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Sri Lanka's debate over inflation 2: The folly of price cuts
03 Dec, 2009 07:12:13
By W A Wijewardena
Dec 03, 2009 (LBO) - In a bid to relieve the public of rising cost of living, the Government has reduced the import duties of ten leading food items and expected the market too to slash the prices.
It was announced that the government controlled Lak Sathosa would reduce the wholesale prices of these items so that their retail prices too would be reduced in a fitting manner.

However, frustrating government’s expectations, the retail prices did not fall in the market to the levels anticipated. As usual, the non – reduction of the retail prices was blamed upon the profiteering private traders by both the politicians and the public.

Election Cycles and Artificial Price Reductions

It is common in many countries that election cycles are followed by this type of artificial price reductions to keep the voters’ wrath over rising cost of living, if existing, in check. However, the examination of the outcome of these policies in hindsight has shown that they have very rarely yielded the anticipated benefit of winning elections.

On many occasions, the ruling party that promised the price reduction got defeated at the elections. It made the newcomer to either disregard them or continue with them at a great cost to their own expenditure programmes.

Artificial price reductions too lure central banks to an unwarranted complacency because the price indices on which they base their monetary policy do not record increases. This is because the price indices are calculated by official statistical agencies by using the artificially fixed prices and not the would-be market prices. It is, therefore, akin to suppressing the price indices by deliberate means.

Price Stickiness after Reduction of Duties and Taxes

Why don’t the prices fall as expected when the governments slash import duties or taxes? That is because the prices are determined by the interaction of two forces, namely, the demand force and the supply force, and the governments’ slashing of taxes could control only one these forces, namely, the supply force.

The intention of the government is to reduce the supply prices of the commodities of which the duties or taxes have been slashed. This intention is actually realised by a reduction in the wholesale prices of the commodities in question.

Economists refer to this as a downward movement of the supply curve, since every commodity unit is now supplied at a lower price than before. This is different from an outward shift of a supply curve where, at every price level, more units are supplied because of an increase in the output.

The Determination of Market Prices

But whether the market prices too would fall in the same manner would depend on what would happen to the demand for the commodities in question.

If the demand remains unchanged at the previous level, then, the market prices too will fall along with a fall in the supply prices. If in fact the demand has declined, then, the market prices will fall much more than the decline in the supply prices. Governments, by slashing import duties or taxes, expect this situation to prevail in the market.

What happens to the Demand?

But the demands would have risen and markets would have worked against the wishes of the governments, fuelled by their own faulty and inconsistent policies in the past.

The main determinant of the total demand for a commodity is the level of the money income of the consumers. An increase in the money income accompanied by an increase in the output will not cause the prices to rise, because the resultant excess demand could be met by the increased supply of the goods. If money income has been handed to people with no consideration for the output they make, then, only the money value of the demand increases and not the output. In that case, contrary to the assumptions of the governments, the demand curve too shifts continuously outward creating an excess demand and thereby preventing the prices from falling, though the supply prices have been slashed.

Unwarranted increases in Money Incomes

In the past, in Sri Lanka, money incomes of people have been increased without regard for productivity or output.

During the five year period from 2003 to 2008, the average broad money supply of the country increased by 16 percent per annum increasing the total money in the hands of the people. It is natural that the excessive money in the hands of the people will chase after goods and services creating a new demand for goods.

During the same period, employment in the central government which does not contribute to the production of goods and services increased on average by 5 percent per annum adding more than 200,000 new workers to the already overstaffed public service.

This expansion in the public service and the subsidies and pensions that the government had been paying had cost the Treasury whopping 211 billion rupees in 2004. This went up phenomenally by an average rate of 15 percent per annum in the subsequent period to reach 370 billion rupees in 2008.

In the private sector, Budgetary Relief Allowance of Workers Act enacted in 2005 and the subsequent wage increases effected at the instance of the government caused the money wages to rise without a corresponding increase in the output or productivity. They simply added to the money income of the people.

The total overall impact of all these measures was to increase the demand for main consumer items continuously over this period.

Supply Prices were reduced against the expanding Demand

Hence, when the supply prices were reduced by the government, the demand had already expanded and the markets reacted by putting upward pressure for prices, instead of falling along with the reduced supply prices.

Thus, attempts at reducing market prices just by manipulating the supply curve alone do not generate the desired results. Hence, such attempts do not relieve the consumers, but generate a number of untended adverse consequences that are costly and difficult to be eliminated.

Unintended Adverse Consequences

First, they create tensions, suspicions and disharmony in the society. Consumers and politicians start blaming the traders for the non – decline in market prices, whereas the traders are helpless, because they do not have an excess supply to meet the rising demand.

