Explaining relative prices – the key element of inflation data

Photo: HT
Photo: HT


These send out critical signals that affect affordability and also the allocation of economic resources

India’s retail inflation is on a decline. This is good news for the economy. There is a crucial piece of information hidden in the price data that is, however, rarely discussed—relative prices. A relative price is a price of a product compared to another one, while inflation is a change in the overall price level.

Changes in relative prices benefit some and hurt others for a given level of retail inflation. Say, if the relative prices of food products increase, it alters the distribution of spending, with the poor having to spend more of their income on food if incomes do not rise sufficiently. A rising relative price also transmits a signal to suppliers to increase production to profit from higher prices. Changes in relative prices, thus, tend to result in changes in the allocation of resources in the economy.

Since 2012, the base year for the consumer price index, the price of the meat and fish group has risen the fastest, an increase of over 110% relative to other food items. There has been a fast rise in relative prices of vegetables, oil and fats, and spices too.

There are some interesting rural- urban differences in terms of absolute price changes that influence relative prices. In the case of meat and fish, their prices have risen to a similar extent in both rural and urban India. In contrast, retail prices of vegetables have risen much more in urban areas, suggesting incremental costs of transportation and storage and higher affordability for urban consumers. As a result, the relative price of meat and fish, a key protein source for many, compared to vegetables, has increased more sharply in rural than urban India.

In contrast, the largest decline in the relative price has been seen for sugar both in rural and urban India. In fact, the absolute price of sugar has risen only by 20% in a decade. Similarly, the relative price of cereals has fallen compared to fruits and vegetables. Among services, transport, communication and recreation and amusement saw prices fall relative to healthcare and education.

A rise in the relative prices of food increases the cost of living for poor families more than what is indicated by inflation. Further, with carbohydrates and sugar becoming more affordable compared to proteins, there is an incentive to consume more. Similarly, a rise in the relative price of healthcare harms the poor more, given high out-of-pocket spending on healthcare in India. While the Centre’s effort to provide free health insurance to the poor is noteworthy, the increase in the supply of the quality healthcare services seems to be lagging.

The poor end up saving less or have to cut down consumption of some other items if the rise in their income is insufficient to compensate for the rise in prices. Since late 2014, there has been near stagnancy in rural real wage growth in India. Real wages are nominal wages adjusted for inflation. This also necessitates higher government transfers and subsidies to the relatively poor.

When consumer prices rise, the gains are distributed between retailers and producers. This depends on how much the wholesale prices of a product go up compared to a rise in retail prices. If the wholesale price is rising faster than the retail price, then producers tend to make higher gains compared to retailers and vice-versa if input costs do not rise. This also matters for the reallocation of production resources.

In India, the wholesale price index has prices of food, fuel and manufactured goods, but no services. Among the categories of products for which both price indices are readily available or can be calculated, retailers have seen higher price gains than producers in eight out of 14 product lines. This is especially the case in meat and fish, which has seen the largest price rise. In effect, despite the rise in the relative price of meat and fish, producers’ incentive to increase supply seems to be limited. Similarly, in footwear and clothing, retail prices have risen faster than wholesale prices.

In contrast, the prices that producers receive for vegetables have risen much more sharply than the increase in the retail price. To a less extent, the same is true for fruits and cereals. The prices that producers receive for cereals, however, are less volatile and move only in upward direction compared to fruits and vegetables since cereals enjoy support prices and do not require cold storage. That is also the case with sugarcane. Despite the fall in the relative price of sugar owing to excess supply, the price signal does not get transmitted to sugarcane producers who enjoy a guaranteed minimum support price.

In services, healthcare and education sectors are more regulated than communication and entertainment. Greater and unpredictable regulation makes the reallocation of resources harder in response to changes in relative prices. Also, when production is to be raised or shifted, it needs investment, and not just a re- arrangement of existing resources. Further, in agriculture, the suitability of land for the type of crop determines if and how quickly a switch can occur.

While the Reserve Bank of India can and should keep an eye on retail inflation, the reallocation of resources in response to relative prices depends more on government regulation and polices, the quantum of investment required, and the ease of switching production and sectors. India needs to make faster strides in this regard.

Vidya Mahambare & Praveen Kumar are, respectively, a professor of economics and director (research), and graduate of Great Lakes Institute of Management, Chennai.

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