The Commerce Commission goes rafting

Back in June, the Commerce Commission ruled on the case of a proposed merger between three commercial rafting operators in Rotorua. As the New Zealand Herald reported (in August):

The Commerce Commission has approved the merger of Rotorua’s three commercial rafting operators, much to the pleasant surprise of those behind the bid.

The ruling, finalised in June, came after months of investigation, during which Rotorua Rafting director Sam Sutton became so resigned to defeat that he and his fellow applicants came close to ditching the proposal.

After two decision extensions amid the commission’s concerns that the merger might lessen competition, Sutton was prepared for bad news.

I briefly covered the economics of antitrust law in my ECONS102 class today. My view still remains that the Commerce Commission's criterion for determining merger applications is deeply flawed. As I noted in this 2021 post, the Commerce Commission exists to enforce the Commerce Act, and section 47 of the Act says prohibits acquiring "assets of a business or shares" if that acquisition would have the effect of "substantially lessening competition".

Now, any merger between competing firms by its very nature removes some direct competition between them. So, the Commerce Commission's decision always hinges on whether a proposed merger meets the threshold of 'substantially' lessening competition. The Commerce Act defines 'substantial' only as "real or of substance", and the case law on this makes it clear that whether competition is substantially lessened is ultimately a matter of degree. So the exercise is inherently imprecise and subjective.

The US Federal Trade Commission (FTC) has a more objective approach, which is to compute the Herfindahl-Hirschman Index (HHI) before and after the proposed merger, and to presume that any merger that increases the HHI by 100 points in an industry that is already classed as 'concentrated' or 'highly concentrated' is substantially lessening competition.[*] The FTC may then choose to contest the proposed merger (in court). That at least provides a much transparent threshold against which mergers can initially be assessed. In my view, a more economically coherent approach would be for antitrust authorities to decide on the basis of economic welfare, as I discussed in this 2021 post.

Interestingly, the Commerce Commission's decision itself illustrates the difficulty of applying the test. Only two of the three Commissioners were satisfied that the merger was unlikely to substantially lessen competition, and all three agreed that it was a "finely balanced decision". Seven months after lodging their application, though, the rafting operators finally have their answer. And now they can get on with their business, safe in the knowledge that they are not 'substantially lessening competition'.

Read more:

• The Commerce Commission, competition and total welfare

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[*] The Herfindahl-Hirschman Index can be calculated by squaring the market share of each firm in the market, and adding up the resulting numbers. An industry with an HHI of under 1000 is classed as 'competitive', an industry with an HHI of between 1000 and 1800 is classed as 'concentrated', and an industry with an HHI of over 1800 is classed as 'highly concentrated'. For example, an industry with just four firms, with market shares of 40 percent, 27 percent, 19 percent, and 14 percent, would have an HHI of 40^2+27^2+19^2+14^2 = 2886, and would be classed as 'highly concentrated'.

David Oks on the bad business economics of airlines

Airlines are a strange business. They seem to have huge numbers of passengers, and yet we routinely hear about airlines struggling financially, entering administration, or shutting down. For example, in 2024 in Australia, Bonza collapsed, while Rex withdrew from major intercity routes after entering vountary administration (see this post for more on those examples). The most recent example is Spirit Airlines in the US, which shut down this month, after its second bankruptcy process in less than two years.

I just discovered David Oks's Substack, which has overnight become one of my favourites. The post that first attracted me was this one titled 'Why airlines are always going bankrupt', inspired by the Spirit Airlines story. Another recent post titled 'Why ATMs didn’t kill bank teller jobs, but the iPhone did' is also excellent, as is 'How funerals keep Africa poor'.

Oks's airline post has a huge amount of depth, so is difficult to summarise without losing part of the story. However, I'm going to try (but I really recommend that you read his entire post, as it is truly excellent).

Oks first notes that airlines are not just badly managed, they are structurally vulnerable and often fail to earn a positive return on capital. He then turns to the game theory of airlines, noting that there is an 'empty core' problem, meaning that there isn't any subset of the airline industry that can form a stable coalition, because some part of the coalition would always be able to make themselves better off by breaking away from the coalition. In other words, no group of airlines and routes is stable for long, because whenever capacity is tight and fares are high, another airline has an incentive to add seats. However, once those seats are added, the market can quickly become unprofitable.

The 'empty core' arises because airlines have high fixed costs, low marginal costs, volatile demand, weak product differentiation, and large minimum efficient scale. All of that means that adding one extra airline on a route, or one extra aircraft, can swing a market from being undersupplied and profitable to being undersupplied and unprofitable. So, what happens in the airline industry is that when there are few airlines, they are profitable and happy, but that encourages new airlines to enter, after which profits decrease until one or more of the airlines shuts down. And then the cycle starts over.

As you can see, there is a lot to unpack from Oks's post. Again, I encourage you to read the whole post. But the key points are, first, that airlines are always going bankrupt because the nature of the airline industry lends itself to a boom-bust cycle when airlines compete with each other.

Second, from the perspective of airline consumers (and, probably, governments as well) there is an uncomfortable trade-off. We want low fares from competition between airlines, and we also want airlines to be financially stable, but it may be difficult to have both. The pursuit of low fares can set off the cycle described above, with competition pushing fares down, leading to falling profitability, and eventually one or more airlines exiting the market. Airline financial stability, on the other hand, probably requires some limit on competition between airlines. One way of achieving this is to regulate airlines more closely, closer to the equilibrium that existed before deregulation in the late 1970s and early 1980s, when regulators had much greater control over fares, routes, and market entry. Airlines segmented the market, flew fewer routes, and were profitable in part because they were not actively competing with each other. The other alternative is to recognise that airlines can diversify into other markets. Oks’s most striking example of this is Delta:

...the most profitable airline in the United States, which started a fruitful partnership with American Express in 1996 and launched a co-branded card with them in 2008. Annual spending on Delta-branded American Express cards comes out to about 1 percent of U.S. GDP. In 2025, this produced about $8 billion in revenue for Delta, accounting for more than the entirety of its profit. That means that without the American Express partnership, Delta would be operating at a substantial loss. In effect, Delta’s aviation business is a loss leader for a much more profitable credit card partnership. So to the extent that Delta is now a good business, it is because it escaped the basic instability of the airline industry by becoming less of an airline.

Allowing airlines to operate in a cartel-like equilibrium, as airlines effectively did prior to the 1980s, doesn't strike me as a very positive solution, especially from the perspective of consumers. Having airlines shut down at short notice, cancelling thousands of flights, is clearly not good for consumers either. Perhaps then we need to tolerate airlines that try to sell us financial services, or unbundling the airline package and separately selling seat selection, checked baggage, meals, and so on (see this post about Jetstar's business practices, or this one).

Facebook Marketplace forces a change in TradeMe's business model, but will it succeed?

TradeMe is one of the key examples that I use when teaching about platform markets in my ECONS101 class. But competition from Facebook Marketplace is causing TradeMe to change its business model, and those changes are risky.

The reason why TradeMe is such a good example is that, by attracting buyers and sellers to its platform in the 1990s, TradeMe managed to keep eBay out of the New Zealand market. How did that happen? In a platform market, the firm (in this case, TradeMe) acts as an intermediary that brings together two parties (in this case, buyers and sellers) who would not otherwise interact or easily connect. Buyers using TradeMe create value for sellers, and the more buyers there are, the more value is created. Sellers using TradeMe creates value for buyers, and the more sellers there are, the more value is created. Once TradeMe was set up and had attracted a large share of buyers and sellers, it would be difficult for any other platform to set up in competition with TradeMe. And so, eBay couldn't get a foothold in New Zealand, and TradeMe had an effective monopoly over online auctions for many years.

