Energy suppliers engage in price discrimination – that’s a good thing

Most consumers are equal parts confused and outraged at energy prices. It’s not simply that they’re too high (although they could be lower), it’s that two customers who get identical products can pay vastly different prices. ‘Loyal’ (low-engagement) customers on standard variable tariffs (SVT) pay substantially more for their energy compared with active switchers who shop around for the best deal. OfGem reckon that customers on the worst deals could be as much as £230 better off each year if they switched to a better deal. But customers don’t even need to shop around to get a better deal. Simply going online and moving from the default standard variable tariff to a fixed rate tariff can save you over £100.

Politicians left and right have condemned this. Tory MP John Penrose writes on ConservativeHome:

“What other industry doesn’t give their most loyal customers any discounts or special deals, but charges them higher prices than anyone else instead? Which companies believe that loyalty should be exploited, not rewarded? Who treats their longest-serving customers as chumps, to be quietly and secretively switched onto expensive, unfair deals when they aren’t looking, and then milked; ripped off mercilessly for as long as possible.”

It just seems unfair. As a result politicians like Theresa May and Jeremy Corbyn have called for price caps. Penrose himself has called for a slightly different policy, backed by the centre-right think-tank Policy Exchange, a relative price cap. He thinks we can fix the energy market by banning firms from changing vastly different prices to different customers.

Penrose is opposed to price discrimination – the practice of charging vastly different prices for goods that cost roughly the same amount to produce. A retailer can charge all customers the same price for a certain product. But some customers might have been willing to buy it for more than that, and some customers won’t be willing to pay for that at all. A Venti coffee at Starbucks costs a penny more than a Grande to make, but lets them charge frugal customers less and profligate customers more for what is basically the same product, allowing them to sell to more customers and maximise revenues. It sounds unfair, but when firms have high fixed and sunk costs its consumers that benefit.

Take research and development intensive industries like pharmaceuticals. In order to produce a new drug, a pharmaceutical firm will have to spend heavily on researching and testing new cures. Producing the first pill is very expensive, but producing the second, third and fourth is incredibly cheap, costing next to nothing. The more drugs a firm can sell the lower the average cost per drug is. That’s why pharmaceutical companies invest heavily in drugs aimed at a mass-market and require subsidies or philanthropic donations to tackle rare diseases. If discriminating between consumers, charging high mark-ups to some and tiny mark-ups to others allows them to sell more pills then they’re able to spread their fixed costs widely, lowering average prices for all.

Politicians are typically quick to blame huge price differentials on a lack of competition. Penrose writes for Bright Blue’s CentreWrite magazine that “This shows this market is completely broken. So broken that even the basic laws of supply and demand aren’t functioning properly. Clearly, we must reform the sector so it behaves like a normal industry where the customer is king – not the regulator, or the politicians.”

But, firms in competitive markets frequently engage in aggressive price discrimination strategies. Take fast food. No one can deny that competition in the market for a quick burger and chips is intense (The Guardian amongst others frequently is concerned about there being too many takeaway firms). But McDonalds doesn’t adopt a strategy of uniform mark-ups. As airline deregulator Michael Levine points out: “It is a commonplace in the business that a fast food restaurant sells hamburgers with a much lower mark-up from variable cost than is entailed by the prices of french fries and soft drinks (which are sold separately at very high margins above variable cost). How can we explain this in a world without market power? …firms constrained by competition from earning monopoly rents will adopt price discrimination as the optimum strategy to allocate common costs among buyers.”

If McDonalds didn’t engage in this kind of price discrimination they would almost certainly go bankrupt as KFC, Burger King and Wimpy would have substantially lower average costs.

The same is true for energy costs. Building a power plant is expensive, but once the power plant is up and running the marginal cost of an extra kilowatt of energy is relatively low. Charging price insensitive customers (those who can’t be bothered to switch) more allows them to cover their fixed costs and charge marginal customers almost no mark-up whatsoever.

This isn’t just elegant, if counter-intuitive, theory. There’s real world evidence to back it up. Sinnhauser and Whish-Wilson, two economists working for large Australian energy incumbent AGL, compare two Australian regions Southeast Queensland and Victoria. Victoria’s retail energy market is almost entirely deregulated with huge price differentials between tariffs, while Southeast Queensland has a regulated price-cap.

