Licensing of economists, and other fortune tellers

There are certain examples I use in my classes where the origins are shrouded in mystery. They likely come from some obscure note I wrote to myself after reading something online. One of those examples is that there are some states in the US that require fortune tellers to be licensed. [*] I use this as an example of the ridiculousness of occupational licensing, which in many circumstances serves no real purpose other than creating a barrier to entry into the market. After all, what harm could befall consumers from receiving the services of an unlicensed fortune teller, that licensing would help to prevent?

It turns out that the fortune teller example is true. Here's the relevant website with links to the law, as well as this hilarious article which asks the most relevant questions:

How cool would that be to have a fortune tellers license? But then I started to wonder how the licensing process would work. Is there a written examination? Do they hand you a blank piece of paper and expect you to divine the questions and then answer them? Is the test multiple choice or essay? Who grades the essays? Other fortune tellers – kind of like bar exam? Is there a road test? Is reading tea leaves or your palm akin to parallel parking?

I was in New Orleans last month. Walking along Bourbon Street, you see a lot of fortune tellers. I could tell the phony ones. They were the ones that beckoned me over. If they could tell the future, then surely they would have known that I wasn't going to walk over to them, no matter how enthusiastic they waved at me?

Anyway, if fortune tellers are licensed in Massachusetts, does that mean economists should need a licence? After all, economists are regularly asked to tell the future - what is going to happen to GDP, unemployment, interest rates, exchange rates, etc.? Whether economists should be licensed or not isn't a crazy question - there have been calls for that in the past (see here and here). And the consequences of bad fortune telling are likely to be as bad, or worse, when an economist gets it wrong as when a palm reader does. Real risk of harm is the reason that governments license doctors, dentists, and nurses. If there is a real risk of harm from people making poor financial decisions on the advice of economists (or other fortune tellers), maybe they do have to be licensed after all?

[HT: Marginal Revolution]

*****

[*] Although, as it turns out, I have referred to licensing of fortune tellers before, with a relevant link (see here).

Read more:

• Should economists be licensed?
• Should economists have licensing, or a Code of Ethics?

The economic welfare gains from the introduction of generic weight-loss drugs

The Financial Times reported this week (paywalled):

India’s powerful copycat pharmaceutical industry is set to roll out generic weight-loss drugs in the UK within weeks, with one leading producer forecasting a “huge price war” that could widen access to the popular medicines.

Bengaluru-based Biocon is the first company to win UK authorisation to offer a generic version of Novo Nordisk’s Saxenda weight treatment and is ready to launch sales by November.

Saxenda is an older drug of the same GLP-1 drug class as the Danish company’s popular Ozempic diabetes treatment and Wegovy weight-loss medication.

In an interview with the Financial Times, Biocon chief executive Siddharth Mittal declined to comment on his pricing strategy for generic Saxenda, but predicted his company’s sales of the drug would reach £18mn annually in the UK after the expiry of its patent protection there next month. Mittal said he expected Biocon’s generic version of Saxenda to be approved by the EU this year and in the US by 2025.

“When the generics come in there will be a huge price war,” he said. “There is a huge demand for these drugs at the right price.”

To see how the introduction of generic medicines affects the market, consider the diagram of the market for Saxenda below. When the active ingredient in Saxenda is protected by a patent, the market is effectively a natural monopoly. That means that the average cost curve (AC in the diagram) is downward sloping for all levels of output. This is because, as the quantity sold increases, the large up-front cost of developing Saxenda (see here for example) will be spread over more and more sales, lowering the cost on average. If Novo Nordisk (the producer of Saxenda) is maximising its profits, it will operate at the quantity where marginal revenue meets marginal cost, i.e. at QM, which it can obtain by setting a price of PM (this is because at the price PM, consumers will demand the profit-maximising quantity QM). Novo Nordisk makes a profit from Saxenda that is equal to the area PMBKL. [*]

Now consider what happens in this market when the patent expires and generic versions of Saxenda enter the market. We end up with a market that is more competitive, which would operate at the point where supply (MC) meets demand. This is at a price of PC, and the quantity of QC. Notice that the price of Saxenda falls dramatically - this is how the price war that Mittal mentions will play out.

Now consider what happens to the other areas of economic welfare. Before the patent expires, the consumer surplus is equal to the area GBPM. After the patent expires, the consumer surplus increases to the area GEPC. Consumers are made much better off by the patent expiry, because they can buy Saxenda at a much lower price, and they respond by buying much more of it. The producer surplus, which was PMBHPC, becomes zero. [**] The competition between the producers drives this producer surplus down. Total welfare (the sum of consumer and producer surplus) increases from GBHPC to GEPC. So, society is better off after the patent expiry.

Now, you could argue based on this that expiring the patent earlier would be even better, given the economic welfare gain that would result. And while I have some sympathy for that view, governments should be a little cautious here. The large producer surplus from having the patent in place creates an incentive for the big pharmaceutical firms to develop these pharmaceuticals in the first place. So, an appropriate balance between patent protection and incentives for pharmaceutical development needs to be found. Nevertheless, it is clear that once patents expire, there is a large welfare gain to society at that point.

*****

[*] This is different from the producer surplus, which is the area PMBHPC. The difference between producer surplus and profits arises because of the fixed cost - in this case, the cost of development of Saxenda.

[**] If we treat this as continuing to be a natural monopoly after the patent expiry, the market makes a negative profit of -JFEPC (because the price PC is less than the average cost of production ACC). However, you could argue that because the firms producing the generic version didn't face the up-front cost of development, this is no longer a natural monopoly once the patent has expired.

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

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

As predicted, the 'regulated grocery retailers' scheme is failing, but there is an alternative worth considering

The supermarket sector in New Zealand has been in the news a lot recently. Bryce Edwards' Political Roundup column in the New Zealand Herald last week did a great job of summarising the media coverage. The column is worth reading in its entirety, but I want to focus on just one bit:

Grocery Tsar Pierre van Heerden made it clear this week how unimpressed he is with the duopoly he’s trying to regulate. He says he proposes further regulatory reform to the Government.