TradeMe profited by charging a 'success fee' to sellers of goods on the platform. Buyers faced no fees. This reflects the principle that a platform firm (like TradeMe) should set a lower price for access to the platform to whichever side of the market has demand that is more elastic, ceteris paribus. In this case, buyers have more elastic demand for access to TradeMe, as there are many other places that they might go to buy things. Sellers, on the other hand, had more inelastic demand for access to TradeMe because no other place had access to the same quantity of buyers. That is, until Facebook Marketplace appeared.

Facebook Marketplace doesn't charge fees to sellers. And through its links to Facebook users, there are a large number of potential buyers on Facebook Marketplace. And so, there is now a viable (and cheaper) alternative to TradeMe for sellers. And now, TradeMe has finally reacted to this competition, as reported in the New Zealand Herald last month:

Trade Me is removing success fees for casual sellers, in a move that one marketing expert says is probably a response to the growing power of Facebook Marketplace.

Sellers have usually been paying 7.9% of the final sales price of items sold via Trade Me.

But a new fee structure will remove them from next week and site spokeswoman Lisa Stewart said casual sellers would be better off.

It is making other changes at the same time: bank transfers will not be possible and Ping will be offered on every listing alongside cash and Afterpay, with a 2.19% transaction fee for the seller. This provides buyer protection up to $5000 if trades go wrong.

Buyers will also pay a new service fee based on the purchase price, if items are more than $20. This will be 99c for goods sold for $20.01 to $100, $1.99 for sales between $100.01 and $250 and $4.99 for items over $250. Stewart said 44% of trades were under $20.

It was a response to customer feedback and what was happening in the market, Stewart said...

Massey University marketing expert Bodo Lang said it was likely to be in response from growth in the use of Facebook Marketplace, which offers no protection for buyers but charges no fees.

With Facebook Marketplace available for sellers, seller demand for using TradeMe has become more elastic. While the 'success fees' have been eliminated, TradeMe will still profit from sellers through mandating the use of its payment service Ping. And notice that buyers will also now pay a 'service fee' to TradeMe on successful purchases over $20. TradeMe is now leveraging its market power to derive revenue from a complementary good (payment services) rather than the auctions themselves. This change makes TradeMe's business model resemble that of Facebook Marketplace. Meta derives revenue from Facebook Marketplace though selling advertising (on Facebook Marketplace, but also on Facebook), rather than deriving revenue directly from the sales on Facebook Marketplace.

It remains to be seen whether Trademe's new business model will be successful. I question the wisdom of charging a service fee to buyers. They are still the more elastic side of Trademe's platform market, and they have a cheaper option available in the form of Facebook Marketplace. TradeMe is banking on buyers valuing the protection that TradeMe offers them, which Facebook Marketplace does not. However, it isn't clear how much buyers value that protection, and if they don't value it in excess of the new service fee, then they will continue to exit to Facebook Marketplace. And if buyers show an increasing preference for Facebook Marketplace, it won't be long before sellers start to reduce their listings on TradeMe. And if that happens, the market could tip and TradeMe could very quickly find itself in an irreversible decline.

New Zealand's supermarket sector needs a hero

In yesterday's post, I discussed market power and competition, noting that when there is a lack of competition, firms have more market power, and that means higher mark-ups and higher prices for consumers. An example of a market where there appears to be a high degree of market power is the supermarket sector in New Zealand.

It wasn't always this way. When I was young, I remember there being a large number of different supermarket brands. In Tauranga in the mid-1990s, along Cameron Road between the CBD and Greerton there was Price Chopper (which was previously 3 Guys), Pak'nSave, Big Fresh, Foodtown, New World, and Countdown (and there may be others that I've forgotten, as well as several smaller superettes).

One of the main ways that a market ends up highly concentrated is to start with a market that has some degree of competition, but then some of the firms merge (or take each other over), leaving fewer firms and less competition. In the context of supermarkets in New Zealand, this process is outlined in this article in The Conversation by Lisa Asher, Catherin Sutton-Brady (both University of Sydney), and Drew Franklin (University of Auckland):

The current state of New Zealand’s supermarket sector – dominated by Woolworths (formerly Countdown), Foodstuffs North Island and Foodstuffs South Island – is a result of successive mergers and acquisitions along two tracks.

The first was Progressive Enterprises’ (owner of Foodtown, Countdown and 3 Guys banners) purchase of Woolworths New Zealand (which also owned Big Fresh and Price Chopper) in 2001.

Progressive Enterprises was sold to Woolworths Australia, its’ current owner, in 2005. In less than 25 years, six brands owned by multiple companies were whittled down to a single brand, Woolworths.

The second was the concentration of the “Foodstuffs cooperatives” network. This network once included four regional cooperatives and multiple banners including Mark'n Pak and Cut Price, as well as New World, PAK’nSave and Four Square.

The decision of the four legally separate cooperatives to include “Foodstuffs” in their company name blurred the lines between them. The companies looked similar but remained legally separate.

As a result of mergers, these four separate companies have now become Foodstuffs North Island – franchise limited share company, operating according to “cooperative principles” and Foodstuffs South Island, a legal cooperative.

And so now we find ourselves in a situation with three large supermarket firms, two of which (Foodstuffs North Island and Foodstuffs South Island) are effectively two arms of the same firm, and certainly aren't competing with each other because they operate only on their 'own' islands. With such a lack of competition many people, including Asher et al., are clamouring for change.

Increasing competition in the supermarket sector could take one of two forms. Asher et al. argue that inviting an international competitor into the market will take too long, citing the example of Aldi in Australia, which "took 20 years to reach scale as a third major player in that country". Their preference is 'forced divestiture', breaking up the existing supermarkets into smaller competing firms. Essentially, this would be something of a return to the situation prior to some of the mergers that have characterised the past 30 years of the supermarket sector in New Zealand, but would require a drastic legislative intervention from government.

However, before the government imposes such a dramatic change on this market, it really needs some solid analysis of the impacts of the change. Large supermarket firms benefit from economies of scale in purchasing, logistics and distribution, as well as back-office functions (like payroll, marketing, and finance). If smaller supermarket firms face higher costs because they can't take advantage of the economies of scale available to larger supermarket firms, then breaking up the supermarket chains into smaller chains could lead to even higher prices for consumers. On the other hand, smaller supermarket chains have less bargaining power with suppliers, which might mean that the supermarket suppliers receive better prices (but again, that means higher prices for consumers). Without some careful economic modelling, which has not been done to date, we can't make a clear-eyed assessment of the likely net change in consumer and producer welfare.

And we should be cautious. If forced divestiture starts to gain some political traction, you can bet that the supermarket chains will release some economic analysis that supports a position that breaking them up will be worse for consumers. And consumer advocates might even be able to support their own analyses, showing the opposite. What is needed is a truly independent assessment. And before you raise it, I doubt that we get that sort of independent assessment from the Commerce Commission. They know that their bills are paid by the government of the day, and they may respond accordingly.

Asher et al. ask us to "stop waiting of a foreign hero". What we need is an economist hero, with an independent analysis of the supermarket sector in hand.

Read more:

• The Commerce Commission and the Foodstuffs merger
• The Foodstuffs merger is rejected, so the wholesale market remains an oligopsony

Market power, competition, and the collapses of Bonza and Rex

Last week, my ECONS101 class covered market power and competition (as part of a larger topic introducing some of the principles of firm behaviour). This coming week, we'll be covering elasticity, which is closely related and builds on the key ideas of firm behaviour.

