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Setting prices

Evan Davis | Vital Statistics |
8 Jan 08, 03:41 PM

What determines a price in a market?

Competition? Regulation? The whims of politicians? Illegal collusion between suppliers?

Looking through history, you'll find examples of all four playing a part in setting the price that consumers pay.

But these days we tend to think competition is the best of the lot.

And as a result, for gas and electricity, we introduced it. We got the regulator out of price-setting, we left politicians to do other things. And we have strict laws against cartels and collusion.

For several years it gave us low energy prices and we never complained. But now we are apparently unhappy.

My instinct is to assume that we consumers are an inconsistent bunch. We like competition if it delivers low prices, but grumble if it delivers the bad news that prices need to go up.

But in fact, it isn't that simpleâ€¦ there are issues in energy markets.

If you eye-ball the graph of the wholesale price of gas and the retail price over the last three years, you wouldn't think another retail price hike is now due. In fact, if anything, it looks as though we might have expected bigger cuts in prices early last year.

Wholesale gas accounts for about half the cost of domestic gas, and you'd think that retail prices are not massively out of line with where they were three years ago, but they will be if prices rise again.

Which raises the question: is competition failing? Are we being ripped off?

Well, a good rule of thumb is that competition doesn't usually fail, it just operates a little clumsily. And its imperfections have long exercised economists.

In this case, it all comes down to the word "oligopoly". It's a lovely word, and applies to many many parts of the economy - including energy. Oligopoly is defined as a market dominated by a smallish number of suppliers. And it has spawned a myriad of different theories as to how prices are set in practice...

One theory that goes back to the 1930s - one that A-level students might recognise as the curve theory - observes that in oligopoly, prices are often sticky.

In essence, suppliers don't like to upset things by pricing aggressively. It's not that they are crooked or anything... it's just market logic. If you cut prices to gain new customers, you'll fail as other suppliers will soon cut prices too, and so no new customers will come. Ergo - don't cut prices unless someone else does.

In energy markets, this could be the case, reinforced by the fact that most of us can't be bothered to switch supplier anyway. If one company cuts prices, the others will have plenty of time to follow them before their customers get off their backsides and make an effort to switch supplier.

In this world, companies will also be reluctant to raise prices because their competitors might not follow. Or competitors might delay rising for a few weeks to follow with their own price rise, hoping to gain some switchers in the meantime.

Being a price-hiking first-mover is an uncomfortable position.

It's the possible asymmetry of competitors' reactions to an initial price cut or price hike that might account for price-stickiness. Companies will only raise prices when they have to as their costs are too high. All one can say is that given the frictions in the energy market, it would be odd if prices weren't a bit sticky, especially sticky downwards.

Of course, the real issue facing us is not whether competition is perfect; it isn't.

It's whether you want to improve it with occasional divine intervention from regulators or MPs. Unfortunately, over the long term, in a complex market, that's a very tall order. You can get the price wrong if you try to influence it, and in the long term if there is free entry into a market, oligopoly can work more competitively.

Best advice - if you're paying too much, don't write to your MP - shop around.

Comments Post your comment

1.
At 04:41 PM on 08 Jan 2008,
Adam Steel wrote:

Thanks this helps me with my E4 economics for a level. THanks

2.
At 05:13 PM on 08 Jan 2008,
Richard wrote:

This article ignores the change in strucuture of the industry that has been permitted since privatisation - production and retail were once completely separated - the competition failings have arisen because vertical integration of generation and supply have been permitted (by successive governments but worse under the labour government). What is required is for that integration to be compulsorily reversed - may be a better job for the OFT than some of the windmills they are currently tilting against.

3.
At 05:17 PM on 08 Jan 2008,
Jason White wrote:

Surely if the gas market is an oligopoly then the government has failed to ensure proper competition, in which case writing to your MP is probably the best thing to do. Shopping around for non existant savings is hardly rational.

4.
At 05:25 PM on 08 Jan 2008,
Dalrymple01 wrote:

The reality of the UK energy market is that, compared with five years ago, the level of competition is very low whilst the barriers to entry are incredibly high.

Some of the barriers to entry are obvious - the more customers you have the greater the economies of scale for example. Others are hidden, however, e.g. the Â£millions of credit you have to be able to provide before anyone will buy and sell electricity with you so you can become a supplier.

It may not be the whole reason, but a substantial reason why prices tend towards the high side, with a disinclination to rock the boat from those that remain, is the low risk of any new entrant appearing.

Prof Littlechild, the originator of the RPI-X formula originally applied to the privatised utilities, himself wrote a report highlightng the barriers to new entrants and consequent lack of real sector competition (to the disadvantage of customers). Regrettably, the dust gathered on that report must be quite thick by now.

5.
At 06:52 PM on 08 Jan 2008,
john gardner wrote:

i would like to know what percentage of gas is imported and how much is imported from the north sea

6.
At 07:57 PM on 08 Jan 2008,
steve belzak wrote:

Once again Evan ignores the crucial issue of resource depeletion. No amount of competition will give consumers lower prices if the resource ceases to exist or is in critically short supply.