The first proposal is to reform the failed “regulated grocery retailers” scheme to make it mandatory that Foodstuffs and Woolworths treat rival retailers equally in providing them with wholesale groceries. However, commentators have been less than convinced by this. The supermarket reform advocates, Grocery Action Group (GAG), have called this proposal “tinkering in a market that has structurally failed”. And the Post’s business journalist Tom Pullar-Strecker suggested that the supermarkets might treat such regulations in the same way that electricity gentailers have managed to game the system: “If the supermarkets do need to supply rival retailers on the same terms and prices as their own stores, one question will be what might stop them making those prices high and shifting their profits from their retail to their wholesaling arms.”

It should be no surprise to anyone that the 'regulated grocery retailers' scheme has failed its objectives, and that further tinkering wouldn't make much difference. In fact, I predicted as much in this post in 2022:

Finally, the supermarket firms are not just retailers, but wholesalers. By itself, this proposal on retail prices would need to be carefully designed. Otherwise, the supermarkets will simply route around it by separating out their wholesale operations into a different business, which sets the wholesale prices, upon which the retail prices (cost-plus wholesale) will be based. Then the supermarket profits will simply back up one step as wholesale, rather than retail, profits... This might be one way that the supermarkets will respond to the Commerce Commission's recommendation that the supermarkets be required to offer wholesale supply to other grocery retailers (see here) anyway.

Why isn't the scheme working? It's more-or-less as I predicted (from Edwards' column):

According to the report, the scheme hasn’t been working as intended. Although former Prime Minister Jacinda Ardern claimed the regulation would “unlock the stockroom doors” of the duopoly to smaller players, instead, Foodstuffs and Woolworths had found a way to jack up the wholesale prices.

The report said: “In our analysis we found that as many as 54% of the products offered by RGRs (regulated grocery retailers) in wholesale could be purchased cheaper at retail”. It seems that the duopoly had managed to exclude competitors from gaining access to the various trade discounts from an array of rebates, payment arrangements and special deals.

So, rather than the scheme resulting in supermarkets and their competitors all facing the same wholesale price, the supermarkets have been giving trade discounts or rebates to their own stores (and presumably not to their competitors' stores). So, while the list price may look the same for everyone, in practice the supermarkets' own stores end up paying a lower wholesale price. And so the big supermarkets continue to profit because the higher wholesale price that their competitors pay ensures that the big supermarkets profit margins are not competed away.

The Grocery Commissioner's proposal to reform the scheme is also doomed to failure, as I noted in my 2022 post and Tom Pullar-Strecker has also pointed out. One solution, which no one seems to have suggested so far, and which might be worth considering, is to regulate wholesale grocery supply to operate under a cooperative model. Under this model, all grocery retailers would be 'members' of a single national wholesale cooperative, with ownership shares in proportion to their wholesale purchases. This is essentially a form of structural separation. Grocery retailers would all receive the same prices and special terms from the wholesale cooperative, which might be prohibited from offering quantity discounts (to prevent the big supermarkets from simply using those discounts to continue to receive lower wholesale prices than their competitors). This would also prevent the big supermarkets from simply shifting high prices to the wholesale level and continuing to profit overall, since the whole sector would now receive the same wholesale prices, whether they are high or low. It's not a perfect solution, and the wholesale cooperative will have a huge amount of market power over its suppliers (even more than the current supermarket duopoly does). But in terms of opening the path to more competition, it is a solution that is certainly worth thinking about.

Read more:

• Supermarkets are not natural monopolies, and should NOT be regulated as public utilities

The commercial landlord oligopoly in Raglan claims a high-profile victim

This week, my ECONS101 class has been covering market structures and market power. By definition, market power is the ability of a seller (or sometimes a buyer) to have control over market prices. The degree of market power that a seller (or buyer) has depends on the amount of competition in the market. A big component of competition is the contestability of the market - how easy it is for other sellers (or buyers) to enter the market. When a market is highly contestable, it is difficult for a seller to maintain high prices (and high profits) because other sellers will be able to easily enter the market, increasing competition and lowering prices. But when a market has low contestability, high prices and high profits are likely to persist for sellers.

So, I was interested to read this article in the Waikato Times today [*]:

Raglan business owners say a landlord monopoly in the small beach town is jacking up rents, forcing them out.

Prominent Raglan music venue and bar Yot Club will soon be up for sale because the owner Andrew Meek says he’s “had enough of the landlords”.

Other operators spoken to by the Waikato Times said there was a power imbalance between tenants and owners with some having seen up to 95% rent increases in less than a decade...

Meek wanted to sell his business and said if it didn’t sell, he would shut the Yot Club by May.

“I hope that someone else can find a way through to maybe deal with the landlords, to maybe have a better relationship with police and licensing.

“This place means a lot to the community and there’s nothing like this in Raglan.”...

A business owner in the town centre, who did not want to be named, said they can’t move anywhere else because of what they called a monopoly on commercial rents.

“This is our life and livelihood, so they know that we are not going to leave and run.

“So they keep increasing the rent and compared to the whole country, the rent here is way too high.”

They said the 60m2 shop was renting for over $55000 for a year - nearly double the same-sized property in Hamilton’s Te Rapa.

“Every two years or whatever the document says, they put up the rent and then they take a management fee as well.

Another small business saw more than 90% increase in rent in the last six years.

“My landlord basically says he can do whatever he wants.”

In downtown Raglan, a few commercial landlords own most of the properties. The commercial property market in Raglan is not a monopoly (in contrast to what the business owner quoted above says), but it is an oligopoly - a market with few sellers. That limits competition and grants some market power to the commercial landlords, which they can use to increase rents. To make matters worse, this is a market with low contestability. Even though rents are high, and commercial landlords are making high profits, there is limited land in downtown Raglan zoned for commercial uses. Since the existing commercial landlord oligopoly holds all (or most) of that property, it is difficult (if not impossible) for other commercial landlords to enter this profitable market and compete. Moreover, Raglan is a long way from the next nearest commercial area which, excluding Whatawhata, is probably the Dinsdale shopping centre in Hamilton, over 30 minutes away. So, there is little alternative for businesses in Raglan other than to deal with the existing commercial landlord oligopoly.

