ECONOMIC Affairs Minister Rafizi Ramli has recently asked owners of restaurants and food stalls why their prices are high despite the lower cost of raw ingredients.
In particular, he lamented the attitude of certain operators who still refused to lower their prices.
Rafizi said sometimes people get angry when they see that raw ingredient prices are falling and electricity rates are staying the same, but restaurant and other food outlets’ prices remain the same, according to a report in Free Malaysia Today.
Rafizi’s argument seems to be rooted in common sense: if production costs decline, then prices of consumer goods should follow the same path.
The idea that prices are determined by the cost of production, while still appealing to many in economic theory and everyday conversation, is misleading, and it ignores the great subjective revolution that occurred in economic science in the 1870s.
Prices are determined by supply and demand, and supply and demand are subjective evaluations.
The interaction between these subjective evaluations generates market prices. This is not only true for the prices of consumer goods but also for the prices of production factors.
Therefore, prices of production factors (cost of production) do not determine prices of consumer goods, but the process works in the opposite way: expectations about future prices for consumer goods determine the emergence of prices for production factors.
An example will help the reader
There is a lot of talk about chicken prices and how they are influenced by rising costs of raw materials.
Instead, we should think about price formation differently: if chicken producers expect good future chicken prices, they will want to produce more, and thus they will enter the market for raw materials with higher demand, and such higher demand will push up the prices for those raw materials.
In a nutshell, consumer goods price expectations influence the prices of production factors.
As explained by University of Manchester Prof Matthew McCaffrey in an educational paper published by the Center for Market Education (CME), consumers’ decisions to buy or not to buy determine the prices of consumer goods, and through these goods, the market prices of all the factors of production used to produce them.
We could say that the value of consumer goods is imputed to the land, labor, and capital used to produce them. These factors only have market value because of their ability to contribute to producing goods and services for consumption.
What is the reason for the high prices now, and why are they not yet moderating?
There are several factors at play. The first is the heated demand following the Great Lockdown and the adjustment time needed for the supply to meet that demand. In turn, demand is high for a series of reasons:
- The festive seasons
- More buying as a reaction to the years of constraints imposed by the Great Lockdown
- Higher employment, which is, in most cases, unsustainable employment as it was artificially created by the expansive fiscal policies implemented during the great lockdown, may then lead to rising unemployment after the post-Covid and inflation-driven economic crisis that CME already predicted in 2021
Beyond the tension between supply and demand, there is the real source of generalised and persistent price increases: the excess of money into circulation that was created during the Great Lockdown with expansive fiscal and monetary policies, which were implemented without thinking about the high costs they were bringing along.
In conclusion, the fight against the rising cost of living cannot be won with moralising slogans, but rather with a deep understanding of the price mechanism and the reasons beyond price increases. Bank Negara Malaysia is acting by tightening monetary policy, but this will not be enough; a plan for gradual government spending cuts is of the utmost importance.
At the same time, that fight will not be without costs; inflation should have been avoided in the first place by avoiding the Great Lockdown; now we cannot fight it without implementing contractionary measures. — Jan 24, 2023
Dr Carmelo Ferlito is the CEO of the Centre for Market Education.
The views expressed are solely of the author and do not necessarily reflect those of Focus Malaysia.
Main photo credit: Harian Metro