The force of scarcity

David Ricardo, the prominent British economist who, among many other things, explained why free trade has the potential to benefit all, set out to explain the sudden rise in wheat prices during the Napoleonic wars in the 19th century.

He formulated a model which is now known as the Ricardian model of scarcity.

The 'assumptions' and focus on the essential underlying relationship between scarcity and bargaining strength made his model useful far beyond his original aim of explaining why wheat prices had risen during the war.

We can apply his model of 'wheat prices' to explain a host of scenarios in our modern world. It can explain why popcorn is so expensive at the movies, soft drinks expensive at restaurants and coffee expensive in train stations.

The focus on the essential underlying processes makes one see the hidden social patterns which one misses by looking at the nitty-gritty details. Without a model, it will be easy to go astray.

Now, let's take one of the questions that I asked earlier: why do soft drinks at restaurants cost on average twice as much as in a supermarket?

One might be tempted to conclude that the soft drink is expensive because the restaurant has to pay high rent, pay the waiter to smile at the customers' annoying requests, and of course, there is brand, culture and myriad of other factors.

This is precisely the way we think without models, which clouds our judgment in understanding what is truly important and somewhat universal.

Ricardo's model shows that these are all but causes of something more fundamental: the force of scarcity.

The soft drink is expensive not because the restaurant incurs higher costs but because you will be willing to pay a higher price for the soft drink at that particular restaurant.

This enables the restaurant to rent a place at an expensive locale, pay the waiters, use funds to advertise their product and pay for the raw materials.

As you see, the causality runs the other way round. Now this direction of causality is substantiated in a host of empirical analyses.

If Ricardo had bothered with 'important' specifics of the wheat market at the time, we would miss out on understanding the fundamental force that was responsible for a rise in wheat price.

The demand for the scarce resource, in this case, a restaurant with specific characteristics (location, food, ambience, etc) that allows one to enjoy their food with a glass of soda.

Now let's analyse whether one is being ripped off by the restaurant owner by being charged twice the market price for the soft drink? There are scarce ideal locations for restaurants.

Think of MM Alam Road in Lahore or Zamzama in Karachi. Because you will pay a high price in that location, the restaurant's landlord will charge a high rent to the restaurant owner.

If the restaurant owner objects to the high rent, there will be many willing prospective restaurant owners wanting to benefit from your 'price-blindness' at the restaurant in that location.

You might still be ripped off, just not by the restaurant owner.

To find out if you are indeed ripped off, you can look at the overall profits of the food industry at that locale.

If only a few restaurants are making high profits, you have every right to be suspicious.

But, if it is relatively easy to set up the restaurant business, then it is more likely that the high profit of the initial restaurant was caused by a natural scarcity, i.e., the high demand for the restaurant at that locale.

On the other hand, it is also possible that the high prices are a result of some foul play.

For instance, if due to lobbying activities, renting 'contracts' at these locales are only awarded to cronies of those in the corridors of power, then you are indeed being ripped off as you are paying what economists call 'monopoly rents'.

Here, it is not the natural scarcity but a 'barrier to entry' unnaturally driving the high prices at the restaurant.

If barriers to entry are done away with, new restaurants would open and offer more competitive prices.
In my next article, I will use Granovetter threshold model to explain how models are not only used to identify hidden social patterns but also can act as 'thinking aids' and help us reach conclusions which we might not think of otherwise.

Then I will go on to apply this model in the context of the challenges that Pakistan currently faces.

Exclusive to Times of Oman in association with The Express Tribune


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