In Victoria prices vary massively with some consumers paying 30% more than others and standard variable tariff offers well-above (around 10%) average unit cost. Southeast Queensland on the other hand has much less price dispersion as the regulated cap forces firms to set tariffs below average unit cost. Many politicians would look at each market and conclude that things were working better in Southeast Queensland. They would be wrong.

Consumers behave very differently in the two different markets. In Southeast Queensland 46% of customers stay on the default more expensive standard variable tariff, with just 22% benefitting from medium-level discounts (there are no high-level discounts). Deregulated Victoria is a different kettle of fish. Just 11% of customers stick on bad-deal standard variable tariffs with 45% accessing high-level discounts and pricing being set at marginal cost for many. Switching rates are also much higher in deregulated Victoria, suggesting that Penrose is wrong to claim “because, at the moment, contrary to all economic theories, the amount of switching does not increase as the size of the potential cost savings rise.”

Based on Sinnhauser and Whish-Wilson’s analysis, capping standard variable tariffs would push average prices up and hurt consumers. But we shouldn’t need economic theory or data from Australia to know it’s a bad idea. We should simply look at OfGem’s recent interventions to simplify the market and reduce price discrimination to see why price controls are a bad idea.

In 2008, OfGem brought in non-discrimination to remove ‘unfair’ price differentials. Banning practices such as offering higher prices in regions where they were the incumbent or largest supplier and lower prices in regions where they were trying to increase their market share. The result? “Competition reduced, customer switching fell by half, and profits of major suppliers increased by nearly £1 billion, at the expense of customers” according to economist and former Director General of Electricity Supply Prof Stephen Littlechild.

But, if at first you don’t succeed, try and try again. Rather than learn the lessons of their failed 2008 intervention, OfGem (under significant political pressure) forced firms to ‘simplify’ their tariffs, forcing firms to only offer four separate tariffs. As Littlechild once again points out "Suppliers naturally chose to keep their most popular and profitable tariff types and phase out their minority preference tariffs…”. The best deal on the market fell foul of the regulations (it was too complex apparently) and was withdrawn. Worst of all, E.ON’s StayWarm tariff that offered customers over 60 years of age a fixed monthly bill regardless of how much energy the customer used was withdrawn. Ironic for OfGem considering that they had singled the tariff out for praise in 2001 because it addressed the needs of the fuel poor.

Price controls simply don’t work. They reduce competition, cause popular tariffs to be withdrawn and push up average prices. The Government should ditch its manifesto pledge to cap energy prices and instead boost competition by scrapping OfGem’s misguided interventions.


Taxes and regulations hurt people not 'business'

There is little more irritating than being told that some new tax or regulation "Will cost business £x" – all the more so if it is preceded by the word "only". The aim (usually of those who are promoting the new taxes or regulations) is to suggest that only a few people whose lives revolve around owning and running businesses will suffer, while the rest of us, normal people, will benefit. And of course being capitalists, the losers can afford it anyway. And being greedy capitalists, they deserve to pay anyway.

But taxes, tariffs, quotas, regulations, licences, trade restrictions and all the rest do not cost business. They cost people. People like you and me, even those of us with no business interests. And they cost us far more than the £x price-sticker suggests. Let me explain.

In the first place, businesses themselves, and the people who own and run them, are not some alien species. Most businesses are small businesses, as small as one person, and most of a country's commerce goes through these small operations. Something that costs "business" in fact costs millions of these same people, from the local farmer to the budding software developer.

Second, business is an entirely imaginary concept. It means networks of owners, suppliers, workers, distributors and customers. That is, people. Something that costs "business" in fact costs all of these individuals And it is not necessarily the owners who bear the bulk of the cost. An increase in business taxes, for example, is borne primarily by the workers and customers. Ordinary folk like us.

If you tax or regulate something, you will get less of it. That goes for business too. Unfortunately, the whole purpose of business is to create value and to produce the things we want to consume. Indeed, the only reason we go to the effort and expense of producing things is to consume them. Less business means that less value is created and there is less to consume. We get less of the things we value, less of what we want.

