The Coal Pricing Dispute between NTPC and Coal India – The real issue

This video sheds some light on an interesting issue that is playing out in the real world. The simple question at the heart of this complex discussion is

“How should the correct price of coal be determined?”

Another issue underlying the ongoing search (as illustrated in the video discussion linked above) for an answer to this important question is that the correct price depends on the quality of the coal being supplied. As seen in the linked video, the dispute between Coal India Limited (CIL) and NTPC fundamentally focuses on the correct way to determine the quality of the coal being supplied as a means to determining the correct price of the coal being supplied by CIL to NTPC.

What I am not going to do in this article

I am not going to analyse the arguments given by NTPC, CIL and the different experts weighing in on the matter and come up with my own wise formula for the pricing of coal.

Why I am not going to do that

Simply put, attempting to come up with my own wise formula for the price of coal would be rather presumptuous on my part. I would actually have to pretend that such a formula makes sense. The truth is that any such attempt is fundamentally unwise and is therefore bound to be incorrect.

What I am going to do

I am going to use the very existence of this dispute to highlight a fundamental and very important economic point – that the market process is the only correct way of discovering the correct price of any good and that any attempt at coming up with a number that is supposed to denote the correct price is necessarily going to be arbitrary and that there is no way of knowing whether the number so identified is the correct one. I am also going to use this understanding to identify what would be a sensible solution to situations of the kind that NTPC and CIL find themselves in.

What is price?

Price is the ratio of the quantities in which the two goods that constitute an exchange are exchanged. If 3 horses are exchanged for 267 barrels of fish, the price of a horse is

Phorse    =    Number of barrels of fish/Number of horses
             =    267/3 barrels of fish per horse
             =    89 barrels of fish per horse

If 3 horses are exchanged for Rs. 6 lakh, then the price of a horse is

Phorse    =    Number of units of money/Number of horses
             =    Rs. 6 lakh/3 horses
             =    Rs. 2 lakh per horse

What determines the price of a good?

The price of any good is determined by the subjective valuations of all the individuals who participate voluntarily in the market process. Every individual enters the market with a value scale on which different goods and multiple units of the same good are ranked. The immediate outcome of this is that for every unit of a good, every buyer has a certain maximum buying price above which he does not have a demand for that unit of the good while every seller has a minimum selling price below which he is not ready to supply that unit of the good. This combined with the Law of One Price translates into saying that at every hypothetical price that one may take up, every buyer demands a certain quantity of the good in question while every seller is ready to supply a certain quantity of the good.

This array of quantity demanded or supplied by an individual at every hypothetical price is what we understand as the individual demand or supply schedule. Since the individual demand and supply schedules only specify the quantity of a good that that individual demands or is ready to supply at every hypothetical price, it is both possible and meaningful to add the individual quantities demanded and supplied by every individual at every hypothetical price into what we may call a market demand and supply schedule for the good. The market demand and supply schedules tell us the total quantity that all the individuals who participate in the voluntary market process put together demand or are ready to supply at every hypothetical price.

Economic reasoning helps us identify two very fundamental laws that help us understand a basic feature of these market demand and supply schedules – The Law of Demand and The Law of Supply. These may be stated and understood as below.

  • The Law of Demand – At a higher hypothetical price, the total quantity demanded will be the same or lower. Conversely, at a lower hypothetical price, the total quantity demanded will be the same or higher.
  • The Law of Supply – At a higher hypothetical price, the total quantity supplied will be the same or higher. Conversely, at a lower hypothetical price, the total quantity supplied will be the same or lower.
  • From these laws, we see that at sufficiently low hypothetical prices, total quantity demanded would be more than total quantity supplied while at sufficiently high hypothetical prices, total quantity demanded would be less than total quantity supplied. At some price in between, demand will be equal to supply and the market is said to be cleared. This hypothetical price which emerges through a market process is called the market clearing price. At any price other than the market clearing price, mismatch between quantity demanded and supplied would drive the price back towards the market clearing price, which is therefore also understood as an equilibrium price.

    Thus we see that individual valuations work through a complex market process to ensure that a particular price emerges or is discovered for each good. These individual valuations cannot be known to any individual or data collection mechanism. They are known only through the preferences demonstrated by individuals in actual voluntary exchange. Therefore, the correct price of a good cannot be known to any individual. No amount of experience, expertise or computational capability can replace the market process and come up with a correct price.