However, things are even worse for the Yot Club than for other tenants. An iconic venue like the Yot Club is known for its current location and setup, including the outdoor area. That gives the Yot Club owner even less bargaining power in negotiating with the landlord than other tenants, since other tenants are more likely to be willing and able to move to a new location (even if that new location is outside of Raglan entirely).

So, the commercial landlord oligopoly in Raglan has a lot of market power. The commercial property market in Raglan lacks contestability. The tenants are paying high rents (note the comparison in the quote above with rents in Te Rapa, where there will be much higher competition between commercial landlords, because there are many alternative commercial areas within Hamilton that a tenant may choose to locate in). The landlords are likely making high profits as a result of their market power.

Having said all that, there are meaningful limits to how high the landlords can push the commercial rents. If rents get too high, then the commercial tenants will start to walk away (exiting the market), as it becomes unprofitable to continue their operations. This appears to be exactly what is happening now. And given the extra challenges that the Yot Club faces in dealing with the landlords, it shouldn't be a surprise that they were one of the first tenants to exit.

*****

[*] In the interests of full disclosure, I was a member of District Licensing Committee panels that have twice declined to renew the alcohol on-licence for the Yot Club. On both occasions, the Committee's decision was overturned on appeal to the Alcohol Regulatory and Licensing Authority. If you're interested, you can read the Committee's decisions here and here, and the corresponding ARLA appeal decisions here and here (and for completeness, you can read a further ARLA decision here, in which the final two sentences are particularly telling). Despite any perceptions that may have formed to the contrary, I bear no ill will towards the Yot Club or its owner, as the tenor of this post should demonstrate.

Certification as a barrier to entry for doggy daycare centres

This week, my ECONS102 class covered monopolies. Monopolies arise because of barriers to entry - there is something that stops other firms from getting into the market and competing with the monopoly. Not all markets with barriers to entry result in a single firm operating (a 'pure' monopoly). However, all markets with barriers to entry convey some market power on the firms - the firms can set a price that is above their marginal cost, and make a profit.

One way that barriers to entry arise is when the government grants an exclusive right to produce and/or sell some good or service, or where being a seller requires a license. Patents are an example of an exclusive right granted by the government, while occupational licensing (like the licenses required to practice medicine, or to be a teacher or taxi driver) is an example of the latter.

A slightly weaker (but similar) form of barrier to entry to occupational licensing is created by a certification regime. Certification doesn't keep sellers out of the market, but it does convey some information to consumers. It is a form of signal of the quality of the seller. For signals to be effective, they must be costly (and a certification involves a cost to the seller who wants to be certified), and costly in a way that low-quality sellers would not want to attempt. Certification may impose restrictions on the practices of sellers, like requiring them to follow a code of practice, having a third party audit the operations of certified sellers, and/or having a public register of certified sellers, as well as a record of sellers who have lost their certification. Any of these characteristics of the certification regime would make becoming certified costly for low-quality sellers in such a way that they wouldn't want to become certified in the first place. And because the certification limits the number of willing sellers, it creates a barrier to entry.

Which brings me to this article from the New Zealand Herald from February:

New Zealand’s one and only SPCA-certified doggy daycare in Whangārei is urging other daycare centres to sign up so owners can start to “expect the best” for their pets.

The Grooming Lounge & Daycare is the first doggy daycare to join the SPCA-certified programme, which lets dog owners know of businesses willing to be independently audited to maintain high animal welfare standards.

Owner Rebekah Thompson said she signed up after a futile attempt to find daycare standards and guidelines when starting her business in 2020.

“There’s no guidelines or certification for doggy daycares, it’s completely unregulated as an industry...”

Currently in New Zealand, anyone can set up a doggy daycare facility with no minimum experience or qualifications.

SPCA developed a set of voluntary standards so businesses could raise the bar and help pet owners choose centres that put animal welfare first.

It costs $800 a year to get certified and businesses get audited twice a year. One of the visits is scheduled and the other is unscheduled.

“I went with it to show my customers I have nothing to hide, and that a third party is validating what we’re doing,” Thompson said.

Notice that the certification, as described in the article, corresponds almost exactly to the case I laid out at the start of the post. It provides a signal that "lets dog owners know of businesses willing to be independently audited to maintain high animal welfare standards". The signal is costly ($800 a year), and the twice-yearly audits will make the certification unattractive for low-quality doggy daycare centres, since it would reveal the real quality of the centres to dog owners.

What happens next will be interesting though. This could be just the start of a creeping regime of regulatory capture. The SPCA and certified doggy daycare operators could start lobbying government for mandatory regulation of the sector - note the scare quote in the article: “There’s no guidelines or certification for doggy daycares, it’s completely unregulated as an industry...” The government might introduce licenses for doggy daycare centres. That would make the barrier to entry into the doggy daycare market a bit higher. Who better to manage the licensing regime than the SPCA? Then, the requirements for getting a licence can be gradually raised, in order to "put animal welfare first". Again, the barrier to entry gets a bit higher.

Will we end up with high barriers to entry into the doggy daycare sector? If it was up to the SPCA and the already-certified operators, then yes. Watch this space.

Should economists have licensing, or a Code of Ethics?

Many occupations require a license before a practitioner (or service provider) can operate. The full list of licensed occupations differs by jurisdiction (here is New Zealand's list), but in most places doctors, dentists, and nurses are included in the list. However, economists are not. Olivia Wills recently wrote a great post on the Asymmetric Information Substack today questioning that outcome. She started by outlining four reasons why the government might put a licensing regime in place:

Safety. Some roles, like those covered by the Health Practitioners Competence Assurance Act 2003, directly impact public health and safety. That Act’s purpose is to protect the health and safety of members of the public by providing mechanisms to ensure the life long competence of health practitioners. By setting minimum standards for education, training, and experience, regulatory bodies ensure that practitioners have the necessary knowledge and skills to do their work.