So customers lose. They may not be able to purchase the things they want, or those things may become more expensive because of the tax and regulation on their production. And here is an important and overlooked point: customers lose far more value than the £x that is lost to "business". The reason is simple: customers do not buy something unless they think its value to them is greater than the price they paid for it. Which means that something that costs "business" costs consumers more.

But perhaps the biggest worry is that all these effects are cumulative. Commerce lost today means fewer opportunities for investors, workers and customers. So there is a smaller base for value-creating opportunities tomorrow. And that in turn shrinks the opportunities available the next day, and the next. 

Taxes and regulations may be deemed necessary. But they have a lasting, expanding cost. And that accumulating cost falls on all of us, not just "business".

Ever such a tiny problem with Owen Jones' latest claim

Owen Jones manages to get two things right in his latest offering. Portugal's economy did not do well an now is doing better. Sadly, he manages to get the why wrong:

But now, thanks to Portugal, we know how flawed the austerity experiment enforced across Europe was. Portugal was one of the European nations hardest hit by the economic crisis.


At the end of 2015, this experiment came to an end. A new socialist government – with the support of more radical leftwing parties – assumed office.

Presumably all was sweetness and light as a result?

The economic rationale of the new Portuguese government was clear. Cuts suppressed demand: for a genuine recovery, demand had to be boosted. The government pledged to increase the minimum wage, reverse regressive tax increases, return public sector wages and pensions to their pre-crisis levels – the salaries of many had plummeted by 30% – and reintroduce four cancelled public holidays. Social security for poorer families was increased, while a luxury chargewas imposed on homes worth over €600,000 (£550,000).

The promised disaster did not materialise. By the autumn of 2016 – a year after taking power – the government could boast of sustained economic growth, and a 13% jump in corporate investment. And this year, figures showed the deficit had more than halved, to 2.1% – lower than at any time since the return of democracy four decades ago. Indeed, this is the first time Portugal has ever met eurozone fiscal rules.

Well, yes, that is the claim, isn't it? The problem with the claim being that economic growth returned in 2013. Something which happened two years before the socialists took power is unlikely to be connected with the socialists taking power really.

We're really quite sure about that.

How To Write An Anti-Sex Work Article

Over the course of this month, several articles have appeared in British media promoting the “End Demand” approach to sex work: criminalizing people who buy sex rather than fully decriminalizing the market. Two of these articles were been released by radical feminist Julie Bindel on the Independent website and in The Spectator respectively, and both promote her upcoming book on the global sex trade (which I look forward to reviewing). The third article—written by UK Feminista co-founder Kat Banyard—was published yesterday on The Guardian’s website, and also promotes a new book titled Pimp State.

These articles are remarkably similar in structure and content—so much so that I’ve created a simple guide for how to write your own article advocating harmful approaches to sex work regulation!

Step 1. Misrepresent advocates of sex work decriminalization as friends of the ‘pimp lobby’. Falsely accuse your opponents of propagating the ‘happy hooker’ myth: the idea that sex workers almost invariably find their job empowering and wonderful.

Bindel’s first article does this from the outset: it’s titled “Tell me if you still think prostitution is empowering after hearing what the buying punters have to say”. Her second article does the same:

We’ve become accustomed to thinking of prostitution as a legitimate way of earning a living, even ‘empowering’ for women...don’t believe the ‘happy hooker’ myth you see on TV...the loudest voices calling for legalisation and normalisation of prostitution are the people who profit from it: pimps, punters and brothel owners.

...I discovered that whatever the lobbyists say, women and girls in prostitution are overwhelmingly from abusive backgrounds, living in poverty, and otherwise marginalised.

Banyard’s article does this indirectly, quoting a German local support worker:

Constabel didn’t hesitate when I asked her who drove efforts for prostitution to be recognised as work. “It was people running the brothels … they wanted these laws that made it possible to earn as much money as possible.”

Step 2. Suggest that commercial sex is by necessity (or almost always) equivalent to rape or sexual abuse.

From Bindel’s first article:

The punter has the most choice, and women have the least. They are paying for sex because without the money the woman would not consent. What else do we call sex without consent?

Her article for The Spectator does something similar, although at least this time it’s an falsifiable empirical claim rather than an ontological one:

In almost every case [sex work is] actually slavery. The women who work as prostitutes are in hock and in trouble. They’re in need of rescue just as much as any of the more fashionable victims of modern slavery.

