Tuesday, February 7, 2012

Banana economics and the value of the Rupee

You may think I have gone bananas, but this is a serious article. It is not often that a banana figures in an Economics text book. Nor is it often that I buy a banana.

Today, after lunch in office, I casually picked up a banana from a street vendor nearby to top up my lunch. As I ate the fruit, my thoughts went back several years ago when, I and a friend of mine used to eat bananas during lunch time everyday, chit-chatting on the footpath, and watching the traffic pass by. It was 1992 - 93. 

Bananas used to cost Rs.2 for three then. I paid Rs.3 for one today. Back in the evening, I calculated that  banana prices have increased by around 8 % per annum over a period of nearly twenty years. I also find that:

1. Bananas are easy to grow and cultivated in several parts of the world. Over long periods of time, supply of bananas is completely elastic.

2. Bananas are perishable, they must be consumed as soon as they are produced (at least, within a reasonable period of time). It is not possible to hoard bananas, create artificial shortage and jack up prices. Bananas are not bought as an “investment”.

3. Hedge funds do not buy bananas, nor are bananas traded on commodity exchanges. There are no Exchange Traded Funds (ETFs) who invest in bananas. You cannot buy bananas “on the margin”. There is no speculative demand for bananas.

4. There are no banks who offer “loans for buying bananas”, which can create artificial demand and cause price bubbles.

5. The demand for bananas does not fluctuate much with economic cycles of boom and bust. Demand can be said to be in a “steady state”, growing “normally” along with the growth in population. I don’t think per capita consumption of bananas has changed much in the last twenty years due to cultural shifts, eating habits or other such reasons.

6. Prices of bananas are not regulated. There is no MSP (Minimum Support Price) or government subsidy either to banana sellers or buyers which distorts price discovery.

7. A banana cannot be said to be the country’s “staple diet”, unlike say rice or wheat. If prices rise more than expected, people will stop eating them, bringing the prices down again. If prices fall too much, banana growers will grow something else, reducing supply which will bring prices up again.

In other words, this is a classic case of what economists call the “long run equilibrium” where prices are determined by free forces of demand and supply, over long periods of time. There are no disruptions.

And yet, banana prices have increased at a rate of 8 percent per annum over the last two decades.

We can therefore draw the following conclusions: 

Ceteris Paribus, (very important in economics!)

Firstly, this rate (around 8 % p.a.) can be taken as the long run rate of currency depreciation for the Indian Rupee. Price of banana has actually remained the same, but the currency has lost its value. Price of every  other natural resource can also be expected to rise at a rate of at least 8 % per annum in the long run. 

Secondly,  prices of natural resources where such an ideal state does not exist (a condition contrary to any point mentioned in 1-7 above exists) can be expected to increase at a rate more than 8 % per annum in the long run. Note that almost all the factors mentioned above influence price upwards, by either increasing demand or reducing supply.

And last but not the least, even monkeys can teach economics.

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