Reputation. Regulation helps uphold the reputation of a profession by setting standards. For example, an experience with one rogue chiropractor could put you off the whole profession, but by limiting who can call themselves chiropractors to those with suitable experience and qualification, there’s a reduced risk of reputational damage to the non-rogues.

Frameworks for when it goes wrong. No matter what restrictions are put on entering a profession, there will always be some rogue players who cause harm. Registration also means an established process for de-registration (e.g. doctors can be struck off the register, and barristers can be disbarred). These steps prevent further harm, allow justice and voice for victims, and again uphold the reputation of the profession.

Reducing information asymmetry. Regulated professions tend to involve specialised knowledge that can be difficult for the rest of us to assess. If I’m injured and looking for a physiotherapist, the idea of choosing based on who has the best search engine optimisation might not get me the best results. A list of accredited practitioners gives a level of assurance about qualifications and competence.

When I discuss licensing in my ECONS101 class, I focus only on the first (safety). Government doesn't want consumers to come to great harm (physically, financially, or psychologically) by dealing with unlicensed service providers. In my ECONS102 class, we also consider asymmetric information. Consumers don't know which service providers are high quality, and a licensing system can overcome that if it ensures that only high-quality service providers with appropriate qualifications are licensed. Where there is both a risk of substantial harm and asymmetric information, that provides a good justification for licensing. This is the reason for only allowing licensed doctors, dentists, or nurses to operate (pun intended).

However, in her post Wills only considers licensing as a possibility, when there is another option: certification. Where licensing prohibits unlicensed service providers from operating, certification allows both certified and uncertified providers to operate. A certification system has lower transaction costs than a licensing system, and doesn't provide the certified service providers with as much market power as licensed service providers have (since it doesn't keep uncertified service providers out of the market, which keeps competition higher than is the case for an occupation governed by a licensing system). Certification makes more sense where there is asymmetric information (about the quality of service providers), but the degree of harm is unlikely to be great. Certification provides consumers with information about the likely quality of the service providers, but doesn't fully exclude the lower-quality service providers from the market. In New Zealand, accountants have a certification regime (they can be Chartered Accountants, or not), but not a licensing regime. This often comes as a surprise to my students.

Anyway, Wills' post is about whether or not economists should be licensed. On that point, she notes that:

In practice, economics is best when exploring new ideas and methodologies, and signing up to an overarching way of working is likely to inhibit this freedom. The reality of enforcing regulation would present practical challenges, particularly in defining the boundaries of the profession. Determining who should be subject to regulation and who should be exempt could be a complex, unfruitful task.

Yet the capacity for economists to cause harm is inescapable. This is why I conclude that, while formal accreditation is neither feasible nor desirable, an ethical declaration would be a useful reminder of our role and responsibility. A Code of Ethics might go some way to encourage humility in our estimations, models and predictions, and appreciate the role our own world views take when informing our work.

When it comes to the strength of the regime governing an occupation, a voluntary Code of Ethics is an even weaker option than certification. It does little to prevent harm, since economists would be free to adhere to the Code or not. It also doesn't solve the asymmetric information problem, if anyone can sign up to the Code at little to no cost.

It seems to me that, in terms of interactions with 'consumers' (broadly defined), there is little for economists to gain from a Code of Ethics. It comes with real practical problems. Economists have legitimate disagreements on models, data analysis, and policy implications, and even what constitutes best practice in those areas. It's not clear that a Code of Ethics would solve those issues, and if not, then it would do little to improve the reputation of economists in the eyes of the general public.

On the other hand, there are positive aspects to a Code of Ethics, if it was focused on some of the problems that are internal to the discipline (rather than those affecting 'consumers'). For example, there is a persistent gender gap in economics (see this post, and the links at the end of it). A Code of Ethics, albeit voluntary, would at least give the impression (and associated warm glow for those who signed up to it) that economics is addressing its internal problems. Maybe it would be one more step in that direction.

Read more:

• Should economists be licensed?

Doctor shortages and the medical licensing cartel

The definition of market power is the ability for a seller (or sometimes a buyer) to influence market prices. More market power means more control over prices. For a seller, that means that they can push the price upwards, and increase their profits. In my ECONS101 and ECONS102 classes, we discuss several ways that firms can obtain market power, one of which occurs when the government grants a firm the exclusive right to produce and/or sell a particular good or service. One example of this is patents. Only the patent holder, or another firm that buys a licence from the patent holder, is allowed to produce and sell the patented product. Other sellers are excluded from the market.

Occupational licensing provides a similar source of market power to patents. When the government creates rules that stipulate that all sellers within a particular market must be licensed, then that excludes other potential sellers from operating in that market. Sometimes, the government handles the licensing process itself, and sometimes it outsources the licensing process to an industry body. The Medical Council handles licensing (registration) of doctors, for example. Unregistered doctors are prohibited from practicing medicine and selling their services. Only those that are registered with the Medical Council are allowed to practice.

The incentives created by occupational licensing systems are obvious. From the perspective of the insiders (licensed professionals, like doctors), more market power means more profits (or higher salaries). So, the insiders will want the licensing system to increase their market power, by excluding as many competitors as possible from being licensed. They can achieve this by ensuring that there are many requirements for new licensees to meet, including training and examinations, knowledge of local context, supervised work requirements, and so on. All of this can be dressed up as 'protecting the public' from low-quality practitioners, when all it really does is limit competition.

If the government is handling the licensing system, the industry association will lobby for these protections to be in place. If the industry association is handling the process itself, there is little to stop them from enacting all sorts of spurious requirements in the interest of 'public safety'. And limiting the number of people who can achieve registration is an effective way of keeping the competition out. Since the real purpose of the licensing system, from the perspective of the industry association, is to limit competition, the effect of the licensing system is essentially government-sanctioned cartel behaviour.

And so we end up in this situation with doctors, as noted in The Conversation earlier this month by Johanna Thomas-Maude (Massey University):

Immigration New Zealand’s recent announcement that all medical doctors would be included on the straight-to-residence pathway doesn’t quite give the full picture. In fact, “all” only includes those doctors who can have their medical registration approved before coming to New Zealand.