Banyard takes a more general approach, equating all commercial sex with ‘sexual abuse’:

For all the ways it is marketed, the sex trade boils down to a very simple product concept: a person (usually a man) can pay to sexually access the body of someone (usually a woman), who does not freely want to have sex with him. He knows that’s the case - otherwise he wouldn’t have to pay her to be there. The money isn’t coincidence, it’s coercion. And we have a term for that: sexual abuse.

Step 3. Reference and misrepresent obviously biased, poor quality research about people who buy sex. Use a choice selection of objectionable quotes for shock value.

Bindel’s first article cites her own research on men who buy sex:

I have been interviewing sex buyers since 1999 when I, with sex trade survivors and other feminist activists, set up a re-education programme for men who pay for sex in West Yorkshire. In 2009 I was a researcher on a major, six country study on men who buy sex. I was part of the team that interviewed 103 sex buyers in London. Over 50 per cent of the men, who were interviewed at length and face-to-face, admitted that they knew the women they bought were trafficked, pimped, or otherwise coerced. Not one man chose not to have sex with the women upon realising this.

Her second article also references her interviews:

I have interviewed a number of punters, both in the UK and elsewhere, and this is the sort of thing they say: ‘I don’t want her to enjoy it — that would take something away from me.’ And: ‘I like prostitutes cos they do what I tell them. Not like real women.’ What about this: ‘It’s no different from buying a burger when you’re starving and the wife hasn’t cooked you anything.’

Banyard follows protocol and cites her conversations, although her quotes aren’t quite as shocking as Bindel’s:

I heard a range of justifications rolled out by the men I spoke to about why they pay women for sex: “I don’t have any option … At the moment I’m just single so I have to buy it”; “It’s just a male thing where it’s get as many as you can” ... “I think it’s just a fact of ‘I’ve done my duty’,” for instance.

What united these men, however, was an overpowering sense of entitlement to sexually access women’s bodies.

4. Make vague, incorrect pronouncements about how sex work decriminalization is useless or harmful. Alternatively, avoid talk of decriminalization entirely and attack legalisation: despite this approach being condemned by sex workers' rights advocates.

From Bindel’s first article:

During one of my book research trips to Holland, where the sex trade was legalised in 2000, I met a punter who told me that prostitution “prevents rape”, and, conversely, if men, were prevented by nasty feminists from puntering, they would be driven to rape “real women”. This is one of the most pernicious of all the myths about prostitution. In the first place, it is an abhorrence, and should be an anathema to all feminists, that we are told that men are programmed to rape if they do not get their rocks off. It is one of the most pessimistic and inaccurate views of male sexuality I have heard.

But equally as dangerous is the view that some women should be made available to men to be sexually violated so that “other” women can be safe from rape.

From Bindel’s second article:

New Zealand, we are regularly told, is the gold standard in dealing with the sex trade. The Home Office Select Committee (prior to its chair Keith Vaz being forced to step down following allegations that he paid for sex with young men) was looking at adopting a similar model of decriminalisation in the UK.

On the streets I met Carol, who looked 70 but was much younger, using a zimmer frame to rest between punters. Carol told me that since prostitution was decriminalised 13 years ago, nothing had improved for the women. The punters are still violent, and police still don’t care, she said. Nor do human rights defenders. While women all over the world fight to end violence and abuse, the Labour party and Amnesty International, to name but two public bodies, betray them.

And finally, from Banyard’s Guardian piece:

Getting governments to facilitate a commercial market in sexual exploitation therefore requires masking it with myths such as: that demand is inevitable; that paying for sex is a consumer transaction, not abuse; that pornography is mere “fantasy” and that decriminalising the entire trade, pimping and brothel keeping included, helps keep women safe.

5. Advocate for the flawed Nordic Model.

From Bindel’s first article:

Buying sex is neither a need, nor a human right. But it is a right for women and girls to grow up in a world where prostitution is an ancient relic.

Bindel tacitly advocates for the Nordic Model in the second piece:

If I suggest to fans of prostitution that nothing terrible will happen to men if they can’t pay for sex, I hear the same complaints…

Banyard praises the Nordic Model in her article too:

First pioneered in Sweden, the abolitionist legal framework works to end demand for the sex trade. It criminalises sex-buying and third-party profiteering, but it completely decriminalises selling sex and provides support and exiting services for people exploited through prostitution.

