SIMPLE ECONOMICS FOR THE COMMON MAN

A little bit of economics in everyones life

A few weeks back, I was talking to a friend of mine. He is an engineer, a common
man with minimal formal training on economics. The discussion veered towards
need for the increase in diesel and LPG prices and whether it was good for the
common man. On the face of it, any common man who buys these goods was worse
off after the decision. Does the common man actually benefit in any manner from this
decision? Why did the stock market cheer the decision?
Understanding how economic policy decisions, either by the Government or by the
Central Bank, impact all of us is slightly tricky and prone to logical fallacies. Modeling
impact of economic policy variables on human behavior and resultant output is
inherently difficult. However this difficulty in magnified multifold because of self-
serving propaganda of self interest groups who may get impacted by the policy
decisions. In this context it is extremely important for the common man to understand
how to think about impact of economic policies, what mental models to use to
analyze policy decisions and views of the people who are for or against it. I would
call it economic literacy.
It is important, if India is to thrive as a vibrant democracy, that a common man who is
impacted (positively or negatively) by various policy decisions is able to think through
pros and cons of various economic decisions of the government and draw his or her
own conclusions beyond what is being propagated by specific groups that have
vested interest in these decisions. The book Economics in One Lesson by famous
economist Henry Hazlit is one book that has the tools that a common man might
need to be economically literate. Hazlit summaries arguably the most important
mental model needed to understand impact of economic policies beautifully in one
sentence: The art of economics consists in looking not merely at the
immediate but at the longer effects of any act or policy; it consists in tracing
the consequences of that policy not merely for one group but for all groups.
Most fallacies in economic reasoning fall in this category. We tend to jump to
conclusions on impact of economic policies by observing the immediate impact of the
policy on a specific group of people, oblivious of the long-term impact on a wider
group of people. However, removed from economics, this reasoning seems obvious.
Dont we know that overspending in the short term can lead to immediate gratification
but has severe negative consequences for us in the long run?
So how do we analyze an attempt by governments to fix prices of good below their
market price using this mental model? Let us look at a commodity A for which our
government might want fix the price (below market price). The typical reasoning for
the same would run like this: If we allow the price of A to be determined by the free
market, primarily the rich but not the common man would be able to buy it. People
would not be able to buy A in proportion to their need but in proportion to their
purchasing power. If we keep prices down, everyone would be able to afford A.
For the interest groups arguing for the same, the reasoning usually is that the prices
of A need to be kept low to keep the cost of living from rising. They assume that
there is a price which is normal, and any price above that is unreasonable,
regardless of the changes in production conditions or demand since the normal
price was established.
The first thing price fixing does is to disrupt the role of prices in balancing the supply
demand mechanism. Without any artificial restrictions, when demand remains high
at a lower price, the relative shortage begins to push prices up. The potential of
making some profit at the higher price leads producers to increase supply, which
then gradually begins to reduce price.
Our effort to keep the price of any commodity below its market level would in time
bring about two consequences. First is the increase in demand for that commodity.
Because the commodity is cheaper, people are tempted to buy and can afford to buy
more of it. The second consequence is the reduced supply of the commodity.
Because people buy more, the accumulated supply is reduced from the stock. In
addition, production of this commodity is discouraged as profit margins are reduced
and marginal producers are driven out of business. If the government did nothing, the
consequence of fixing the price of A would be to bring about shortage of A. But this
is precisely what the government wants to avoid. Some governments try to fix this by
rationing. However, this often leads to a thriving black market in the commodity.
Many governments try to fix the above problem through subsidies. It recognizes that
when it keeps the price of commodity A below market prices, a shortage may result
because of lower profit margin compared with other commodities. Therefore
government tries to compensate this by paying subsidy to the producers of
commodity A. Though the subsidy is being paid to the producers, the people who
are actually being subsidized are the consumers. Now, unless the subsidized
product is rationalized, it is those with most purchasing power buy most of the
subsidized product A. That means people with more purchasing power are being
subsidized more than people with less purchasing power. The classic case here is
the most expensive diesel SUVs, the gas guzzlers, which have the worst efficiency
and the most polluting, and serves to subsidize the richest in society. LPG cylinders
are another example, where the large kitchens of the richest households, who
consume the most cylinders per family member, enjoy the largest per capita
subsidies.
So how does government fund subsidies? By increasing taxes, reducing expenditure,
or just by printing more money (many a times governments use more than one tool at
a time). Increase in taxes hurt the common citizen, depending the tax bracket in
which the increase has been made. It reduces the purchasing power of common
man, which impacts the demand for a number of other goods. So this might result in
lesser profits for the neighborhood kirana shop from whom you purchase a lot of
goods because your disposable income goes down due to increase in your taxes. By
reducing expenditure, the government reduces its investment in social programs and
infrastructure projects. This again hurts the common man, although silently and in a
manner not so apparent to him. Higher investment in infrastructure could have led to
reduction in transportation cost for various essential goods, which could have
impacted the common man positively through reduced prices of vegetables and
many other essential commodities. By printing money government creates fodder for
high inflation. Whom does high inflation impact? Again, the common man. However,
all these are secondary effects, which happens over a period of time, which most of
us fail to recognize. We just analyze the immediate impact of increase in subsidy,
which makes us happy.