For many foreign-trained doctors already living here, the obstacle preventing them from working isn’t immigration – it’s medical licensing. If more is not done to streamline and speed up the licensing process, New Zealand risks losing prospective doctors to countries that make the process easier.

Doctors trained in Australia, the United Kingdom and Ireland, or other “comparable health systems”, can usually register and receive a job offer before immigrating.

But as of mid-November, more than 50 foreign-trained doctors who have met the Medical Council’s standards are still caught in a bottleneck, waiting for supervised hospital positions that will allow them to be provisionally registered before their exam pass expires.

Yes, you read that right. In the midst of a doctor shortage, doctors trained internationally in medical systems that are substantially comparable to New Zealand's, cannot get registered here due to a lack of supervised hospital positions. They need to spend some time in a supervised position before they can be registered, because it is a requirement of the licensing regime. And to make matters worse:

Potentially hundreds of other doctors already in New Zealand are also waiting to take the required local clinical skills exam (NZREX), which is only open to 30 people at a time. The exam has only been offered four times – instead of the usual nine – in the past three years, with only one currently scheduled for 2023.

More licensing rules, that simply serve to protect the market power of the medical licensing cartel by limiting incoming competition from overseas. By limiting the number of exam slots, and limiting the availability of supervised hospital positions, current doctors will have more market power to push up their own salaries. The solution is obvious, as Thomas-Maude notes:

New Zealanders should be pushing for further change. At a minimum, there should be viable supervised pathways for all doctors who demonstrate the required knowledge through international and local exams, as well as more exam offerings.

I'd go even further. Registration in 'comparable health systems' should be deemed comparable enough that registration in New Zealand is automatic when a job offer is extended. We don't need to be excluding good doctors from Australia, the UK or Ireland, from working in New Zealand. The medical licensing cartel needs to be reined in.

[Update: Eric Crampton at Offsetting Behaviour makes some additional comments]

The value of market power in alcohol sales

As Reason reported this week, Massachusetts is looking at revising its alcohol sales restrictions. The current regime is interesting because:

Massachusetts restricts license availability in two ways: creating quotas on how many licenses are available based on an area's population and restricting the number of licenses a single entity can own. While some other states have population quotas or quantity caps, very few have both of these restrictions in place at the same time.

Population quotas for alcohol retailing licenses ensure that only one license can be granted per several thousand residents in a municipality, based on a formula laid out in state law. There is a quota in place for both on-premise establishments like restaurants, as well as off-premise sellers like grocery and liquor stores.

The result of this limitation is that if a certain region has already met its quota for licenses, then any new retailers hoping to open up are barred from obtaining a license. If an alcohol seller goes out of business, however, that old license can become available on the so-called secondary market.

Since these secondary licenses are often the only chance for a new business to gain the right to sell alcohol, they have become immensely expensive in certain parts of the state. In Boston, bar liquor licenses have sold for north of $450,000. In states where population quotas do not exist, licenses can cost less than $100, underscoring the extent to which Massachusetts unnecessarily saddles its businesses with prohibitive startup costs.

If the government restricts the number of alcohol licences, then this restricts competition in the market for alcohol, and creates some market power for the holders of licences. As you can see in this 2018 post, this would lead to the price of alcohol being higher, but more importantly, the profits of sellers would be higher with the restrictions than if there was more competition. That's why a bar licence in Boston can sell for $450,000, when in other states a similar licence sells for less than $100. The prospective bar owner is willing to pay a premium for the licence, because they know that it grants them market power. They can recoup the cost of the licence through their higher future profits, generated by that market power. The value of that market power is measured by the premium paid for the licence.

Now, if the Massachusetts state government was smart, and wanted to maximise the profits they generate from the sale of alcohol licences, they would require that licences are surrendered to the state when a seller goes out of business. The licence could then be auctioned to the highest bidder. This way, the government would be able to extract nearly all of the monopoly profits from the buyer of the licence, because in theory that is the most that the buyer would be willing to pay for the licence. That the Massachusetts state government doesn't do that, and that licences are instead sold on a secondary market, is interesting in itself.

Also interesting, but not surprising, is that licence holders prefer the current regulations, over an alternative that would increase competition. An industry group represented licence holders has even gone so far as to offer a proposal that:

...cleverly packages a decrease in the most valuable type of license as an increase. Worse yet, the proposal does nothing to address the state's quota restrictions. This means that the overall pool of alcohol licenses would not increase, further condemning the state to its current restrictive system.

This is an example of rent seeking behaviour. The current licence holders are very profitable, so they have a strong incentive to try and protect (or even entrench) their current position, so that they can remain equally (or more) profitable in the future. This is why firms sometimes surprisingly prefer their own industry to be strictly regulated - it keeps out the competition.

Also interesting is that this is also a case where public health advocates might actually agree with the alcohol sellers. As I noted in my 2018 post, having local alcohol monopolies increases the price, and reduces the quantity of alcohol consumed, leading to less alcohol-related harm. This is almost literally the example of 'bootleggers and Baptists', first coined by the economist Bruce Yandle in the 1980s. Yandle noted that government regulations are often supported both by groups that propose the regulation (the Baptists), and by groups that should in theory be harmed but actually profit from the regulation (the bootleggers).

So, market power in alcohol sales may have value in two ways - value for the licence holders (higher profits) and value for public health (lower alcohol-related harm).

[HT: Eric Crampton at Offsetting Behaviour]

Read more:

• Why you might want alcohol sellers to be monopolies

Supermarkets are not natural monopolies, and should NOT be regulated as public utilities

In The Conversation last week, Robert Hamlin (University of Otago) wrote:

The Commerce Commission’s report into New Zealand’s supermarket sector has been criticised for not going far enough to reduce food prices, but the answer to the current duopoly might lie in treating the sector as a public utility instead of a private industry...

This fairer supermarket sector could be achieved if the industry power players were governed as regulated public utilities, much like power and water. But such an approach would need to be legislated and has to combine simplicity with easy and effective enforcement.

To do this, the government should implement some key regulatory principles.

