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.