The price of everything and the value of nothing

Apologies everyone but it’s been a while since my last post. I’ve had a busy summer completing my review of the Government’s legal aid reforms for The Law Society and preparing for Little Cookson’s arrival next year (apparently it’ll be here quicker than we realize).

Not much has changed since my last post. We’re still staring down the barrel of a second recession, Greece still hasn’t raised any tax revenues, and Dave and George are still steering HMS Britannia like a pair of drunken pleasure cruisers.

The conference season generated many ideas for blog posts, and I’d like to start with Chris Huhne’s war on energy suppliers. He is going to force them to make it easier to switch supplier and to make it easier to find out who is the cheapest supplier.

But why are energy tariffs so confusing? Part of the answer lies in search costs.

If we could switch energy suppliers at zero cost and could identify who offered the lowest price without cost then competition in the market would force energy prices to their marginal cost. After all, one unit of electricity from EDF is the same as one unit from British Gas. Electricity and energy more generally are homogenous goods and suppliers are near perfect substitutes for one another.

The problem for energy suppliers is that they want to exploit some market power and push prices above marginal cost to make a profit. One way to do this is to make it difficult to determine which supplier offers you the cheapest energy. Making tariffs deliberately confusing and complex drives up the cost of finding the cheapest provider – the so-called search cost. The result is price dispersion: different firms charging different prices for the same good.

Firms use many techniques to make it difficult to compare goods and services on purely price. Supermarkets, by offering price comparison services, legitimately change their store prices frequently across a broad range of items. Mobile phone companies offer a confusing array of tariffs which combine varying quantities of “free” calls, SMS (text) messages and data transfers. Different retailers may offer different bundles of “free” postage and packaging, installation or accessories with their product(s) to make it difficult to determine the actual cost of the good in question.

All of these strategies add friction to the market by driving up consumers’ search costs. At the same time, different consumers have differing opportunity cost of time. The result is that firms push prices above their competitive level.

The internet was supposed to make life easier for consumers. We would be able effortlessly compare the price of goods and services. Firms have responded in kind however leveraging technology to make it more difficult to compare prices through the bundling and de-bundled of goods and services (think EasyJet versus Ryan Air). I’m therefore skeptical that Huhne’s reforms will actually bring much long term clarity to energy prices. Where there’s a profit, there’s a way and I expect energy suppliers to invent other ways of increasing search costs.

One final note, while Chris Huhne’s plans – if they work – will force energy prices closer to marginal cost it does not guarantee that energy prices will fall. If the wholesale energy prices continue to rise then so will prices.

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