Market power is the ability of a seller (or sometimes a buyer) to influence market prices. The greater the amount of market power the seller (or buyer) has, the more they can raise their price above marginal cost. That is, sellers with greater market power will have a higher mark-up (which is the difference between price and marginal cost).

How do firms get market power? There are several ways, but the greatest contributor to market power is the extent of competition in the market. When firms face a lot of competition in their market, they will compete vigorously on price, and so their mark-up will be lower. When firms face less competition in their market, they don't have to compete on price to the same degree, and so their mark-up will be higher.

Another way of seeing this is to consider the price elasticity of demand. When there are many substitutes for a good, the demand for that good will be more elastic. If the seller raises their price, many of their consumers will buy (one of the many) substitutes instead (because those substitutes are now relatively cheaper). So, firms selling a good that has many substitutes (a good that has more elastic demand) will have a lower mark-up. And if a firm's good has many substitutes, that means a lot of competition.

On the other hand, when there are few substitutes for a good, the demand for that good will be less elastic. If the seller raises their price, few of their consumers will buy substitutes instead (because there are few substitutes available). So, firms selling a good that has few substitutes (a good that has less elastic demand) will have a higher mark-up. And if a firm's good has few substitutes, that means less competition.

Taking all of this together, when a market loses one or more of the competitors, and competition reduces, we should expect to see an increase in prices. A clear example of this is what happened when the Australian regional airlines Bonza and Rex closed down last year. As Doug Drury (Central Queensland University) wrote in The Conversation last November:

In 2024 alone, we’ve seen the high-profile collapse of both Bonza and Rex, airlines that once ignited hopes for much greater competition in the sector. Now, we’re beginning to see the predictable effects of their exit.

According to a quarterly report released on Tuesday by the Australian Competition and Consumer Commission (ACCC), domestic airfares on major city routes increased by 13.3% to September after Rex Airlines halted its capital city services at the end of July.

The collapse of the two low-cost domestic airlines in Australia reduced competition on domestic routes. Unsurprisingly, the lower competition means more market power for the remaining airlines, Qantas and Jetstar. And that greater market power has translated into higher prices for domestic airfares in Australia.

The importance of competition for prices cannot be overstated. As one other example, a lack of competition has been implicated in the perceived high prices in New Zealand supermarkets (a point I will come back to in my next post, but this is a topic I have written about before here). The Commerce Commission is understandably concerned whenever there is a lack of competition, and whenever competition will be substantially reduced by the merger of two or more firms (for example, see here and here about the recently rejected Foodstuffs supermarket merger). When there is a lack of competition, sellers have more market power, demand will be less elastic, and for both of those reasons we can expect prices to be higher.

The Foodstuffs merger is rejected, so the wholesale market remains an oligopsony

Yesterday we learned the Commerce Commission's decision on the merger application by Foodstuffs North Island and Foodstuffs South Island (which I posted about last month). As NBR reported yesterday (paywalled, but you can read this briefer New Zealand Herald story instead, or the Commerce Commission's decision here):

Foodstuffs wanted to see the co-ops merged within and under the management of a single national grocery entity, which it claimed would be better able to compete with the national Woolworths NZ chain.

It argued the proposed merger would lead to cost reductions (including overhead and product costs), efficiency gains, increased agility and innovation, and a more cohesive national offering, which would ultimately deliver better value for retail consumers at the checkout.

But ComCom chair John Small said today the proposed merger would reduce the number of major buyers of grocery products in New Zealand from three to two, reducing the number of buyers to which many suppliers can supply their products, and creating the largest acquirer of grocery products in the country.

“This would result in the merged entity having greater buyer power than Foodstuffs North Island and Foodstuffs South Island each do individually, which would harm the competitive process, and we consider is likely to substantially lessen competition in many acquisition markets.

“As a consequence of the substantial lessening of competition and the associated increase in buyer power, the merged entity would likely be able to extract lower prices from suppliers and/or otherwise adversely impact suppliers in the relevant markets.

“We are also concerned that the consolidation with the proposed merger would lead to reduced investment and innovation by suppliers, meaning reduced consumer choice and/or quality of grocery products in New Zealand for consumers.”

As I noted in my previous post, it is interesting that the Commerce Commission does appear to be considering competition as it relates to suppliers, and not just consumers. The problem is that, when there are fewer supermarkets, there is less competition among the buyers of suppliers' products. And the supermarkets could use their market power as a buyer to drive down the prices that they pay to suppliers. The Commerce Commission seems to consider there to be a real risk that the merger would lead to a substantial lessening of competition among the supermarkets in buying from their suppliers.

One thing that has disappointed me about the coverage is the lack of the use of a rarely-used word in economics: the oligopsony. What's an oligopsony?

When a market has a single seller, it is a monopoly. When a market has a single buyer, it is a monopsony. When a market has just two sellers, it is a duopoly. When a market has just two buyers, it is a duopsony (which is essentially what we have avoided by this merger not being approved). When a market has a few sellers, it is an oligopoly. The retail market for supermarket products is an oligopoly, since consumers can only buy from one of a few sellers. When a market has just a few buyers, it is an oligopsony. With only three large supermarket chains (Foodstuffs North Island, Foodstuffs South Island, and Woolworths), New Zealand has a supermarket oligopsony in the wholesale market for supermarket products, since suppliers can only sell to one of a few buyers. The Commerce Commission decision ensures that the wholesale market remains an oligopsony.

Read more:

• The Commerce Commission, competition and total welfare
• The Commerce Commission and the Foodstuffs merger

Australia may have passed peak craft beer, but that could just be the start of a new cycle

I've written a couple of times about the craft beer industry and how, as many new craft breweries had entered the market, prices and profits would be falling, and eventually firms would start to exit. This is a type of market dynamic that I discuss with my ECONS101 class.

It appears to be playing out in Australia as well. As the National Business Review reported last month (paywalled):

For beer lovers, the craft brewing industry is like beer nirvana.

So many cool brands to sample, so many varieties, so many hip brewery venues to visit.

For a time, around a decade ago, it seemed the industry was unstoppable as a flood of new breweries with clever names and unique flavours posed a threat to the established players.

If you were a serious beer fan, why would you take a can of plain old VB when you might try something really exotic, like a Sydney dark ale called Motor Cycle Oil or a Juicy Banger from Byron Bay?

On the production side, a craft brewing startup was an inspiration to a younger generation of entrepreneurs who could create a unique beer and sell it in a trendy destination venue, often with live music and ‘designer burgers’. It was not just beer, it was marketing a lifestyle.

And, if you got lucky, there might be a big payday if one of the major brewers came calling with a cheque book.

Like so many exuberant business cycles, however, the craft brewing industry in Australia is enduring a painful reality check, with multiple business failures and an uncertain outlook. These are not just growing pains or over-investment. There are some significant economic headwinds that have emerged for craft brewers...

There are about 700 craft breweries in Australia, with the industry growing by 80% or so in the past eight years. It’s a market worth A$160m and, according to the Independent Brewers Association (IBA), it contributes A$1.93 billion to the economy and employs about 10,000 people.

In the past 18 months, however, about 30 breweries have folded and there are predictions that a new wave of failures is on its way.

The problem here is the over-enthusiasm of craft brewers. In the 2010s, the industry was flying high, with (relatively) high prices and profits. The problem was that, with the advent of contract brewing (where craft brewers contract out their brewing operations, and therefore don't require a large investment in brewing equipment), the barriers to entry into craft brewing fell. So, many more brewers could enter the market. And that's exactly what happened in Australia and New Zealand.