And there you have it! That’s how to write your very own anti-sex work article.

The rise in the self-employed is just disguised unemployment

And those in such self employment are making pennies - it's a common enough comment being made about that rise in self employment since the crash. It's one of those things which could even be true, therefore one of those things we need to test:

Britain's public finances were back in the black last month as a surge in self-employed workers' tax payments boosted the Treasury's coffers.

The surplus of £184m is the first in any July since 2002, figures from the Office for National Statistics (ONS) show.

Economists had expected the Treasury to record a deficit of £1bn, up from the £308m additional borrowing in July 2016. But instead rising self-assessment tax receipts gave the Chancellor a boost.

The July figures show that payments of self-assessed income tax increased by 11pc from the same month of last year to £8bn, the highest level since records began in 1999.

Ah, so, having tested it we find that it's one of those things which turns out not to be true. Ah well.

Which is an interesting little reminder of a deeper point. There are many things which could be true in something as complicated and chaotic as the economy of 65 million people. This could be causing that, it might actually be doing that other over there. A priori we're really not sure, as here, theory isn't good enough to tell us whether self employment is a push matter, people not being able to find anything else, or a pull, people doing it because it's better. We just have to wait and find out.

Which runs us smack into Hayek's wall about the pretence of knowledge. Theory isn't good enough, only facts can aid us in deciding. But facts are difficult to come by and they're certainly not available beforehand, only in fragments and afterward. Thus we cannot go around planning and in detail simply because the information we need isn't there to predict that future.

Tech giants are undercutting business - and that's a good thing

In today’s Times, consumer affairs reporter Andrew Ellson argues that “Feckless ministers have let tech giants undercut business”, but his objections are rather wrong-headed.

First, he’s concerned that Amazon will outcompete car dealers and the treasury will get less tax as a result. He writes:

“Car dealers will soon be the latest victims. After being told that they must pay an extra 15 per cent in business rates over the next five years, they now face the prospect of Amazon, which benefited from a rates cut in April, selling cars online. Expect blood on showroom floors. Car dealers are not high on anyone’s list for sympathy but they do pay a decent amount of corporation tax, which will disappear if they go bust. Last year Amazon paid only £7.4 million tax on earnings of £1.46 billion.”

Where to begin?

First, business rates aren’t a tax on business but a tax on property. They reflect property values and because of our incredibly restrictive planning system the incidence falls mostly on the landowner not the business owner. Without business rates, car dealers would simply pay higher rents. (Of course, if we fixed our godawful planning laws and let firms build then the burden would shift to business owner and it’d become a big problem, but until then…)

Second, Amazon, like other online retailers, chooses to locate its warehouses on the outskirts of cities where rent is cheaper. Ellson’s complaint is essentially that Amazon uses land more efficiently and as a result will be able to offer lower prices. A problem for car dealers not for car buyers.

Third, Ellson’s worried that Amazon outcompeting car dealers will leave a hole in the public finances. He points out “Amazon paid only £7.4 million tax on earnings of £1.46 billion” but corporation tax is levied on profits not revenues. Amazon keeps its mark-ups low and reinvests in expanding into new markets. A company abusing its monopoly to charge high mark-ups would almost certainly pay more in tax, but we’d all be worse off as a result. I doubt Ellson would praise a firm that laid off its minimum wage workers and used the savings to boost CEO pay, because it meant they paid more to the Exchequer.

Amazon isn’t the only innovative firm in Ellson’s sights.

“At every turn, technology giants using favourable tax arrangements are undercutting British businesses. Airbnb, for example, has won a huge chunk of revenue from hoteliers because its users do not have to pay VAT on their stays while hosts do not have to adhere to the same safety standards.”

Again, Ellson is misinformed on the tax front. He seems to describe Airbnb’s tax arrangements as the result of ministerial sloppiness. Airbnb does pay VAT on its cut. It’s the host that doesn’t and the reason why is simple. The threshold for registering for VAT is an annual turnover of £85,000. Few hosts will earn that. Now perhaps, we should lower that rate to take into account the rise of self-employment, but Airbnb hosts and Uber drivers wouldn’t be the only ones to pay.