Broad based price fixing may often appear to be working for a short period of time
where everyone benefits. However, in the long run there are serious negative
consequences as explained above. It is also true that seldom an honest effort is
made towards preserving the price for a particular commodity for a particular group
of people that need it the most. Mostly, the policies veer towards providing the
goodies to the politically most powerful or the vote bank. Many of the current price
fixing policies are targeted towards farmers, workers, and traders however rich or
poor.
One of the most controversial commodities that are fixed below their market price by
many emerging economies including India is fuel. In order to make the price of
various types of fuel including petrol, kerosene, LPG, diesel, more affordable to its
citizens, governments sometimes hold the prices lower than the market price i.e.
price at which the producers can independently sell in the market. They do it by
asking the producers to sell the fuel at a lower price either reducing their profit or
compensating them for the loss (subsidy). However, if oil prices increase, countries
that heavily subsidize oil prices may suffer, because the cost of the subsidies will
start consuming ever-larger amounts their budgets. This many a times leads to
money being taken away from other areas of public funding, such as social programs
and infrastructure. This effect gets magnified by the fact that the demand for oil in
these countries end to remain stable, or even grow, because the lack of change in
fuel costs fails to provide any incentive for citizens to reduce their consumption.
Eventually as an end game, the government would have no choice but to remove the
subsidy.
In the Indian context, for example, little effort is being made to reduce the
dependency of the economically weaker section of the society on kerosene, and the
easy tool of subsidizing the use of kerosene is being used. Alternate sources of
energy for the common man is not being not being pursued on a war footing, which
may result in long term hardship for the common man in generations to come. For
instance, a natural thrust for increasing sustainable energy sources should have
been solar energy, with India enjoying one of the highest exposures to the Sun. The
money that is being given for kerosene subsidies could have given for solar lanterns
and cooking vessels, which would also have the additional benefits of bringing per
unit costs (and hence prices) down by increasing production scale, making
commercial manufacture more viable.
Another direct impact of fuel subsidy in India is rapid increase in privately owned
vehicles, which cause enormous harm to the environment. Not enough investment is
made on public transport, nor taking public transport made a habit with a much larger
section of the population because of the fuel subsidy.
So am I arguing a case against subsidies? No. Short-term negative impact on
increase in prices on certain underprivileged sections of the society can be tackled
through subsidies that are targeted only to the needy ones and for the period they
need it. The intervening period of adjustment can be used for finding alternate ways
of addressing the needs of the target segment. Everyone does not need petrol or
LPG subsidy, so they should not get it. Most of the times the biggest beneficiaries of
fossil fuel subsidies are not the poor. In fact, studies show that many subsidies are
regressive in nature. A recent IMF study of fossil fuel subsidies globally determined
that the wealthiest 20 percent of the population gets a disproportionate 43 percent of
the benefit from fossil fuel subsidies, while the poorest 20 percent gets only 7
percent. In fact, the poorest 60 percent of the population still doesn't get as much
benefit as the wealthiest quintile. Globally, fossil fuel subsidies are estimated to cost
between US$455 billion and US$485 billion. There may be better ways to provide
assistance to the people who need it most that are also less expensive for the
national budget. By one estimate, the cost of transferring US$1 to the poorest 20
percent of the population via gasoline subsidies is US$33. Is this the desired
outcome of any subsidy program? Just think how much the same amount of subsidy
would be effective if only the needy population got petrol, kerosene or LPG subsidy.
This requires an honest administration capable of putting in an infrastructure to
identify the target population and distribute the subsidy only to them. Using the
Aadhar number to provide direct cash transfer to the target population is a step in the
right direction.
Indias fiscal position has been weak, given the penchant of the government to live
beyond its means (much like a family which chooses to live beyond its monthly
income and borrows every month from friends). Sometimes, higher spending (more
than revenues generated) in right areas may be necessary in the short run in order to
spur long-term growth. However, given the vulnerability of our current fiscal position,
any economic decision (like reduction of fuel subsidy) that works towards reducing
structural fiscal deficit is typically cheered by the stock market. It means that more
resources would be available to the government to invest in areas needing
immediate attention e.g. infrastructure, affordable healthcare, education, etc. With
the government needing to print less money due to reduced subsidy, this also brings
down structural inflation, which is also good for the economy.
So when the common man is persuaded by vested interest groups to support broad
based subsidy regime, they are manipulated to think of the short-term effects on
them. The long-term impact on a wider set of people remains hidden from them, as
the vested interest groups do not expose the secondary effects. We as common
citizens can make much better decisions in supporting or opposing various economic
policies if we use the correct mental models in our analysis. We should not get
swayed by what we see as immediate effect on a visible group of people. We need
to think about long term consequences on a wider set of people of any economic
policy decision before deciding to support or oppose the same. Otherwise our
children and grandchildren would need to bear the burden of our wrong decisions.