This increase in market entry increased the supply of craft beer, which has decreased the price as well as the profits to be made from brewing. Many of the brewers are closing down. I described these dynamics in this post in 2017.

However, all is not lost. This market is cyclical. After the market shake-out is complete, and prices and profits are low, there may be an opportunity for new craft brewing entrepreneurs to get in early on the next wave of the cycle. The smartest of these entrepreneurs will try to pick the bottom of the cycle, just when consumers have become frustrated with the faux-craft offerings of the major brewers and the decrease in quality of the craft products that they have bought out. It is bound to happen. The only question is when.

However, it is not easy to pick the bottom of a cycle, and an entrepreneur who gets in too early is likely to lose big. That is part of the challenge of the 'hit-and-run' strategy - trying to pick the bottom of the cycle (and hit the market). The other part of the challenge, of course, is trying to pick the top of the cycle (and run from the market, probably by selling out to one of the major brewers).

As I predicted in that 2017 post, many investors in craft brewing have lost big. However, it won't be long before the profit opportunities for new entrepreneurs in this market rebound. This will be an interesting market to watch in the next few years.

Read more:

• The rise and fall of craft beer?
• Are we reaching peak craft beer yet?

The Commerce Commission and the Foodstuffs merger

This week, my ECONS102 class covered monopoly. As part of that topic, we look at competition policy, and in particular whether a government competition or antitrust agency (in New Zealand, that's the Commerce Commission) should allow two (or more) firms to merge. In theory, the government should allow a merger if that merger would make society better off - in other words, if economic welfare were higher than without the merger.

However, as I noted in this post back in 2021, that isn't the remit of the Commerce Commission, which is expected to oppose any merger that 'substantially lessens competition'. As I noted then:

The wording "substantially lessening competition" comes from Section 27 of the Commerce Act, which is the legislation that the Commerce Commission exists to enforce (among other things). However, I think that wording is problematic, because lessening competition is not necessarily the same as decreasing total welfare. In fact, it is entirely possible for a merger between two firms to increase total welfare, while at the same time substantially lessening competition.

Anyway, this year's example comes from the supermarket sector, where Foodstuffs' North Island and South Island operations are looking to merge (they are currently separate companies). As the New Zealand Herald reported back in July:

Foodstuffs (both North Island and South Island) maintain that the merger is aimed at improving efficiency in their businesses, and that reducing costs - such as duplicate overheads across the likes of head offices and key supply-chain functions - will help to drive prices lower than they otherwise would have been (though perhaps not lower in an absolute “before and after” sense, given the significant other variables).

Chris Quin, head of Foodstuffs North Island and the proposed head of the merged entity, has also pointed to the freshly erected guard rails of the new regulatory regime as a reason to allow the merger to proceed.

The commission does not appear to share his view. The latest statement noted that the new regulations: “are designed to address some of the competition issues brought about by the existing high levels of concentration in the grocery sector. They are not intended to, and would not, mitigate the structural loss of competition in relevant upstream and retail grocery markets that would result from the Proposed Merger.”

It is interesting that the Commerce Commission does appear to be considering competition as it relates to suppliers, and not just consumers. And it is also interesting that Foodstuffs are pushing the idea that this merger will lead to efficiency and ultimately to lower prices (and therefore higher economic welfare, as shown in my 2021 post).

The Commerce Commission is due to make a final determination on 1 October. It will be interesting to see what their determination is.

Read more:

• The Commerce Commission, competition and total welfare

Paul Blacklow on types of competition

In my ECONS101 lecture this morning, we covered market structures. In a weird coincidence, this new article on The Conversation by Paul Blacklow (University of Tasmania) was published today, also on market structures. As Blacklow notes, there are four main market structures:

In the most ideal, a perfectly competitive market, firms must use resources efficiently to produce what we consumers want at the lowest possible cost...

At the opposite extreme, in monopoly markets, there is only one seller of a good or service. Typically, there is some barrier preventing new firms from entering the market and driving prices down...

More common than monopoly is what’s called monopolistic competition, which is the market structure for many of our tech, entertainment and dining goods and services...

In Australia, many key goods and services are traded in oligopoly markets.

Oligopolies arise when a few large firms dominate a particular industry, such as supermarkets, domestic airlines, banking, mobile telecommunications, and petrol retailing.

I like Blacklow's description of the market structures, which is not dissimilar to how I describe them in class. If you are interested in learning more, I encourage you to read the article. However, in my view there are a couple of additional points to note, in relation to monopolistic competition.

First, monopolistic competition is actually more common than Blacklow suggests. He uses the examples of tech, entertainment, and dining, but the range of markets in which there is monopolistic competition is much broader than that. Monopolistic competition involves firms selling products that are differentiated from the similar products being offered by other sellers. When it comes to most of the goods that we buy, sellers are trying to differentiate themselves from their competitors who are selling goods that are otherwise very similar. As I see it, most markets are either an oligopoly (like supermarkets) or monopolistic competition (like service stations). [*]

Second, Blacklow focuses on firms differentiating their product by advertising, or research and development. Most differentiation is actually enacted through branding (which is not quite the same as advertising). [**] By branding their products, a firm can make their offering seem different to those of their competitors. For example, service stations are selling the same product (fuel), but differentiate themselves through their brand. Firms can also differentiate themselves spatially, by the location of their stores. Service stations do this as well. The make their offering different from their competitors because the location of their service stations are different. And, firms can also differentiate themselves through the range of products that they sell. Again, service stations provide a good example. Some have a minimal, convenience store range of products in-store. Others have a more upmarket cafe offering. So, there are many ways that firms can differentiate themselves from their competition, and once you realise this, you start to notice just how common monopolistic competition is.

*****

[*] There isn't really a stark distinction between an oligopolistic market and a monopolistically competitive market. Some more realistically, most markets are actually in some uncomfortable space in-between these two market structures. They may even change over time, sometimes being more oligopolistic, and sometimes more monopolistically competitive.

[**] Yes, a firm would advertise its brand as a way of differentiating its product. However, that is not the only purpose of advertising - it also changes consumer preferences, as I noted in this post from several years ago.

The Commerce Commission, competition and total welfare

This week in my ECONS102 class, we will be covering monopoly. One aspect of that topic is a consideration of public policy that can be applied to reduce the deadweight loss of monopoly. A deadweight loss is a loss of total welfare, and this is important because total welfare is our measure of how much net benefit is generated by the operations of a market. In the simplest sense, total welfare is made up of the consumer surplus (the gains for buyers of participating in the market) and producer surplus (the gains for sellers of participating in the market - essentially, their profits). If a monopoly creates a deadweight loss, then that means that the market isn't generating as much total welfare as it could.

A monopoly creates a deadweight loss because in its efforts to maximise profits, it restricts the quantity that it sells below the welfare-maximising quantity. This is illustrated in the diagram below (which uses a constant-cost monopoly as a simplifying example). The monopoly operates at the profit-maximising quantity, which is where marginal revenue meets marginal cost, at the quantity QM. To sell that quantity, the monopoly would want to set the price at PM (since at PM, the quantity demanded is exactly equal to QM). At that price and quantity, the consumer surplus is equal to the area ABPM, the producer surplus is equal to the area PMBDP0, and total welfare is equal to the area ABDP0.

However, if this market was perfectly competitive, it would operate at the quantity where supply meets demand, which is Q0. The equilibrium price would be P0. Consumer surplus would be equal to the area ACP0, producer surplus would be zero (because every unit costs P0 to produce, and that is equal to the selling price), and total welfare would be ACP0. This total welfare is maximised (because the quantity Q0 is the quantity where marginal social benefit is equal to marginal social cost, which is the required condition for maximising total welfare). Total welfare is lower for the monopoly firm by the area BCD, which is the deadweight loss of the monopoly.