Ellson also complains that Airbnbs don’t have to comply with the same safety standards of hotels. But Airbnb’s rating system corrects for safety and quality control just as well as any government bureaucrat.

Ellson believes that these ‘favourable’ tax arrangements are enabling ‘libertarian tech barons’ to ‘grow to such dominance that the economy and innovation suffers.’ He cites Google’s search dominance and Apple’s mobile dominance claiming that “one has to question whether these companies are really creating wealth or just using their market share to extract a cut of someone else’s.”

But it’s clear that Amazon, Apple and Google are creating wealth. Amazon has delivered low prices and near instant delivery, Apple’s iPhone has revolutionised the world, and Google are constantly innovating by producing driverless cars as well as the best search offering on the market. All three firms may have driven others out of business but that’s exactly the sort of market competition that delivers for consumers.  

Perhaps someone should tell the Scottish Government that the research has already been done?

There's nothing wrong with having a new idea of course, that's the very way in which civilisation advances. Yet it's also worth pointing out that many people have had new ideas over the years and millennia and those ideas have often even been tested. One of the points about civilisation being that it's, in one view, the manner in which we transmit to ourselves in the present and also the future which o those ideas work and which don't.

That is, a useful thing to do with a new to you idea is to see if someone else did it first, then examine what the results of trying to implement that idea were?

Scottish ministers have indicated their willingness to consider a tax on disposable coffee cups if there is evidence that such a move would reduce waste.

A spokeswoman for the Scottish government said that ministers were keen to embrace “innovative ideas” to tackle waste and this could include a 5p levy on every disposable coffee cup bought in Scotland.

A coffee-cup tax is likely to be debated at the SNP conference this year. If it is supported, the Scottish government would be expected to take the idea on to see if it would work.

This has in fact been tested. As explained here.

Idiocy may not be a word contained within the report, but the research found that a charge of 25p per cup only gets a few per cent of people to take a reusable one. The vast majority of people shrug and take the standard ones which, after that 20 minutes of use, pile up in a landfill site. 

If 25p doesn't cut it then 5p isn't going to either, is it? 

Note that this is entirely different from the underlying point, which is that recycling coffee cups costs more than any benefit gained from the recycling, meaning that we shouldn't be doing it. This is the more brutal point that we've tested 5p and it doesn't work. We've tested it recently, on the current British population, and it doesn't work.

Therefore, obviously, we shouldn't do it.

Regional inequality: also a housing supply problem

Over the past few years compelling evidence has come out suggesting that housing policy errors are behind slow productivity growth, wealth inequality, and the cost of living crisis. But a raft of new work suggests housing policy errors might also be a key explanation for rising regional inequality in the West, and more specifically the rise of the Englands South East and the relative decline of the Midlands and North.

A speculative and controversial new working paper from Greg Clark and his collaborator Neil Cummins looks far back to determine why the North, the site of the UK's industrial revolution, has declined relative to much of the country, especially London. He looks at a genealogy of 78,000 people and finds that people with distinctively Northern surnames actually have not lost out relative to those with distinctively Southern surnames.


But many of the best and brightest have moved to London, and this has accelerated in recent years, even into the late 2000s, just as the productivity gap has opened up. He links these two phenomena together: being unable to keep their smartest has hampered the success of commerce and industry there. Large fiscal transfers make relatively little long term difference if they don't attract people. And one-size-fits-all policies (like national pay bargaining) that might be thought to help poorer areas actually worsen the problem, incentivising people to queue for the far more generous pay that the public sector offers in poorer areas.


What Clark's work lacks is an explanation. Why has the migration South been skill-biased? Why has it sped up so much recently? A recent literature suggests that restrictive housing supply, which raises rents (and house prices), deters low-skilled movers much more than high-skilled movers, raising the average talent in the host city and cutting it in the sending city. This compounds itself, because the move itself affects the desirability of the places to live in, especially for the high-skilled.


The data comes from the USA, but the situation is the same. Between 1880 and 1980 per capita income between US states converged steadily and significantly. If you heard that things were better somewhere else, you upped sticks and moved. It's the point of America! But convergence fell from nearly two percent per year to under half of that in the last two decades. And a new NBER working paper points the finger directly at falling migration.

