Opportunity cost makes the news

Opportunity cost is one of the most underappreciated concepts in economics, and yet it is fundamental to good decision-making. Whenever we choose to use our resources for one thing, we give up what we could have done with them instead. The opportunity cost of something is the cost of foregoing the opportunity of using the resources for something else. More specifically, the opportunity cost is measured as the value of the next best alternative that is foregone.

Despite its importance, it is surprisingly rare to see opportunity cost mentioned in the media, even in business or economics stories. So, it was a delight to see this recent article in the New Zealand Herald:

Financial adviser Niran Iswar says almost every rental property he’s ever owned has lost money – and he thinks more people are coming around to the idea that it’s not always a surefire way to make money.

Iswar, who is head of accounting, wealth and advisory at Float, said once he counted the rates, insurance, maintenance and the opportunity cost of money tied up in rental properties, every rental he had held had gone backwards, except one that worked because it was bought at the right time “which is luck dressed up as skill”.

When making a decision about how to invest their savings, an investor has many alternatives to choose from. Each alternative comes with an opportunity cost - the return they could have earned from the best of the other alternative investments. The economic cost of an alternative includes all of the explicit costs, as well as the opportunity cost. In the case of rental properties, Iswar notes the rates, insurance, and maintenance, as well as the opportunity cost of the savings tied up in the investment.

Iswar is essentially saying that, once you take the opportunity cost into account, the cost of investing in rental properties (including the opportunity cost) exceeds the benefits. That is what he means when he says that the rental properties "have gone backwards". The savings would have been better off invested in some other alternative. As an example, an investor might be attracted to a rental property investment that offers an annual net return of six percent, but fail to consider that an alternative investment of comparable risk offers eight percent. The opportunity cost of the rental property investment is eight percent return foregone from the other investment. So although the rental property earns a positive net return of six percent, relative to the next-best alternative it actually generates an economic loss of two percent. By investing in the rental property, the investor would give up an eight-percent return in order to earn six percent.

Now, there is one important caution to note. In the context of financial investments, a straight comparison of returns ignores the role of risk. Different investments come with different risks, and different investors will have different appetites for risk. So, where investments differ substantially in risk, it is their expected returns adjusted for risk that should be compared. Only where the alternatives have broadly similar risks is a more straightforward comparison of returns appropriate.

Finally, while opportunity cost is not often mentioned explicitly, I imagine that many investors are implicitly taking it into account. Anyone who weighs up alternative uses of their savings and chooses the alternative that offers the best risk-adjusted return is already thinking in terms of opportunity cost. But making the opportunity cost explicit is useful, because it reminds us that simply earning a positive net return doesn't necessarily mean that an investment is a good one. We need to consider what else could have been done with the savings instead. That is why it was refreshing to see opportunity cost brought to the fore in the New Zealand Herald story.

Supermarket structural separation stupidity

This week, the National Party proposed that, if re-elected, it would pursue structural separation of the supermarkets (as reported in the NBR, One News, and the New Zealand Herald). This was interesting timing. My ECONS102 class has just covered firms with market power and monopolies, and one of the regulatory options available to government is structural separation. If this news had broken a week earlier, this would have made a great example for an assessment question. Instead, I'll have to console myself with a blog post.

In short, the proposed structural separation is nonsensical. Foodstuffs is currently comprised of two cooperatives - Foodstuffs North Island, and Foodstuffs South Island. The two cooperatives run three brands of supermarkets: Pak'n'Save, New World, and Four Square. The National Party is proposing to separate the business into two, with Pak'n'Save as one business and New World and Four Square as another.

There are several elements of the proposal that are plain dumb. The first problem with the proposal is that it would require a substantial reorganisation of the two existing geographically-based cooperatives into two nationwide businesses. This proposed reorganisation is somewhat ironic, given that the Commerce Commission declined a Foodstuffs merger into a nationwide business in 2024. Both of the two new supermarket chains would then have to create their own warehousing, logistics, and other backend systems, separate from the other new chain. And the two pre-existing warehousing and logistics (and other systems), which are geographically separated at present, would need to be split up in order to do this. In its own house, the government is busy trying to reduce back-office functions to increase efficiency. And yet, it seems quite happy to generate inefficiency in a private sector business?

Moreover, the cost-benefit analysis that Sense Partners completed for the Ministry of Business, Innovation and Employment demonstrates how sensitive the case is to assumptions about supply-chain costs. The preferred analysis assumes supply-chain costs rise by one percent, generating an estimated net benefit of $2.9 billion over 20 years. However, if supply-chain costs rise by two percent, the estimated benefit falls to around $920 million, and if supply-chain costs rise by more than two percent, the costs outweigh the benefits. That doesn't leave much margin for the proposal to go wrong before society is worse off overall.