Anyway, coming back to policy, one of the options available to the government is to restrict monopoly's market power by preventing monopolies from forming in the first place. After all, one way that we get large firms like monopolies is when two or more moderately-sized firms merge together. So, government can use anti-trust legislation to prevent these mergers and reduce the deadweight loss of monopoly. No monopoly means no deadweight loss (or, more likely, more competition means something that is closer to perfect competition than to monopoly, and higher total welfare). So, increasing competition seems like a good thing.

Which brings me to this example, from the New Zealand Herald back in February:

Trade Me has applied to the Commerce Commission for clearance to buy property business homes.co.nz.

The Commission said it got a clearance application from Trade Me Limited to buy 100 per cent of the shares or assets of PropertyNZ, which owns and operates the homes.co.nz website...

A public version of the clearance application will be available shortly on the Commission's case register.

The commission says it will give clearance to a proposed merger if it's satisfied it won't substantially lessen competition.

The wording "substantially lessening competition" comes from Section 47 of the Commerce Act, which is the legislation that the Commerce Commission exists to enforce (among other things). However, I think that wording is problematic, because lessening competition is not necessarily the same as decreasing total welfare. In fact, it is entirely possible for a merger between two firms to increase total welfare, while at the same time substantially lessening competition. [*]

To see how, consider the diagram below. Initially, there are many firms in perfect competition, operating at the quantity where supply meets demand, which is Q0. Total welfare is equal to the area ACP0 (this is the same as the previous diagram above). However, when the firms merge to form a single monopoly producer, there are cost savings. Perhaps the single firm doesn't need as many back office functions like finance or HR, and can consolidate some functions. This is represented by the lower marginal cost line MSC'. The merged firm is going to profit maximise by operating at the quantity where marginal revenue equals marginal cost, which is Q1, with a price of P1. The price is higher than the many perfectly competitive firms were charging. Consumer surplus falls to the area AEP1, so consumers are worse off. Producer surplus increases to the area P1EFG, which is much larger than zero (which is why the firms want to merge, no doubt). Total welfare is now the area AEFG.

Has total welfare increased? That depends. The area ECH was part of total welfare under perfect competition, but has been lost in the merger. However, the merger leads to a gain of total welfare equal to the area P0HFG. The question is, which of those two areas (ECH or P0HFG) is larger? It is entirely possible that P0HFG could be larger, in which case the merger increases total welfare (and therefore makes society better off in total). That would require your anti-trust authority to estimate the gains and losses of total welfare arising from the merger and compare them. But, if your test is whether the merger lessens competition (as is the rule applied by the Commerce Commission in New Zealand), even if total welfare increases, the merger could still be declined.

Of course, in practice the word 'substantially' becomes key in the Commerce Commission's assessment of merger applications, because all mergers must lessen competition to some extent. It seems to me, though, that the test potentially excludes some welfare-increasing mergers. A more suitable test is whether the merger reduces total welfare.

[HT: One of our tutors from last year, Taylor, who alerted me to the difference between the theoretical welfare test, and the test that the Commerce Commission actually applies]

*****

[*] Note that I am not saying that this necessarily applies to the TradeMe and PropertyNZ application.

How Costco gets firms to compete with themselves

 In my ECONS101 class last week, we covered pricing and non-price strategy for firms. This is a topic that you wouldn't see in a 'typical' first-year economics principles class, because it covers some very applied business economics and managerial economics - pretty important stuff for business students to understand, but not seen by most principles lecturers as important enough to squeeze out all the excitement of teaching the principles of cost curves (!).

Anyway, one of the strategies that I cover in this topic is situations where a firm finds it profitable to compete with itself. The examples I use are firms like Unilever, which makes several different brands of laundry powder, effectively making its own products compete with each other. However, by crowding the market with its own brands, Unilever makes it more difficult for other firms to compete. There is limited space on supermarket shelves, so if you can fill up those shelves with your own products, then it increases your profits. The supermarkets play along, because it is lower cost for them to deal with one supplier that can supply a range of products (and therefore make it look to the customer like a wide variety), rather than dealing with many suppliers.

So, I was really interested to read this article by Adam Keesling last month, which illustrates something fairly similar:

If you’re anything like the nearly 100 million people worldwide who have a Costco membership, you probably love Costco’s Kirkland Signature. You can get two dozen cage-free eggs for $6.50, or a 1.75-liter bottle of French vodka for $19.99. 

But despite these products’ exceptional prices, their quality doesn’t suffer at all. In fact, the exact opposite is true. Many of their products pass purity tests with flying colors. 

Kirkland also has a passionate and loyal fan base — not something you typically find with a private label brand. One guy even got a Kirkland Signature tattoo on his left arm and held his 27th birthday party at the Costco food court. 

Kirkland’s success defies our intuition and experience. Shouldn’t lower prices lead to lower quality products? How can they offer rock-bottom prices but still have some of the best products around? 

The answer is this: they get the best manufacturers in the world — who already have products on Costco shelves — to make Kirkland products. Yeah, you read that right. While customers might not know it, Kirkland products are often made by the same manufacturers who make the branded products that sit next to them on the shelves. 

Now, we don't have Costco in New Zealand. However, the explanation of the economics underlying how Costco gets its suppliers to compete with themselves is eye-opening:

Shortly after learning that brands would actually manufacture and package Kirkland products for Costco, I wondered how it worked. Why would a brand — say KIND Bars or Jiffy Peanut Butter — create a product for Costco and use the Kirkland brand? And make it 1% better than their own product? 

In a normal Costco purchasing example, a company might sell their product for $0.95 and Costco might retail it for $1.00. This would result in a 5% margin (in reality the margin is a bit lower, but let’s use these numbers for estimates). 

This $0.95 would be the brand's revenue. If we use some industry averages for margins — marketing budgets average 24% for CPG brands, and gross margins hover around 40-50% — then we can estimate their cost profile.

Keesling estimates that the manufacturer earns about 16% profit on selling their standard product at Costco. Then:

What about Kirkland products? As mentioned above, Costco aims to save customers 15-20% on the Kirkland products compared to their branded counterparts. So in our example, retail price would be $0.80 per unit for the Kirkland products. If that’s the only adjustment, the brand would be in a tricky position. Marketing expense is $0.20, non-marketing expense is $0.60 and the retail price is $0.80. That wouldn’t leave much margin for either the brand or Costco. In fact, it would leave none at all. 

But here’s the kicker: with the Kirkland products, brands don’t have to spend nearly as much money on marketing. They don’t need to pay for Facebook ads or run television campaigns. The only remaining marketing expense might be the account reps associated with the Kirkland account. Let’s say this lowered the marketing expense from $0.20 per unit to $0.05 per unit.  

In this case, Keesling estimates that the manufacturer earns about 14% profit on Kirkland products. So, while it's not the same level of profit as for their standard product, if selling the Kirkland product is what it takes to get your standard product on Costco shelves, then many manufacturers would be willing to do so. After all, Costco is bringing in revenue of nearly US$150 billion per year, so the manufacturers know they are going to sell a lot of products if they are on Costco shelves.

And that is how Costco gets firms to compete with themselves.