The mechanism we propose for explaining the decline in income convergence can be understood through an example. Through most of the twentieth century, both janitors and lawyers earned considerably more in the tri-state New York area (NY, NJ, CT) than their colleagues in the Deep South (AL, AR, GA, MS, SC). This was true in both nominal terms, and after adjusting for differences in housing prices. Migration responded to these differences, and this labor reallocation reduced income gaps over time.

Today, though nominal premiums to being in the New York area are large for these two occupations, the high costs of housing in the New York area have changed this calculus. Lawyers continute to earn much more in the New York area in both nominal terms and net of housing costs, but janitors now earn less in the New York area after subtracting housing costs than they do in the Deep South.

This sharp difference arises in part because for lawyers in the New York area, housing costs are equal to 21% of their income, while housing costs are equal to 52% of income for New York area janitors. While it may still be worth it for lawyers to move to New York, high housing prices offset the nominal wage gains for janitors.

This effect only appears in places that regulate land use and housing supply tightly. Another paper, by Andrii Parkhomeno, puts 23% of the rise in wage dispersion down to housing issues. In the forty years to 1940-1980 inequality both regional and overall income inequality fell, with migration explaining a huge chunk of this. The opposite has happened more recently both in the USA and the UK, as the incentive and ability to move has crashed.

The world of 2017 has a lot of big problems. Clearly some of them (dealing with new technology, North Korea, and terrorism) are things that reforming housing has little to do with. But many of the most important issues today are almost entirely driven by housing problems. At Berlin or Tokyo rents per square metre my life would be completely transformed. I could save go on an extra holiday a year, save up for a house, put more into my pension, and go out for dinner more—all at the same time.

If this flow were driven by inevitable socio-economic factors then maybe the infamous paper would be right: we should just abandon declining places and move their residents. But it looks like regional decline is a policy choice just as the productivity puzzle, wealth inequality, and high rents are a policy choice. We abosolutely can do something about them.

Margins and monopoly

Last week, a new working paper purports to provide evidence supporting the idea that overall market power exhibited by firms in the US has increased over the past 30-40 years.  This was then picked up by a few blogs/media outlets.  In short, the paper claims that there has been an increase in overall profit margins (or mark-ups) since 1980 and, therefore, this implies that overall competition between firms has decreased and that antitrust enforcement is not working.

The initial basis for the paper’s argument is that under 'perfect competition;, firms are supposed to charge a price equal to their cost. In standard economic theory, 'perfect competition' is a rather idealised scenario in which there are many buyers and sellers, each of which is a price-taker (i.e. no individual buyer or seller has any influence over the price of the product). Under these, and a few other conditions, in a 'perfectly competitive' market, the price of producing a unit ends up being equal to the cost of producing that unit – i.e. each producer in such a market makes zero economic profit (the 'economic' nature of the profit, as compared to accounting profit, is a crucial distinction).  The paper then compares this to the standard economic theory of monopolistic pricing, in which one firm is the sole producer of a product and therefore can charge a price above cost – i.e. the monopolist obtains a positive profit margin on its sales. The paper then claims that the fact that its data indicate an increase in margins over time mean that the US economy has (in the aggregate) moved away from the 'perfectly competitive' scenario and towards the monopolistic scenario, thereby implying a reduction in the overall levels of competition in the US economy.

Unfortunately the paper fails to take into account a number of factors. For example, and at a rather basic level that the paper’s authors should really be getting right, the “costs” in the theoretical perfectly competitive market do not coincide with measures of costs that are calculated in companies’ accounts.  In particular, economic costs include an 'opportunity cost' of using the resources for the next best option – i.e. economic costs include an additional element beyond the balance-sheet cost of using/purchasing the input that is not usually picked up in accounting measures of cost. Under the perfectly competitive model, although there is no difference between the price of a product and the economic cost of producing it, there is likely to be a difference between said price and an accounting measure of cost – in other words, even under the perfectly competitive model, individual firms are likely to make some positive accounting profits.

Despite this, the paper goes ahead and calculates margins (and makes inferences thereof) using accounting cost - the paper uses the accounts of publicly-traded firms in the US over the period 1950-2014.  In other words, the paper automatically fails to measure the true margin as is relevant for economic theory. Hence, any attempts to link an increase in the margins in this paper to the competitive landscape as suggested by economic theory is flawed.

