Saturday, 28 September 2013

Freezing energy prices will not work: what will?

Labour leader Ed Milliband hit the headlines this week with his plans to freeze energy prices if elected into power in the 2015 UK general election. The response was pretty fervent. But can a price cap work?
   The microeconomics textbook says that price caps are almost always a bad idea. To understand why it is interesting to see how labour defended the plan. Or, more properly, I should say how labour did not defend the plan. When questioned about the merits of the price freeze every shadow minister I heard reeled off a long list of reasons why the energy market is failing. What I never heard once was a minister argue that the price freeze will solve any of the market failures. And that's the problem, a price freeze will not solve any of the market failures! It will just make them worse.
   For example, I heard several spokespmen bemoan the fact the market is dominated by only six firms. Put aside for the moment that six firms is more than enough for competition to work, will an arbitrary price freeze encourage more firms to enter the industry? Of course not, it will scare away investment, in the short and long term. This illustrates the general point that a price freeze is arbitrary meddling in a market. Arbitrary meddling is never going to encourage competition. And if the government freezes prices at the wrong level then everyone, including consumers, are going to loose out. California's experience with a price freeze is a perfect example of how bad things can get. Freezing prices, therefore, is more political symbolism than economic sense.
    But what can fix the market failures? The main cause of market failure in the UK energy sector is consumer apathy. A market can only work if consumers go hunting for good deals. And UK consumers are not hunting for good deals. Instead, they are doggedly sticking with the supplier they have always used. This blunts competition. And the energy market is by no means the only market where we see this. A similar story can be told about many other services such as bank accounts, car and house insurance, telephone supplier etc.
    In order to fix consumer apathy we need to know what causes it. I would suggest three distinct causes: lack of information, procrastination and the endowment effect. If consumers do not have enough information to know where the best deals are then it is no surprise they do not go chasing them. Procrastination is where the consumer does want to change supplier but puts off changing until tomorrow, and then the day after, and so on. The endowment effect is where a consumer values something they have, like a long run relationship with the current supplier, more than something they do not have, like a relationship with a rival supplier; basically, it's better the devil you know. If these are the causes of consumer apathy then we can think of progressively more extreme measures that can try and improve matters:

(1) You could try and enthuse customers by making it easy to change supplier. The current UK government has done a lot to try and make this a reality. For example, a recent initiative makes it easier to switch bank accounts. They have also told energy companies to simplify their bills and tariffs. This solves the lack of information problem but does nothing about procrastination or the endowment effect. 

(2)  One way to directly tackle procrastination is to force energy contracts to be for a one year fixed term. Hence consumers would have to 'rejoin' a supplier at the end of every yearly contract. They cannot procrastinate any more. Surely this will force them to shop around? Well, what I'm proposing is very similar to what already happens in the insurance market, where car and house insurance come up for renewal once a year. This 'forced' renewal undoubtedly encourages some competition. But, we know that far too many consumers fail to search out good deals when renewing insurance. They simply stay with the existing supplier.

(3) That leaves us with the endowment effect. To get rid of this we can stick with the one year fixed term contracts but rule out a consumer staying with the same supplier two years running. We force customers to change supplier every year. Surely this will force them to shop around?

       This final measure might work, but looks well beyond what is acceptable. We are denying the consumer liberty to sign a long term contract or to stick with an existing supplier. It all looks a bit too draconian. But, if this is draconian then what is our overall objective from intervening in the market? If consumers cannot be bothered to shop around then is it right to force them too? Indeed, if the problem with the energy market is consumer apathy then is it a problem at all?
       Following this line of logic I come to the conclusion that the claims of market failure in the energy market are overblown. Consumers are not getting the best deal, but the that's because consumers are choosing to not get the best deal! Encouraging competition with a few nudges (measure 1) sounds good but anything more (measures 2 and 3) seems too much. And government's dictating prices is the most extreme measure of all.