[HT: Marginal Revolution]

Why Uber drivers will make no money in the long run

This is the third post in as many days about Uber (see here and here for the earlier installments), all based on this New York Times article. Today, I'm going to focus on this bit of the article:

Drivers, on the other hand, are quite sensitive to prices — that is, their wages — largely because there are so many people who are ready to start driving at any time. If prices change, people enter or exit the market, pushing the average wage to what is known as the “market rate.”

The article is partially right here. It isn't just the price elasticity of supply that is at fault - it is the lack of barriers to entry into (and exit from) the market that create a real problem for drivers. A 'barrier to entry' is something that makes it difficult for other potential suppliers to get into the market. A taxi medallion is one example, if a medallion is required before you can drive a taxi. However, there is nothing special required in order to be an Uber driver, and most people could do it. Similarly, a 'barrier to exit' is something that makes it difficult for suppliers to get out of the market once they are in it, such as a long-term contract. Barriers to exit can create a barrier to entry, because potential suppliers might not want to get into a market in the first place, if it is difficult to get out of later if things go wrong. Again, Uber has no barriers to exit for drivers. These low barriers (to entry and exit) ensure that, in the long run, drivers can't make any more money from driving than they could from their next best alternative.

To see why, consider the diagrams below. The diagram on the left represents the market for Uber rides. For simplicity, I've ignored the 'Uber tax' (that I discussed in yesterday's post). The diagram on the right tracks the profits of Uber drivers over time. The market starts in equilibrium, where demand is D0, supply is S0, and the price of an Uber ride is P0. This is associated with a level of profits for Uber drivers of π0. For reasons we will get to, this is the same earnings that an Uber driver would get in their next best alternative (maybe that's driving for Domino's, or as a taxi driver, or working as a stripper).

Now, say there is a big increase in demand for ride-sharing, from D0 to D1. The price of an Uber ride increases to P1, and the profits for driving increase to π1. Now profits from being an Uber driver are high, but they won't last. That's because many other potential Uber drivers can see these profits, and they enter the market (there are no barriers to entry, remember?). Let's say that lots of drivers enter the market. The supply of Uber drivers increases (from S1 to S2), and as a result the price decreases to P2, and profits for Uber drivers decrease to π2.

Now the profits for Uber drivers are really low. There's no barriers to exit, so some drivers decide they would be better off doing something else (driving for Domino's, etc.). Let's say that a lot of drivers choose to leave, but not all of those who entered the market previously. The supply of Uber drivers decreases (from S2 to S3), and as a result the price increases to P3, and profits for Uber drivers increase to π3.

Now the profits for Uber drivers are high again (but not as high as immediately after the demand increase). Drivers start to enter the market again, and so on, until we end up back at long-run equilibrium, where the price of a ride is back at P0, and driver profits are back at π0. At that point, every driver who is driving makes the same low profit as before. So, in the long run, even if demand for ride-sharing is increasing over time, the drivers are destined not to profit in the long run. [*]

*****

[*] You might have noticed that the producer surplus is higher after supply increases, which implies that drivers (as a group) are earning higher profits after the market has settled back to long-run equilibrium. However, remember that supply is higher than before - those higher profits are shared among many more drivers, so the profit for each driver individually is the same as before.

[HT: The Dangerous Economist]

Read more:

• Uber is a tax on ride-sharing
• Passengers benefit more from Uber than drivers
• Uber just told us there is elastic demand for rides

Should economists be licensed?

Ross Guest (Griffith University) wrote a provocative piece in The Conversation last week about whether economists should be licensed:

The great British economist John Maynard Keynes said he longed for the day when economics could be thought of as a “matter for specialists - like dentistry”.

It’s easier to become an economist than a dentist, or a doctor or a lawyer. For those and other professions you need to be accredited - you need a licence to practice.

The economics profession requires nothing other than a university degree, and this month in its regular poll of 54 leading economists, the Economic Society of Australia asked whether it should set the bar higher.

The first question asked whether:

"…professional accreditation for the economics profession would attract more people to economics as a career."

This was rather timely, since this week in my ECONS101 class we were discussing market power. One source of market power occurs when the government gives you an exclusive right to operate. Occupational licensing is an example of this. It makes sense to licence some occupations, like doctors, dentists, or nurses, where the government wants to ensure certain safety standards are met. Other occupations are licensed because the government wants to ensure trust in the profession, like real estate agents or financial advisors. On one (or both) of those two grounds, you could (and many do) argue in favour of continued licensing of teachers, and taxi drivers. However, it's a little harder to argue in favour of some other licensed occupations in overseas jurisdictions, like beekeepers, fortune tellers, dog groomers, and librarians. What about economists?

Guest's article quickly strays into talking about ensuring certain standards of education for economists, which is separate from the question of whether they should be licensed. He also points out the gender gap in economics (which has been a theme I have discussed many times on my blog - see here and here for my latest posts on that topic). However, it isn't clear how licensing would address the gender gap, or the number (or distribution) of students studying economics more generally.

One thing we do know about occupational licensing is that it restricts competition. Only people who are licensed are allowed to practice that profession. That gives the licensed practitioners some degree of market power - it allows them to command a higher price (or salary, in this case). The outcome of licensing economists would likely be higher salaries for economists. It seems somewhat self-serving for an economist to argue in favour of licensing economists, in the same way that social workers or sex workers who argue for licensing are being self-serving.

It isn't clear to me that higher salaries for economists would address the gender gap in economics. In fact, it might even make it worse, if the marginal student that is attracted to economics by higher salaries is male, rather than female (at the least, we know that female economics students are less likely to specialise in finance, which tends to pay more).

Probably the best argument against licensing economists is defining who they are. Most economics graduates don't get a job with the title of 'economist'. Instead, the majority would end up an 'analyst' of some description (market analyst, business analyst, price analyst, etc.). So, how would you even enforce licensing? This probably explains why Guest focused on certifying economics education, rather than licensing economists directly.

So, should economists be licensed? It seems to me that the only people who would benefit would be economists.

More on the Oregon marijuana market shake-out

A few weeks ago, I wrote about the ongoing shake-out of the marijuana market in Oregon. Last week, the New Zealand Herald ran another story on this issue:

When Oregon lawmakers created the state's legal marijuana program, they had one goal in mind above all else: to convince illicit pot growers to leave the black market.

That meant low barriers for entering the industry that also targeted long-standing medical marijuana growers, whose product is not taxed. As a result, weed production boomed — with a bitter consequence.

Now, marijuana prices here are in freefall, and the craft cannabis farmers who put Oregon on the map decades before broad legalization say they are in peril of losing their now-legal businesses as the market adjusts...

The key issue there is that the profit opportunities for new growers attracted a lot of additional supply, leading to decreased profits for all. Usually, we think of barriers to market entry as being a bad thing, and indeed they are from the consumer's perspective - they decrease competition and lead to higher prices. However, from the perspective of the sellers, barriers to entry are a great thing because they provide the sellers with some amount of market power - that is, some power to raise the price above their costs.

So, how did Oregon get into this situation? The Herald story explains:

The oversupply can be traced largely to state lawmakers' and regulators' earliest decisions to shape the industry.

They were acutely aware of Oregon's entrenched history of providing top-drawer pot to the black market nationwide, as well as a concentration of small farmers who had years of cultivation experience in the legal, but largely unregulated, medical pot program.

Getting those growers into the system was critical if a legitimate industry was to flourish, said Sen. Ginny Burdick, a Portland Democrat who co-chaired a committee created to implement the voter-approved legalization measure.

Lawmakers decided not to cap licenses; to allow businesses to apply for multiple licenses; and to implement relatively inexpensive licensing fees.