New regulations would need to ensure supermarkets do not engage in wholesale or manufacturing activity. The key to supermarket power is their control of the retail point of sale. If supermarkets are to be regulated as public utilities, then it is essential they are restricted solely to this activity.

The problem with Hamlin's argument is that he equates supermarkets with other utilities like power and water. However, supermarkets and public utilities like power and water differ in two fundamental ways. First, power and water are natural monopolies. They have large up-front costs, and then the marginal costs of production and distribution are fairly low. Natural monopolies are a tricky problem for governments, because as I noted in this earlier post, if the government regulates them such that total welfare is maximised, the natural monopolies make a loss and reduce investment and service quality, and may even shut down entirely. The second-best solution here is to regulate the natural monopoly, but not to such an extent that it makes economic losses. That is essentially what Hamlin is arguing for, when he writes:

As public utilities, individual supermarket sites should only be allowed to charge a single fixed and publicly stated margin on the goods they sell. This is a novel requirement, but it is core to the process of regulating a supermarket as a utility.

Supermarkets act as a middleman between consumers and producers. The mutual ignorance of what is happening on the other side of the retail barrier allows the supermarkets to manipulate consumers and suppliers at will. It is the key process that converts supermarket power to profit.

The requirement that supermarkets must apply a single, publicly posted margin to all the products in their store sets this capacity to zero, and promptly makes the retailer a fully transparent channel for suppliers and consumers.

This 'publicly-posted margin' is essentially what economists refer to as 'cost-plus' regulation. As Eric Crampton noted earlier this week, that solution is totally impractical, because of the second difference between public utilities and supermarkets: supermarkets sell many products. Public utilities typically sell one product, e.g. water, or electricity. That makes it relatively straightforward to impose a 'cost-plus' pricing regulation, since there is only one product to calculate this cost-plus margin for. working out the costs is not straightforward because of the mixed of fixed and variable costs, depreciation and other things. But that process is even more difficult when a firm sells many products. As Crampton wrote:

 A big part of the fight at ComCom was around calculating rates of return. How capital costs get treated matters. How land costs under the supermarkets are counted matters. There are piles of complex lease agreements around those that need to be worked through, and would themselves be endogenous to whatever stupid rule you set to regulate rates of return. 

It isn't straightforward. 

And then this guy wants to run it product-by-product as some kind of mark-up regulation with a fixed mark-up on each good? How's that going to work? Different goods have different turnover. A foot of shelf-space that turns over three times a day pays for itself differently than a foot of shelf-space that turns over once every three days. 

The policing of this kind of thing would be impossible. If you force a single markup on all products based on the price at which the retailer bought it, you force slow-moving goods off the shelves. If you allow some measure of the cost of shelf-space to enter in, you're going to be chasing your tail forever in policing it. It's just so impossibly stupid.

However, it's not just heterogeneity of products that make this proposal unworkable. It's the heterogeneity of supermarkets as well. Public utilities are easy to regulate, because there is few of them (they are natural monopolies, after all). But supermarkets are actually quite diverse. There is about a hundred-fold difference in turnover between a corner dairy and a large urban supermarket. Even within the supermarket category (i.e. excluding dairies), I wouldn't be surprised if there was a fifty-fold difference in turnover between supermarkets in small urban areas like Te Kauwhata and large cities like Hamilton. Should the government impose the same cost-plus regulation on all supermarkets, regardless of size? This could easily make small supermarkets unviable, leaving consumers with less choice and ultimately worse off.

Then, there are the incentive effects. When firms have to worry about their profits and margins, then they have an incentive to keep costs low as it keeps their profits high. However, if a firm has a cost-plus regulation in place, then they can earn the regulated margin regardless of their costs. There is less incentive for keeping costs low. This proposal could easily have the unintended consequence of higher prices for consumers in the long run, more waste and less efficiency in the supermarket sector.

Finally, the supermarket firms are not just retailers, but wholesalers. By itself, this proposal on retail prices would need to be carefully designed. Otherwise, the supermarkets will simply route around it by separating out their wholesale operations into a different business, which sets the wholesale prices, upon which the retail prices (cost-plus wholesale) will be based. Then the supermarket profits will simply back up one step as wholesale, rather than retail, profits. [*] This might be one way that the supermarkets will respond to the Commerce Commission's recommendation that the supermarkets be required to offer wholesale supply to other grocery retailers (see here) anyway.

All in all, regulating supermarkets as public utilities is thoroughly impractical, and possibly counter-productive. The Commerce Commission has made its recommendations. In general, they seem a sensible way of opening the retail grocery market (if not the wholesale market) to more competition. We should see whether those changes work before we open the door to crazy ideas.

*****

[*] This would work for Countdown, which owns all the retail stores, but possibly not so well for Foodstuffs, where the stores are owner-operated. However, I'm sure Foodstuffs could find some way to make a flavour of this work.

The case for waiving patent protection for coronavirus vaccines is weak

The week before last, my ECONS102 class covered intellectual property rights. So, the unfolding story of the US announcing the waiving of patent protection for coronavirus vaccines is timely. As the New Zealand Herald reported:

The United States is throwing its support behind efforts to waive intellectual property protections for Covid-19 vaccines in an effort to speed the end of the pandemic.

US trade representative Katherine Tai announced the Government's position amid World Trade Organisation talks over easing rules to enable more countries to produce more of the life-saving vaccines.

"The Administration believes strongly in intellectual property protections, but in service of ending this pandemic, supports the waiver of those protections for Covid-19 vaccines," Tai said.

But she cautioned that it would take time to reach the required global "consensus" to waive the protections under WTO rules, and US officials said it would not have an immediate effect on the global supply of Covid-19 shots.