    The additional complexity in the discovery of prices of producers’ goods

    The process described above explains the discovery of the prices of consumers’ goods, i.e., goods that immediately and directly satisfy human ends. Producers’ goods, however, are a more complex affair as they are valued not for their own immediate usefulness in satisfying human ends but for their usefulness in eventually churning out consumers’ goods. For instance, coal is valued not for its immediate usefulness but for its usefulness in operating thermal power plants which produce electricity which is in turn valued because it may be further transmitted and distributed for consumption either in further production or in running appliances like bulbs, fans, air-conditioners, televisions, microwave ovens, mixers, grinders and a whole host of home appliances that immediately and directly satisfy human ends.

    Producers’ goods are valued by producers. A producer produces to further exchange his output for monetary revenue, which in turn would help him obtain consumers’ goods to satisfy his own ends. Economic theory explains that the valuation of producers’ goods in done by every producer based on his estimate of the contribution of the marginal unit of a given supply of a producers’ good to his revenue. This concept, called the Marginal Value Product or MVP is imputed backwards by the producer based on his subjective assessment of the quantitative relationship between the marginal unit of the supply of the producers’ good and the revenue obtainable from the sale of the final consumers’ good (called the production function).

    Economic theory demonstrates that every producer whose subjective imputed assessment or MVP of a given supply of a producers’ good is greater than a hypothetical price would have a demand for the producers’ good at that hypothetical price. A fundamental economic law known as The Law of Returns demonstrates that the relationship between the MVP and the quantity of any producers’ good would take the form of a downward sloping curve. In other words, it establishes that the Law of Demand as defined for consumers’ goods works just as well for producers’ goods, i.e., at higher hypothetical MVP, quantity demanded of any producers’ good would be lower while at lower hypothetical MVP, quantity demanded of any producers’ good would be higher. The downward sloping MVP curve thus becomes the downward sloping demand curve for the producers’ good.

    Economic reasoning further establishes that the opportunity cost of supplying a produced producers’ good is zero, which would result in a vertical supply curve for the producers’ good. The interaction of the downward sloping demand curve and the vertical supply curve establishes the market price of the producers’ good.

    Summarising the complexity in discovering the prices of producers’ goods

    Prices of producers’ goods are also eventually determined by the subjective valuations of all the individuals who constitute the market. Their valuations as consumers determine the market prices of consumers’ goods. Their valuations as producers based on their subjective assessment of the demand schedules of consumers’ goods further determine the prices of producers’ goods. So we see that a complex but strong and robust market process based on valuations that cannot all be known to any individual drives the determination of the market price of any producers’ good.

    Why is this process failing to work in the coal market and why are NTPC and CIL engaged in a tussle?

    The reason is very simple. The market process has been disrupted by the establishment of two massive monopolies on the two sides of the coal exchange market. CIL and NTPC are both government entities with a monopoly on the supply of coal and the production of coal-based thermal power respectively. There is therefore no real free market in coal. In the absence of a free market for coal, there cannot be a market process for the discovery of the price of coal. The act of creating these two monopolies is a direct subversion of the market process. Problems related to the pricing of coal are an inevitable outcome of such subversion.

    Citing, as the Chairman of NTPC does in the video, that NTPC is working as per the regulations of the CERC (Central Electricity Regulatory Commission) does not constitute an answer. It is only an example of bureaucratic washing-my-hands-off-the-matter. The claim that pricing should be according to calorific value is also a very poor answer because it is a technocratic solution, not a market solution. A bunch of technical experts sitting together and systematically analysing reams of data does not constitute a market process of price discovery. It still remains a technocratic solution that will necessarily end up as arbitrary number fixing with no connection to the complex market processes that would otherwise determine the price. Government getting in and mediating the discussion will only transform the price that emerges thus from a technocratic solution to a political solution, not an improvement in any sense.

    What would constitute a real solution?

    The real solution would require breaking the monopoly of NTPC and CIL over their respective product markets. It will, in all probability, involve breaking the huge monoliths into multiple smaller pieces and completely privatising their ownership and operations. It would involve government completely renouncing its claims over the underlying resources by transferring them in their entirety to private hands and letting the new owners decide how to operate their individual facilities. It would involve further privatising the entire mechanism of transmission and distribution of power, thus letting the market decide what is the proper price of every factor of production including coal. Clearly, this solution is very challenging and there is bound to be a lot of political opposition to its implementation. That, however, does not take away from the fact that absent a free market in power, pricing of goods like coal will continue to attract controversy and remain a festering problem periodically inviting technocratic and political intervention to throw up inappropriate solutions.

    Related articles:
    Key Concepts in Economics – 3 – Subjective Value to Exchange and Price discovery

    The Coal Pricing Dispute between NTPC and Coal India – The real issue
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