The problems in the oil and natural gas markets reflect problems of supply rather than oligopoly.

7.
At 09:47 PM on 08 Jan 2008,
Andrew Steer wrote:

I have never been able to see past the fact that since they privatised utilities, you still get exactly the same electricity out of the same cable, and the same gas out of the same pipe, regardless of your so-called "supplier". Surely the only differences are in who sends the bill, what deal that company can strike with its upstream suppliers, and the level of profit they choose to price in?
Different companies have different tariff structures, some with standing charges, some without. Some with differing numbers of initial units at a higher price and subsequent units at a lower price. The "comparison" sites mostly overlook this complexity, quoting instead "typical" bills.
This absurd market is not even transparent. What chance has it of being "efficient"?

8.
At 10:38 PM on 08 Jan 2008,
ajcc2 wrote:

Wouldn't the best way to analyse this be to check if changes in prices truly reflect changes in underlying costs to the gas companies? Under competition theoretical profits should be zero leaves prices equal to costs (although this obviously isn't the case in real life) and we generally deem this to be an acceptable means of determining who gets what and who pays what. If prices have increased roughly in line with costs when averaged over the period of competition then we shouldn't have too much to complain about.

9.
At 01:04 AM on 09 Jan 2008,
Charles Graham wrote:

The main problem with energy costs is that they fail to reflect the true cost of energy. There is no accounting for environmental devastation associated with fossil fuel extraction. There is no accounting for emission damages to a benign climate. There is no accounting for the destruction of social and cultural cohesion or for the generation of conflict over access to supply.
If these factors at least, were taken into account, then the real cost of energy would be many magnitudes greater than exist currently.

10.
At 01:49 AM on 09 Jan 2008,
wrote:

To my mind there is no competition if each of the oligopoly are buying gas, oil or coal at a global wholesale price. After cost cutting exercises and downsizing as much as they can their ability to be competitive ceases because, they are all buying the raw materials at the same price.

I know that it is not quite that simplistic, as not all providers and producers are buying at the same time, so when they buy gives them a slight option to exercise some competitive pricing and there is a futures market so depending on your combination of buying practices your price and your margin are probably usually set for the long term anyway thus further reducing competitive flexibility. This is probably another factor which adds to price stickiness.

11.
At 02:15 AM on 09 Jan 2008,
Christopher Cathles wrote:

To me there are two types of "competition" - one where companies compete WITH each other on a fair share for all basis (not necessarily equal), and the other is where companies compete AGAINST each other on a winner-takes-all basis. The latter is more the Corporate America model, and the reason I don't think it is fair is that someone else always pays, usually redundant workers. I'm told it's all part of "the game" in corporate trading.

It seems to me the article is more connected to the former type of competition, and I found it most interesting.

12.
At 07:44 AM on 09 Jan 2008,
Andrew wrote:

Energy should have been fully private from the beginning without government run manopolies and favours. Why??? Because the price of (carbon) energy would have freely gone up allowing alternatives to enter the market more freely. How it is, no one is capable to compete so government NOT the businesses involved in the energy industry are to blame.

Centralist planning again rears its ugly head and it has caused a great great mess which will be solved by.......more centralist planning, dont expect to ever have cheap energy again until there is a fundamental shift away from socialist planning towards laissez faire capitalism (read Murry Rothbard).

However, this isnt likely due to "global warming" whereby a government can take control of any industry or tax it to death in the name of "saving the planet".

I would also suggest some of your readers look into "global warming" and the myths behind it after all we have been heating up at a steady rate since the last 12,000 years when England was covered by ice. 12,000 years isnt a long time in the history of the earth but that wont stop governments using it to take more control. Dont confuse global warming with air pollution (which is a violation of property rights and should be controlled by the courts).

One final thought, apart from the obvious advantages to government power global warming is also being used to stem the use of carbon energy because it will peak (or has peaked). So governments would rather "spin" the truth than deregulate the industry.

13.
At 09:00 AM on 09 Jan 2008,
Ian Kemmish wrote:

I'd agree with Dalrymple01 that it's not the number of suppliers so much as the cost of entry. I made my money in a different oligopoly (the PostScript software market) which had almost zero cost of entry (just the few man years required to write the software) and it worked quite well.

As for consumers - well, there are an increasing number of players (the Consumer's Association plus the increasing number of "comparison" websites) who have a vested interest in consumer dissatisfaction. Area-based pricing, for example, was an inevitable and easily predictable consequence of energy market deregulation. The fact that people only grumble about it when the CA gets onto Breakfast TV to talk about it, suggests that, left to their own devices, consumers would be less upset about it.

14.
At 02:22 PM on 09 Jan 2008,
PhilT wrote:

A year ago I bought my heating oil at 28p/litre, just before Christmas I bought the same amount at 42 p/litre. A rise of 50%. Welcome to my world, gas consumers !