The announcement has generated a lot of debate. Before we get to that though, let's review the arguments for and against strong protection of intellectual property rights. The 2018 Nobel Prize winner William Nordhaus outlined the trade-off inherent in intellectual property rights. Strong protection of intellectual property rights provides an incentive for investment in the creation or development of new intellectual property, but this also provides a limited monopoly to the holder of the intellectual property rights (patents are one example, but so are trademarks, which I discussed in this 2018 post). The monopoly that the strong intellectual property rights creates leads to a higher price for the goods or services derived from the intellectual property, and under-consumption (relative to the welfare-maximising quantity of consumption). Weak protection of intellectual property rights allows anyone to make use of the intellectual property, but reduces the incentive to create it in the first place. This is the trade-off: strong protection of intellectual property rights leads to under-consumption, but weak protection leads to under-investment.

By waiving the intellectual property rights on patented coronavirus vaccines, the US would move the needle from strong protection to weak protection. In theory, that would lower the price of vaccines and increase the quantity consumed. However, that assumes that the pharmaceutical firms are deriving monopoly profits from the vaccines. Despite Pfizer reportedly making billions of dollars from vaccine sales, and no doubt the other pharmaceutical firms are doing likewise, are they really profit maximising here? Remember that coronavirus vaccine sales are being made in response to advance market commitments - governments lined up to guarantee future vaccine purchases at an agreed price before any vaccine had even been approved. Although the pharmaceutical firms had a lot of market power, it seems unlikely that they were really exploiting that power in the face of a high degree of public scrutiny (they're not all being run by Martin Shkreli, after all).

However, as most commentators on the announcement have noted, the assumption that pharmaceutical firms are restricting the supply of vaccines in order to raise the price (which is what a monopoly firm would do in order to maximise profits) doesn't stand up to scrutiny. As Alex Tabarrok noted:

Patents are not the problem. All of the vaccine manufacturers are trying to increase supply as quickly as possible. Billions of doses are being produced–more than ever before in the history of the world. Licenses are widely available. AstraZeneca have licensed their vaccine for production with manufactures around the world, including in India, Brazil, Mexico, Argentina, China and South Africa. J&J’s vaccine has been licensed for production by multiple firms in the United States as well as with firms in Spain, South Africa and France. Sputnik has been licensed for production by firms in India, China, South Korea, Brazil and pending EMA approval with firms in Germany and France. Sinopharm has been licensed in the UAE, Egypt and Bangladesh. Novavax has licensed its vaccine for production in South Korea, India, and Japan and it is desperate to find other licensees...

That doesn't sound like firms that are trying to restrict supply. At least, that's the outward impression one gets. The vaccine supply chain is complicated, and has lots of moving parts. Derek Lowe has written about where the bottlenecks in the vaccine supply chain really are. He is worth quoting at length:

I’ve gone over these other problems before, but here’s a brief summary of those – not in any order, because it’s difficult to rank them and those ranks change. An obvious first problem is hardware: you need specific sorts of cell culture tanks for the adenovirus vaccines, and the right kind of filtration apparatus for both the mRNA and adenovirus ones. You also need specialized mixing equipment for the formation of the mRNA lipid nanoparticles. A good proportion of the world’s supply of such hardware is already producing the vaccines, to the best of my knowledge. Second, you need some key consumable equipment to go along with the hardware. Cell culture bags have been a limiting step for the Novavax subunit vaccine, as have the actual filtration membranes needed for it and others. These are not in short supply because of patents, and waiving vaccine patents will not make them appear. Third, you need some key reagents. Among others, there’s an “end-capping” enzyme that has been a supply constraint, and there are the lipids needed for the mRNA nanoparticles, for those two vaccines. Those lipids are indeed proprietary, but their synthesis is also subject to physical constraints that have nothing to do with patent rights, such as the availability of the ultimate starting materials. Supplies have been increasing via the tried and true method of offering people money to make more, but switching over equipment and getting the synthesis to work within acceptable QC is not as fast a process as you might imagine. Fourth, for all these processes, there is a shortage of actual people to make the tech transfer work. For most reasonably complicated processes, it helps a great deal to have experienced people come out and troubleshoot, because the number of tiny things that can go wrong is not easy to quantify. Moderna, for one, has said that a limiting factor in their tech-transfer efforts is that they simply do not have enough trained people to go around. And keep in mind that these all have to do with producing a stream of liquid vaccine solution – but you need what the industry calls “fill-and-finish” capacity to deal with it after that. Filling and capping sterile vials for injection is a specialized business and the great majority of large-scale capacity is already being used for the existing vaccines. Time and money will fix that, and has been, but waiving vaccine patents won’t.

Eric Crampton made some related points here. I'm not a huge defender of patents. I talk at length in my ECONS102 class about the problems they generate. But, for once at least, it is likely that patents are not the problem here. Similarly, pharmaceutical firms have a lot to answer for. Unlike their early approach to AIDS drugs though, it doesn't seem like they are the problem either. In fact, for once the pharmaceutical firms may actually be primarily focusing on providing social good (no doubt with a selfish eye on the good publicity that comes from being a successful vaccine manufacturer that 'saved the world').

We should also be considering the long-term incentives here. If governments squash intellectual property rights early following this pandemic, then that reduces the incentive for pharmaceutical firms to generate vaccines in the advent of future pandemics (remember the trade-off between strong protection and weak protection of intellectual property). If governments are intent on this path, then they really need to consider some alternative way of maintaining the incentive to innovate. Perhaps creating a fund like the Health Impact Fund, but for contingencies such as future pandemics. The WHO (or some other body) could administer the fund, which would be built up by contributions from governments. In the advent of a pandemic, pharmaceutical firms could be paid out of the fund, in exchange for making their vaccines available in the public domain. The challenge of course is determining the right amount to pay out of the fund. Perhaps the fund could be combined with a predetermined advance market commitment that would apply to any pandemic. It's a difficult question, with many aspects to be worked through, but definitely worth considering.

[Update:] The Economist also raises some good points (which I have also seen elsewhere):

We believe that Mr Biden is wrong. A waiver may signal that his administration cares about the world, but it is at best an empty gesture and at worst a cynical one.