Second, the central bankers are driven to a false complacency about the success of their monetary policy, because they observe a slow growing price index generated by the artificially fixed prices of commodities. The index fails to reflect the growing excess demand in the market and the central bankers get unwittingly blinded by it.

Third, when the prices do not fall, the governments over – react by tightening the enforcement laws that require them to introduce new laws and regulations, expand the bureaucracy and raise the public expenditure on price controls and price regulations. They worsen the already tight budgetary conditions faced by the governments.

Fourth, the duty and tax cuts will derail the governments’ planned budgetary programmes. They reduce the governments’ revenue, increase their current expenditure and expand the budget deficits. To fill the deficits, the governments will be forced to borrow or print money. Borrowing will raise the debt burdens of future generations and printing of money will bring about new inflationary pressures. It will trap the governments in a never ending vicious circle of inflation and poverty.

Fifth, the protections normally given to domestic producers will also be diluted, because the tax cuts reduce supply prices and, with high prices being paid by consumers, contribute to enhance the intermediary margins. So, the governments, producers and consumers will lose, while the objective of reducing the market prices is not realised.

What is to be Done?

Hence, attempting to reduce prices just by manipulating the supply curve only will not yield the desired results when the governments have expanded the money income of people without regard for productivity or output increases. The best way to relieve the consumers is to maintain a stable price regime through appropriate monetary policies pursued continuously and consistently.

The writer is a retired deputy governor of the Central Bank of Sri Lanka. To read previous columns in the series go to the WatchTower section on the main navigation panel or click on the links below.

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5. W.A Wijewardena Dec 08
To Tharu22,
Thanks for the query which has been made in order to add to the knowledge through free discussion of the issues. Taxes on goods are artificial changes in the free market system because they lead to unanticipated consequences by resulting in a totally different people bearing the burden (tax incidence) of the tax.

That is why the principles of taxation requires the governments to impose taxes with practically zero burden on unexpected people (like the bee which sucks nectar without crushing the flower). Since commodity taxes are usually imposed on the goods consumed on a massive scale in order to enhance the tax revenue, it is the poor people who normally bear the burden.

That is why a good tax system has a larger income tax component because it cannot, except under exceptional circumstances, be shifted onto others. Hence, the initial tax is an artificial intervention; once the market has reached a new equilibrium, the ad hoc reduction of the tax is a further artificial price reduction. A proper price reduction should come from an increase in supply where suppliers are prepared to supply a larger quantity at a given price. When a tax cut is offered, suppliers now supply the same quantity at a lower price.

Though the supply price is now lower, it does not mean that the market price too will be lower. This is because the market price is determined by both the supply and demand and not by supply alone. (Alfred Marshall had a good example to illustrate this:no one can say which blade, that is, the upper or the lower, of the scissor that cuts the clothe)

So, the magic wand to reduce the market price is to have an excess supply in the market. Imports will increase the total supply, but, if the demand curve has shifted to the right, there is still an excess demand which does not push the prices downward. This will become worse if the world market prices too have risen in the meantime, which is the situation experienced by SL today.

4. Tharu22 Dec 08
My point was that it is unclear which action is the 'artificial' one. Is it the initial imposition of the tax or the later removal of it?

Also in your demand supply analysis shouldn't you consider the simultaneous nature of the relation? That is, when demand increases due to tax cuts, supply can increase as well (since these are imports the supply is quite elastic) so it need to prevent possible price reductions.

3. W.A Wijewardena Dec 04
To Tharu22 below:
It becomes artificial due to two reasons:
First, since prices are determined by both demand and supply, once the supply has been restricted by a tax, a new equilibrium price is determined in the market in relation to the prevailing demand.

Hence, any arbitrary change in the tax is simply an artificial reduction in the prices, since it is not brought about by changes in the market demand or supply. Besides, since the demand has now changed, even when the tax is removed, the price does not come down to the earlier level.

Second, the government has not taken measures to fill the revenue loss due to the tax reduction. Whether it is through a reduction in the recurrent expenditure, a reduction in capital expenditure, an increase in other taxes, borrowing from domestic sources, borrowing from foreign sources or printing new money. The adoption of anyone or some of or all of these measures will create a disequilibrium elsewhere. So, it is an artificial price reduction.

2. Tharu22 Dec 04
What do you mean by 'artificial price reductions'? If prior prices included import taxes weren't those the 'artificial' prices? If the import taxes were reduced, then shouldn't new prices be closer to what would be 'natural'?
1. thalapathpitiye hemanada Dec 03
Rubbish price is definitely low, go to phulyaya and other outlets that sell low cost items i never go to lak sathosa