Even if the observation that margins have increased was valid (i.e. the margin was calculated appropriately including the economic cost of production), then that is still insufficient to support the paper’s claims that overall competition has decreased.  In essence, by making such a claim based on the path of margins, the paper is claiming that the entirety (or, at least, the vast majority) of the increase in margins was due to a decrease in competition, thereby ignoring any other factors that could have resulted in an increase of margins over time.  Although the paper looks at one other factor that could explain the change in margins (changes in the average size of firms), the paper ignores factors such as changes in the types and nature of industries over time (e.g. some industries might have much higher up-front costs and lower marginal costs, and if those types of industries grew over time, then that could explain the increase in average margin without any change in competition levels).

On a more technical note, margins can also be related to price elasticities of demand via the “Lerner Condition” – this is a mathematical relationship stating that a firm’s margin is inversely proportional to its own price elasticity of demand. Obviously, different industries can have different demand elasticities regardless of the level of competition in each industry and, as such, margins can differ due to that reason as well. This is particularly relevant if, as seems likely, the composition of the economy (in terms of which industries are most prevalent) has changed over time.

Worse still is that the paper’s result of margins increasing over time is likely to be affected by a “survivorship bias”.  Specifically, as the paper tracks firms over time, clearly the more successful firms (the ones that survive and earn higher profits) will remain in business, while the less successful firms (the ones that go bust due to making lower profits) will exit the market. Consider a stylised example: suppose at the start, an industry consists of six firms of equal size in terms of revenues, but five firms each make a margin of 30%, and the sixth firm makes a margin of 1%. At the start, the average margin would be about 24%. Now suppose that the owner of the firm obtaining a margin of just 1% decides that they can do better in another industry, so decides to shut down – this means that the average margin would increase to 30% despite there not being any real decrease in the level of competition in the industry (as the five remaining firms would still compete against each other).

Hence, over time, one would expect the sample of firms over which the margin has been calculated to contain mainly successful firms and to lose the less successful firms, thereby resulting in an increase in average margin over time. The paper does not seem to have tried to account for this. (Note, too, that firms going bust is a sign of healthy competition – a more efficient firm is able to outcompete a less efficient firm such that the less efficient one stops trading.)

Overall, therefore, although the paper claims that 1) there has been an increase in margins over time; and 2) this implies that industries in the US have become more monopolistic over time, those claims do not stand up to scrutiny. Indeed, the paper’s approach to demonstrating such claims is flawed at the most basic level.



No wonder The Guardian is a little odd on economics, tax and business

Phillip Inman is the economics editor for the Observer and an economics writer for The Guardian. Within his latest piece we can get an inkling of why the newspapers can be quite so odd when discussing economics, business and tax.

He is right in part of course, there are indeed some 1,000 or more various tax breaks out there. Many of them somewhere between silly and risible. We can and probably should pare many of them back. So far so good.

He then suggests that government could thereby raise lots more tax revenue, we disagree there, we think that we should do so to lower tax rates more generally by removing those special privileges. But that's a difference of opinion. It this next which explains the general oddity perhaps: 

Companies would drop plans to buy the equipment they need without tax relief. Likewise, private landlords would let their flats go unmaintained if the cost were not tax-deductible.

Private landlords are taxed as if they are a business on the useful grounds that it is a business. And businesses are taxed upon their net income. The revenues from being in business minus the costs of being in business to generate that revenue. There is no other logical manner of taxing business either.

Where the confusion comes in is that there are indeed various "tax reliefs" here. But they are rules not stating that you may deduct your costs, as you must be able to do. Instead, they're rules about how quickly you may deduct your costs. That is, you may not deduct them when you've spent the money but rather as what you've spent it upon starts to wear out, depreciation rules and all that.

If the taxation of business simply worked on a cash basis then we wouldn't have those reliefs and so on at all. There wouldn't even be any difference in the amount of tax paid, only in when it is paid.

As we say, no wonder we see economic, business and tax howlers in those newspapers if this is the supposed adult in the building, the one who is meant to know these things among the assembled snowflakes and arts graduates.