My Say: Dealing with sticky prices

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Nor-Zahidi-Alias_MySay-WeeklyBACK in the 1980s, people were told by a group of economists that lower taxes would incentivise workers to work hard. That, in turn, would raise production, boost economic growth and increase the amount of taxes they pay to the government. Higher tax contributions would then help the government overcome a budget deficit problem.

This all certainly sounds logical and, when accompanied by an economic graphical presentation (known as the “Laffer Curve”), the argument looked very convincing. Some financial market editors bought the idea. The late US president Ronald Reagan also experimented with this theory during his administration — hence the term “Reaganomics”, also known as “supply side” or “voodoo” economics — only to find that it did not really work in the real world. Budget deficits rose instead.

Many arguments that seem so plausible in economics textbooks fall apart when implemented in the real world. There are many reasons for this, and the primary one relates to human behaviour, which, contrary to what was preached in the 1970s under the “rational expectations” theory, might at times be irrational. And behavioural economics — an alternative field to neoclassical economics — is not an easy subject to understand, to say the least.

The same thing happened in the local economy recently. With global crude oil prices falling by more than half of their cyclical peak (June 2011) and pump prices slashed by as much as 26% from their October 2014 levels, many expected the prices of goods and services to decline in tandem.

There is a good rationale for this argument: transport costs will decrease, yielding lower overall input prices. This will reduce the burden on businesses as their costs decline. When producers reduce the prices of their goods and services, consumers’ financial burden will be partially lifted.

Surprisingly, that scenario is not yet playing out. In fact, recent new reports have focused on the unwillingness of businesses to reduce their prices. Consumers are naturally furious — businesses are quick to push up prices when fuel costs rise, but are reluctant to pass on the cost savings when pump prices decline. As a result, the government has to step in to encourage businesses to pass on their “gains” to consumers through lower prices. In addition, with the recent reduction in electricity tariffs, the government is arguing that there is now more justification for businesses to lower their prices for the benefit of consumers.

But, as mentioned earlier, things are not as straightforward as the textbooks go (due to space constraints, I shall not discuss complicated theories such as the vertical supply curve and the likes in this column).

Among the reasons given by businesses are: (i) the costs of labour and other inputs have not changed; (ii) the drop in pump prices is just temporary; and (iii) prices are bound to rise again soon when global crude oil prices recover. These make sense, to some extent.

Of course, there are also other reasons that economists normally cite: (i) menu costs (the costs associated with changing prices); (ii) downward price stickiness (it is more difficult for prices to go down than up); (iii) lack of competition; (iv) asymmetric information, and so on.

Another important reason is that with global economic uncertainties that may affect the domestic economy in the near future, businesses are bracing for a tougher business environment. Sentiment among businesses has somewhat deteriorated, as evidenced by the Malaysian Institute of Economic Research (MIER)’s Business Conditions Index (BCI), which fell to a six-year low of 86.4 points in the fourth quarter of 2014, almost the same level as in 2008-2009 during the Global Financial Crisis.

With weak sentiment and expectations of slower revenue and profit growth going forward, businesses tend to cling to whatever profit-generating opportunities they have now (for example by not reducing prices) to make up for any possible deterioration in business performance in the near future. This also makes sense.

As a result, while inflation (commonly represented by the Consumer Price Index or CPI) tends to soften, actual prices remain relatively unchanged. Indeed, prices have not generally declined but have also not increased significantly from their previous levels. This explains the recent minute 1% growth in January’s CPI, which may look benign from one perspective, but could also suggest that consumers are still facing relatively high prices compared with their income levels.

The good thing is that the government is now making extra efforts to ensure that prices do not get misaligned further from their norms. The recent campaign to encourage businesses to reduce prices and the preparation for proper enforcement of the Price Control and Anti-Profiteering Act 2011 are some examples. But more can be done. For instance, the list of goods with “fair” prices should be aggressively distributed by now (besides putting them on the government’s website).

The avenues for consumers to highlight their dissatisfaction about prices of goods and services can also be made known more widely to the public through the mass media. In addition, shopping outlets with the lowest prices can be given free publicity on government websites. This can be done by encouraging the outlets to disclose their prices in special databases managed by, for instance, a special government agency. Periodically, outlets that sell goods at the lowest prices can be disclosed to consumers. This will encourage businesses to compete and disclose their prices.

It is encouraging to see the government taking steps to prevent unbridled price gains, especially when the Goods and Services Tax (GST) is barely a month from implementation. While some analyses have shown that GST will not lead to substantial price increases, the impact of the human behavioural element might not have been fully incorporated in these analyses (actually, it is difficult to incorporate it in the first place). As such, we should prepare ourselves to see the “unexpected” (that is higher-than-expected increases in prices).

Fortunately, the government has envisioned this and is getting ready to face such challenges. The crux of the matter will be the enforcement, which, if properly done, will not cause businesses to raise prices unnecessarily.

Nor Zahidi Alias is chief economist at Malaysian Rating Corp Bhd

This article first appeared in Forum, The Edge Malaysia Weekly, on March 9 - 15, 2015.