Limiting the number of licences would create an effective barrier to entry into the market. By not limiting licences, Oregon's legislators set up a situation where marijuana sellers have to compete with many others. Note that, for now, this is only a problem for the sellers, who end up with low profits as a result of the competitive market. However, if the coming shake-out results in a smaller number of large firms being the only ones left, and Oregon goes on to crack down on the issue of new licences (which is a possibility), then we could end up in a situation where not only is there market power, but where it is concentrated in the hands of a few large sellers. Of course, that will be highly profitable for the sellers, but marijuana buyers will be much worse off.

Read more:

• The shake-out of legalised marijuana growers is underway

The shake-out of legalised marijuana growers is underway

The New Zealand Herald reported this week:

A glut of legal marijuana has driven Oregon pot prices to rock-bottom levels, prompting some nervous growers to start pivoting to another type of cannabis to make ends meet — one that doesn't come with a high.

Applications for state licences to grow hemp — marijuana's non-intoxicating cousin — have increased more than twentyfold since 2015, and Oregon now ranks No 2 behind Colorado among the 19 states in America with active hemp cultivation...

It's a problem few predicted when Oregon voters opened the door to legal marijuana four years ago.

The state's climate is perfect for growing marijuana, and growers produced bumper crops.

Under state law, none of it can leave Oregon.

That, coupled with a decision to not cap the number of licences for growers, has created a surplus.

Oregon's inventory of marijuana is staggering for a state its size. There are nearly 1 million pounds (450,000kg) of usable flower in the system, and an additional 350,000 pounds (159,000kg) of marijuana extracts, edibles and tinctures.

The legalisation of marijuana in Oregon (and many other U.S. states) was supposed to bring on a boom time for marijuana growers. But, the removal of barriers to entry into the market caused a massive increase in the number of growers (and the quantities they were growing). Absent the legalisation aspect, this sort of boom-and-bust is common in agricultural markets, where barriers to entry are low (agricultural markets are among the closest to perfectly competitive).

Consider a perfectly competitive market for marijuana, as shown in the diagram on the left below. It's probably not quite perfectly competitive, because growers require licences, but it is pretty close. The diagram on the right tracks changes in growers' profits over time. Initially (at Time 0) the market is at equilibrium (where demand D0 meets supply S0) with price P0, and firms are making profits π0. Now say there is a permanent increase in demand at Time 1, to D1 (this increase in demand derives from the legalisation of the consumption of marijuana). Prices increase to P1, and growers' profits also increase (to π1). There are no barriers to entry (other than growers requiring a licence and some land, so this is a perfectly competitive market), so the higher profits encourage new growers to enter this market. Supply increases to S2 (more growers) at Time 2. Price falls to P2, and growers' profits also fall (to π2).

At this point in the story of the market shown in the diagram, profits are low so growers start to exit the market. And indeed, that is what appears to be happening:

"Word on the street is everybody thinks hemp's the new gold rush," said Jerrad McCord, who grows marijuana in southern Oregon and just added 12 acres of hemp.

"This is a business. You've got to adapt, and you've got to be a problem-solver."...

In Oregon, the number of hemp licenses increased from 12 in 2015 to 353 as of last week, and the state now ranks No 2 nationally in licensed acreage.

Growers are exiting the marijuana market and entering the hemp market instead, since most of the growing techniques are the same (so that makes the barriers to exit the marijuana market low, and barriers to entry into the hemp market also low). Once there are fewer growers growing marijuana, the price (and profits) should recover for the remaining growers. In the market diagram above, supply decreases to S3, with prices increasing to P3 and profits increasing to π3. But we should expect the market price for hemp to come under pressure shortly, from the increase in the number of growers in that market!

I've previously argued that this sort of cycle is likely happening in the New Zealand craft beer market, though I'm still waiting for the large-scale exits to happen. In that case, demand increases appear to be just high enough to keep the small craft brewers in the market. For now.

Are we reaching peak craft beer yet?

If you keep predicting that something bad will happen, eventually you will be right. Except maybe for those predicting the Nibiru cataclysm. Last year I wrote a post about the rise and fall of craft beer, in which I concluded:

Lots of investors got burned in the kiwifruit industry in the 1980s. Will craft beer burn investors next?

It hasn't happened yet, but there is still cause for concern that we may be approaching peak craft beer. Max Towle wrote in The Wireless this week:

There are now about 200 craft beer brands in New Zealand, with the number of beer companies in New Zealand up almost 300 percent on a decade ago, according to Figure.nz. The amount of high percentage alcohol that’s available (anything over 5 percent) has risen 220 percent in the past 10 years despite, in the same period, less beer overall being produced.

If craft beer is a bubble, it’s getting pretty damn big. Some say it’s ready to burst...

As I argued in my post last year, the craft beer industry is cyclical. We've seen a big increase in demand for craft beer. That pulled a lot of new suppliers into the market, which means that even though demand is higher, craft beer is pretty unprofitable. But clearly not so unprofitable that there are a lot of firms exiting the market. I certainly wouldn't be getting into craft brewing right now (read Towle's article and it's easy to see why), as it appears that profitability still has a little way to fall before the least financially secure and/or highest-cost brewers start to shut down. Once that happens, the dynamic supply and demand model (see my previous post) suggests that is probably a good time to think about getting into the market (a surprising and counter-intuitive result), as after the shake-out there will be fewer craft breweries and lower competition, which will raise prices and profitability for the industry.

Read more:

• The rise and fall of craft beer?

Regulation of charlatans in high-skill professions

The title of this post is also the title of a recent working paper by Jonathan Berk (Stanford) and Jules van Binsbergen (University of Pennsylvania). The paper is theoretical and quite technical, but can be fairly easily summarised (I think) as follows. In many professions, it is possible for unskilled producers (charlatans) to pass themselves off as skilled, and essentially sell a worthless service to consumers. Consider an unskilled real estate agent, or financial advisor, for instance. To protect consumers from this possibility then, governments might require certification (that professionals in these fields must pass some sort of certification test in order to practice), or licensing (that professionals must hold some licence in order to practice). Berk and van Binsbergen show that these requirements may make consumers worse off, because even though the quality of services they receive would increase (by preventing charlatans from providing services), this would be more than offset by reductions in competition between professionals. I'm probably oversimplifying their arguments, which require some deeper thinking to get your head around. Here's what the authors say in the paper:

It is often argued that informing consumers better about the products they buy, leaves them better off, because they can make better choices. However, this logic ignores the equilibrium effect on prices that such information revelation has. Consider the case where the government is perfectly informed about who the charlatans are, and instead of setting standards, simply communicates this information to consumers. It is tempting to conclude that by providing this information, the government will make consumers better off. We prove the opposite. Even though the information fully drives charlatans out of the market, consumers are left worse off. The reason is that once again, there are two price adjustments that follow from such information revelation. First, prices of the remaining professionals will go up to reflect that consumers now have a zero probability of dealing with a charlatan. This leaves consumers indifferent, they pay more, but they get better service. But second, because competition amongst providers is reduced, prices will go up further, and this second effect reduces consumer surplus...

These insights also have important implications for the debate in the economics literature on certification and licensing. The difference between these two regulations is that a professional cannot practice without a license, but can practice without being certified. Consequently, we can interpret a licensing requirement as a minimum standard and certification as requiring information disclosure. The existing literature comes down in favor of certification because it provides consumers with information they otherwise do not have access to... Although the observation that certification reduces competition less than licensing is correct, the argument misses the fact that certification also reduces competition and as a result it also reduces consumer surplus... In summary, in our setting, certification is never preferred, not by producers nor by consumers.

