a mistake had to involve reduction of wages- it would lead to massive outrage from workers. Also, firms with established labour unions would find it incredibly difficult to reduce wages. Moreover, keeping wages higher and prices low helps in keeping the morale of consumers and employees of a firm high, which would lead to better performances and higher sales.
Let’s come back to our previous question: How effective are market settings when it comes to solving mistakes by consumers, i.e. how effective is the invisible hand in a typical market setting? As mentioned, market settings are essentially used to efficiently set and maintain market conditions in an economy. The ‘invisible hand’ should, as per this theory, work to auto-correct mistakes made by consumers. Notwithstanding this, George Stiglitz once famously remarked, “The reason why the invisible hand often seems invisible is because it is often not there.” Therefore, despite the ‘efficient pricing’ quality of the invisible hand, I believe it is now safe to say that they may not always be very successful in fixing every problem that consumers face, thus leaving the state of our invisible hand more shaky than stable. Regardless of this, firms should be able to use market settings to an extent to help reduce problems faced due to mistakes made by consumers, to ensure a smoother demand-supply cycle. This means that in order to effectively fix mistakes made by consumers, price signals should perhaps be adhered to- until a certain limit (in terms of price, waste or wages)- after which governments should intervene.