The second problem is that this proposal leaves the other major player in the supermarket sector, Woolworths, structurally unchanged. While the proposal would reorganise Foodstuffs into two separate nationwide supermarket groups, Woolworths would be free to continue its current operations, which also includes three brands: Woolworths, FreshChoice, and SuperValue. Admittedly, the two businesses are not structured in exactly the same way. Woolworths operates its Woolworths supermarkets directly, while FreshChoice and SuperValue are locally owned stores franchised through a Woolworths subsidiary. So, there may be good reasons why the same form of structural separation would not be appropriate for Woolworths. But the obvious question then is, if structural separation is the answer to weak competition in the supermarket sector, why is restructuring only one of the two big market players the right approach?

The third problem is that this proposal ignores another, arguably more obvious, form of structural separation that could be enacted, which could be applied symmetrically to both of the large supermarket players. This is to structurally separate wholesale and distribution from supermarket retail. Currently, both Foodstuffs cooperatives and Woolworths benefit from substantial economies of scale in purchasing, wholesale, and distribution. Those economies of scale may themselves create a barrier to entry, because a new supermarket chain that cannot obtain groceries on similarly competitive terms faces higher costs and will struggle to compete effectively.

Structurally separating wholesale and distribution from retail could potentially address that problem by allowing existing and new retailers to access the scale economies of the established distribution networks on fair and non-discriminatory terms, without having to build their own nationwide wholesale and distribution systems. This isn't a new idea (for example, see here and here). Wholesale ownership separation was explicitly considered in a government-commissioned study in 2022, although that analysis raised significant concerns about whether an independent wholesaler would remain viable after structural separation. Despite those concerns, this remains an alternative worth considering, and the Labour Party announced a policy along these lines earlier today. Its proposal would require Foodstuffs and Woolworths to run their wholesale businesses independently from their retail businesses, although it would not require the wholesale businesses to be separately owned.

As I note in my ECONS102 class, structural separation can be an effective way of regulating a monopoly. Typically, it is used with natural monopolies, where increasing competition across the entirety of a sector is not straightforward. For example, in New Zealand we structurally separated the telecommunications backbone (now run by Chorus) from the retail. We also separated electricity lines businesses from generation and retail, although generation and retail were allowed to remain integrated in the so-called 'gentailers'.

Now, supermarket retail itself isn't obviously a natural monopoly, but wholesale and distribution may contain some of the characteristics that we associate with natural monopolies, including high fixed costs and large economies of scale. Regardless, it is clear that to date government's various measures have been largely ineffective in increasing competition in the supermarket sector. So, structural separation may be more effective than what has been tried so far. However, what is being proposed by the National Party is only one possible form of structural separation. The more important question is where in the supply chain separation would do the most to reduce barriers to entry while preserving the economies of scale that keep costs down.

This week in research #144

Here's what caught my eye in research over the past week:

• Tompsett (open access) finds that the opening of new bridges over major rivers increase per capita economic activity

Also new from the Waikato working papers series:

• Luengo et al. investigate the causal impact of AI advice on price discovery in a controlled asset-market experiment, and find that access to AI advice significantly reduces mispricing relative to the baseline, regardless of whether the AI advice was aligned with long-term fundamentals, or myopic and based on current prices

Try this! Pull incentive sizing tool

My ECONS102 class covered intellectual property rights this week. As part of that topic, we discuss how governments might incentivise the development of new intellectual property without necessarily relying on strong intellectual property rights. One of the potential alternatives is pull funding - where the government funds successful research and development efforts once they have been developed.

In class, I focus on particular examples of advance market commitments and rewards or prizes. Advance market commitments involve governments making a commitment to buying the goods and services from intellectual property, after the IP is developed. Rewards or prizes involve the government offering to pay the reward or prize to whoever successfully develops some particular intellectual property.

That discussion leaves an important question unanswered. Pull funding creates an incentive for firms (or individuals) to develop some particular intellectual property. But how effective is that incentive? Or, turning that question around, how big does pull funding have to be to incentivise firms (or individual) to work on solving a particular problem?

The Market Shaping Accelerator team (a collaboration between researchers at Dartmouth College, the University of Chicago, and the Center for Global Development has provided a tool that gives us some idea of the answer to that question. You can find the tool here (and associated blog post here). Choose whether you want to use a prize, an AMC, or an AMC with milestones. Then decide on the number of stages in the development process (as well as how long each stage is, the cost, the probability of success of each stage, and how much cost can be covered from other sources). Then provide a discount rate for firms, and the firms' target probability of success. And then hit calculate!

The tool reports the number of firms that would be incentivised by your pull funding, the overall chance that at least one firm succeeds, and the size of the prize required. The tool also provides a comparison with push funding - where the government pays for research and development up-front, regardless of whether it will be successful or not. And the tool also allows you to compare different scenarios.

There is far more to this tool than I can do justice to with a short blog post. There are a lot of models running behind the scenes in this tool, and a lot of assumptions. Fortunately, the documentation gives you all the detail.

If you are interested in push funding, and how it can provide incentives for firms to develop new ideas, I recommend that you try the tool out for yourself. Enjoy!