Professionals prefer the licensing rather than certification, because it allows them to increase their own profits (although it reduces total welfare - a classic result of their increasing market power). There isn't much in the way of empirical support in the paper, but I expect this is something that others will follow up on in the future. The paper left me wondering whether having risk averse consumers would make a big difference, and in that case whether licensing or certification may be welfare enhancing given that consumers would be willing to pay to avoid the risk of dealing with a charlatan. The authors allude to this in the final sections of the paper, but I don't think they have fully dealt with this issue.

One last point: I really loved this footnote from the paper:

Even homeopaths and psychic readers have certification boards. One Chief Examiner of The National Certifying and Testing Board of the American Federation of Certified Psychics and Mediums Inc. is specialized in pet communication. On a more existential note, one wonders why a psychic examiner would even need to administer an examination to determine whether a candidate is qualified.

Nice.

[HT: Marginal Revolution, back in June]

Teacher proposal tries to increase market power

As reported in the New Zealand Herald last week, the Education Council (the professional organisation for teachers) are floating a change that would require all prospective teachers to have a post-graduate qualification. Here's what was reported:

People wanting to become teachers would need to get a post-graduate qualification, under a change floated by the Education Council in a bid to raise the status of teaching.

The change would cover all teachers - early childhood, primary and secondary - and has the backing of universities.

First, it's not at all surprising that this proposal would have the backing of universities. If teachers require post-graduate qualifications, that means more people studying post-graduate qualifications (albeit probably not a whole lot more - see below), which means more fees for universities.

Second, it's really hard not to be cynical and see this as a simple way for existing teachers to increase their market power. If you raise the threshold for new graduates to become teachers, this creates a barrier to entry for graduates into the teaching market. [*] Essentially this restricts the supply of new teachers, because it would cost more to become a teacher (an additional year of student loans and foregone earnings, made even worse by student allowances not being available for post-graduate study). This would make alternative occupations (that are cheaper to get into), just a little bit more attractive. So, while this wouldn't stop everyone considering teaching as a career from following that path, at the margin it will be enough to dissuade some. Which is essentially what the PPTA says in the article:

However, the PPTA is unconvinced, saying teacher supply problems could worsen as a result.

Requiring all future teachers to get a post-graduate qualification would raise the bar for entry into the profession, and would likely be most keenly felt at the primary and ECE level.

Restricting competition makes sellers (in this case, sellers in the labour market for teachers) better off. It raises the bargaining power of the existing teachers, and when schools are looking for new teachers there are fewer options available, so they have to offer slightly higher salaries to attract applicants. Voila! Existing teachers are made better off, whether they are staying at the same school or moving between schools, at the expense of people who would have become teachers but for the higher barrier to entry.

The Education Council argues that this proposal would "raise the status of teaching". However, it's hard to see how it does that, other than by increasing teacher salaries at the margin. It may increase the quality of new teachers, to the extent that you believe a post-graduate qualification adds to their quality (dubious, when compared with the alternative of giving a graduate a year of actual teaching experience).

I'd argue that we probably need to go in precisely the opposite direction, especially for high school teachers of STEM subjects. When my father was at university, he taught chemistry at a high school in Auckland while studying his Bachelor of Science. That gave him a little bit of free cash flow, and benefited the school by providing a cost-effective way of teaching a subject that was difficult to recruit quality teachers for (and it certainly hasn't gotten any better since then). Why not open up teaching in STEM subjects to final-year graduates (probably economics too), given the teacher shortages in those subjects? Who knows? Some of them may actually enjoy the experience enough to stay on and become teachers (which they wouldn't have done otherwise). Raising the bar for people to become teachers is ridiculous, when you can't fill the vacancies for quality teachers in STEM subjects (and other subjects) now.

*****

[*] Ok, there is already a barrier to entry because teachers require a qualification. However, this proposal raises the barrier to entry even higher.

[HT]: Tertiary Update

The rise and fall of craft beer?

I was interested in this long article by Michael Donaldson in the New Zealand Herald last week, entitled "End of the golden age of craft beer" (the Herald also had a follow-up editorial the next day). Donaldson writes:

But despite massive growth in the industry, [Epic brewer Luke] Nicholas fears there's a regression of sorts at work - it's almost as hard now to sell beer as it was back in the day when he was knocking on doors until his "knuckles are bleeding".

"The other day I was trying to figure when we were in the 'golden age' of having the right number of breweries and customers and I think it was 2012 - that was the time before all the me-toos started coming on board.

"Every wannabe homebrewer, every person with money who wanted to buy a brewery, every branding guy who says, 'Look at this double-digit growth, I'm jumping on that.'

"People who are doing that now are already late because things are going to get tough."

That bit struck me because it reminded me of a model that we discuss in some detail in ECON100, based on dynamic supply and demand (or what Steven Lim calls in our ECON100 class 'the cyclical patterns model'). Here's how it works.

Consider a perfectly competitive market, as shown in the diagram on the left below. The diagram on the right will track changes in firms' profits over time. Initially (at Time 0) the market is at equilibrium (where demand D0 meets supply S0) with price P0, and firms are making profits π0. Now say there is a permanent increase in demand at Time 1, to D1 (this increase in demand is the discovery of craft beer by hipsters). Prices increase to P1, and firm profits also increase (to π1). There are no barriers to entry (this is a perfectly competitive market), so the higher profits encourage new firms to enter this market (new brewers flood the market, as noted in the quote by Nicholas above). Supply increases to S2 (more producers) at Time 2. Price falls to P2, and firm profits also fall (to π2). This is where we are probably heading now.

Of course, that's not the end of this little story. Now, at Time 2 profits are low and some firms will exit the market (no barriers to exit because this is a perfectly competitive market). Supply decreases to S3 (fewer producers) at Time 3. Price increases to P3, and firm profits increase to π3. As you can see from the profits over time (in the right-hand diagram), a cycle of high profits-low profits-high profits- etc. is created.

How realistic is this model? If you have a long memory, you may recall something similar in the kiwifruit industry in the 1980s (see for example page 6 of this paper about Katikati). Initially, a few farms made big profits. More farms planted kiwifruit. A few years later, the price collapsed due to oversupply. Many kiwifruit farmers went bust, and investors lost big. There are other similar examples as well, like venison in the 1990s.

All that is required are two things: (1) a perfectly competitive market (or one that is close to it); and (2) some shock to kick things off. In the case of craft beer, is it a competitive market? Remember that the characteristics of a competitive market are: (1) there are many buyers and sellers; (2) all products are homogeneous (the same); (3) information flows quickly and accurately; (4) there is freedom of entry into and exit from the market. The most problematic of these in the case of craft beer is the last one. Is there free entry and exit from the market? Now that craft brewers can simply lease existing plant from other brewers, I'd argue that there probably is low barriers to entry, which makes this market somewhat (but not perfectly) competitive.

There are a couple of other things to take away from the model above. First, a smart player in this market would adopt a 'hit-and-run' strategy. If prices and profits (and the costs of entry) are low, this might be a good time to get into the industry, but if prices and profits are high, this might be a good time to cash out (and bank a large capital gain). Maybe think twice before investing in that new craft brewer, unless you are confident the boom will continue (how confident are you that we haven't yet reached peak hipster?).

Second, the amplitude of the cycles on the right of the diagram gets smaller over time. This is because people are learning, i.e. more people recognising the cycle and trying to take advantage of it, such as by getting out before it hits the peak. Which may go some way to explain the motivations of the previous owners of Emerson's or Tuatara on their decisions to sell out to the major brewers.

Lots of investors got burned in the kiwifruit industry in the 1980s. Will craft beer burn investors next?