Friday, 20 September 2013

Cottage holidays and social norms

For those unfamiliar with cottage holidays, the ideas is pretty simple: You rent a house, bungalow, or beach hut for a week or more, make yourself at home, relax and enjoy. What I want to explore is how different the experience feels in the UK and Denmark.
      When you arrive at a cottage in the UK you can expect ample supply of toilet rolls, kitchen towels and logs for the fire. There will almost certainly be a library of books, CDs, DVDs and local maps for you to enjoy. Bed linen is provided free of charge. At one cottage we recently went to there was a complimentary bottle of wine.
     Contrast this with Denmark. Here you have to pay for any electric, water and gas you use. Don't expect any toilet rolls or kitchen towels, let alone a complimentary bottle of wine. There's no library. Bed linen, or anything else, comes with an extra charge.
      Which system would you prefer? The economist in me says that I am supposed to prefer the Danish system. All the 'complimentary' things that are provided in a UK cottage are clearly added on to the overall bill. So you ultimately end up paying for them. Which means we are almost certainly better off in the Danish system because we use less than the average in terms of gas, electric and water, we're happy to bring our own bed linen, and we don't really like drinking cheap wine.
      There's something about the Danish system, however, that we don't like. To understand why it is necessary to think about social norms. The UK system makes you feel more at home. You feel like a welcome guest. You can relax. The Danish system puts more emphasis on money. These reminders of the fact you are paying money, e.g. reading the utility meters at the start and end of the holiday, crowd out the 'welcome' feeling. You are not a welcome guest, you are a paying customer. This makes it a bit less pleasant. I'm sure it also means guests will take a bit less care of the cottage during their stay.   
     The more general point this contrast illustrates is how social norms and money don't mix all that well. The cottage holiday system relies heavily on social norms. You are trusted to look after the cottage, to not steal anything, and to basically leave the place as you found it. The UK system with its complimentary bottle of wine lets social norms dictate. The Danish system with its itemized costs risks crowding out social norms. Which may explain why guests cannot be trusted with a library. 
      This kind of trade-off between social norms and money is very common. Consider, for example, effort in the workplace. In most jobs you inevitable have to put some trust in workers to do their best. You cannot constantly monitor performance. The more 'performance targets' and the like a worker is subjected to the more the social norms to do a good job are crowded out.
      Be careful, therefore, when mixing money with social norms. As Dan Ariely discusses in his book Predictably Irrational it is a not a good idea to mention how much the dinner cost on a first date. 

Friday, 13 September 2013

Apples and the sunk cost fallacy

   It is apple season for another year. The trees in the village where I live are packed full of tasty, fresh, organic apples. And, most of them are going to be left to fall to the ground and rot! Which I think is a great waste. I also think it is a great example of the sunk cost fallacy in action.
    Here's the issue: Consider someone called Mark who goes out to the supermarket and buys some apples. He will almost certainly eat those apples and go out of his way to not waste them. Mark, however, ignores the apples growing in his garden and does not think twice about letting them go to waste. Why does Mark save the apples he bought and not the apples  growing in his garden?
    You might say it is a difference in quality; but, the apples in my garden are easily as tasty as those in my local supermarket. You might say it is the difficulty of harvesting the apples; but, it takes seconds for me to harvest 20 apples from my garden. The difference, therefore, must be psychological. That is where the sunk cost fallacy comes in.
     A sunk cost is a cost that cannot be recovered. Given that it cannot be recovered it should not influence future choice. When Mark walks out of the supermarket (and throws away the receipt) the money he paid to buy the apples is a sunk cost. As such, the amount of money he paid for the apples should not influence whether or not he eats the apples.  We see, however, that it does: He is more likely to eat an apple he has bought than one growing in his garden. This looks like the sunk cost fallacy: Mark lets sunk costs influence his choice.
    Richard Thaler in his classic paper on mental accounting gives a slightly different example. In this case Mark has bought some expensive shoes that do not fit. The more expensive they are the more likely Mark will continue to try and wear them and the longer he will keep them in his cupboard. Note the subtle difference between these examples. In the shoe example the emphasis is on how Mark 'over-values' the shoes he has paid a large sunk cost for. In the apple example the emphasis is on how Mark 'under-values' the apples that he has got for free.
      The classic take on the sunk cost fallacy is that it is about mental accounting (see the paper by Richard Thaler). While buying this interpretation, I also think the fallacy is partly caused by people confusing the price they paid for something with the value it has for them. Mark, for instance, should focus on how much he values an apple and how much he values the shoes. For example, he might value a fresh apple at $2 and shoes that do not fit at $0. Instead, he will focus on how much he paid for the apple or shoes. If he got the apple for free he think it cannot be worth much, if he paid $1 for the apple it seems more valuable, and if he paid $300 for the shoes then they must be worth saving.
      The lesson, therefore, is to ignore how much something cost when deciding whether or not to use it. And, just because something is for free does not mean it is not valuable. So, let's get making some apple pie.