A waiver will do nothing to fill the urgent shortfall of doses in 2021. The head of the World Trade Organisation, the forum where it will be thrashed out, warns there may be no vote until December. Technology transfer would take six months or so to complete even if it started today. With the new mrna vaccines made by Pfizer and Moderna, it may take longer. Supposing the tech transfer was faster than that, experienced vaccine-makers would be unavailable for hire and makers could not obtain inputs from suppliers whose order books are already bursting. Pfizer’s vaccine requires 280 inputs from suppliers in 19 countries. No firm can recreate that in a hurry.

In any case, vaccine-makers do not appear to be hoarding their technology—otherwise output would not be increasing so fast. They have struck 214 technology-transfer agreements, an unprecedented number. They are not price-gouging: money is not the constraint on vaccination. Poor countries are not being priced out of the market: their vaccines are coming through covax, a global distribution scheme funded by donors.

Splitting Kiwirail into two entities makes sense

Every year it seems, Kiwirail is in the news for the losses that it makes. However, that need not be a bad thing, as I wrote in this 2014 post:

Having the natural monopoly make a loss (and this is an economic loss, so it includes opportunity costs, and would be greater than any accounting loss) may be a good thing because it increases total welfare. However, relative to profit maximisation, it entails a transfer of welfare from taxpayers (who ultimately end up paying the loss) to consumers of rail services (and ultimately, to consumers of stuff that is transported by rail).

It was interesting to see Kiwirail in the news this week for something slightly different, as the NBR reported (gated):

A proposal to split KiwiRail into two is still on the table but is not a pressing priority for the government.

Treasury made the suggestion in late 2017 after the Auditor-General’s office had raised concerns about the state-owned rail company’s financial reporting...

Under the specific proposal put forward by the Treasury in late 2017 and early 2018, one entity would be responsible for the tracks and be publicly funded, while the other would have a commercial State-owned enterprise responsible for all the above rail services. The SOE might get some government money but largely would be expected to fund its capital investment itself.

In a paper dated February 2018, and obtained by NBR under the Official Information Act, the Treasury said KiwiRail had an uncomfortable mix of profit-oriented assets and services and public-benefit oriented assets and services.

“This mix distorts KiwiRail’s investment decisions, operating and financial performance, and the Crown’s funding model and level of influence and control,” it said.

The Treasury said the “above rail” aspects of KiwiRail – its locomotives, rolling stock, ferries and commercial work with customers – were profit oriented and properly belonged in an SOE. But the “below rail” network assets – the rails, rail formation, bridges, tunnels, signalling and power infrastructure – were public benefit infrastructure.

The key problem with Kiwirail is, as I noted in that earlier post, that Kiwirail is a natural monopoly. It has a very large up-front (fixed) cost of production, which is the cost of the rail infrastructure, and the marginal costs (the cost of transporting an additional unit of freight) are very low. A privately-owned natural monopoly would profit-maximise, decreasing the quantity of its services and raising the price. A government-owned natural monopoly could do that too, but if government wanted to increase economic welfare, it would prefer the monopoly to set a lower price. And if it sets the price at the welfare-maximising level, the natural monopoly makes a loss (see my 2014 post for details).

Treasury's proposal is to split Kiwirail into two entities. The natural monopoly would remain a government-controlled public-benefit entity, in charge of the infrastructure. The for-profit entity would run its services on the lines owned by the public-benefit entity. The infrastructure could then be government-funded using a pure subsidy, like roads. The for-profit entity would (presumably) no longer make a loss, and look a lot better for the government (controlling the loss-making Kiwirail is not a good look, which is why it is in the media every year).

The parallel with the funding of roads is important here. Separating the infrastructure funding from the operators using that infrastructure seems to me to be an improvement. It would make the funding applied to rail infrastructure wholly transparent to the taxpayer, and allow us to have a better sense of the relative government spending on roads and rail. With the infrastructure coordinated centrally and separately from the commercial rail services, rail services could be opened to competition, with other rail service companies allowed to use the same rail lines (with signalling and scheduling handled through some centralised process). That could lower the costs of rail services further, and allow allegedly 'uneconomic' lines like the rail line from Gisborne to the Hawkes Bay to attract alternative providers if they can be made profitable. Competition could be good for rail passengers as well, with potentially lower fares and more on-time services. Although, care would need to be taken that we don't simply swap one set of problems for another, such as we are seeing with Wellington buses at the moment.

There are also parallels with how airports are run. They aren't owned by the airlines that use the airport infrastructure. Presumably the public-benefit entity will receive fees from Kiwirail (and any other rail service operators on the network), but it could also develop the stations and receive commercial rents from retail firms, hospitality, and so on. This could reduce the subsidy required from the government, and if successful enough, perhaps no subsidy would even be required (although I think this unlikely).

Finally, it would be interesting to know if Treasury has similar views about other state-owned or privately-owned natural monopolies. We have Transpower, which runs electricity transmission lines on a similar model. But what about telecommunications infrastructure? Or water supply infrastructure? In each case public or private firms could deliver services over those networks, paying a fee to a public-benefit entity for the use of the infrastructure under their control. Given the recently compounding issues with Wellington's water infrastructure, an alternative model is definitely worth considering. But first, Kiwirail.

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 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. [*]

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.

The Financial Markets Authority doesn't understand basic barriers to entry

Market power is the ability of a seller (or sometimes a buyer) to have some control over the price. At one extreme, a seller in a perfectly competitive market has no market power at all, because there are so many other sellers all selling the same good or service, that the firm couldn't raise its price without losing all of its customers. At the other extreme, a monopoly has a high degree of market power, because the consumers have no other options buy to buy from the monopoly firm, if they really want the good or service. The monopoly firm can raise its price up to the point where it is maximising profits - a much higher price than the perfectly competitive firm would receive.

Sellers can get market power in various ways. One is to sell a differentiated good or service - something that the consumers perceive as different from other goods or services. That leads to a market that we refer to as monopolistically competitive, and the sellers in that market will have a small amount of market power.

To get a lot of market power, the seller would want to be a monopoly - the sole seller of its good or service, which has no close substitutes. To become (and remain) a monopoly, there needs to be some barriers to entry into the market, that prevent other firms from entering the market and competing. If there are no barriers to entry into the market, then a highly profitable monopoly seller would find that other firms enter their market and sell in competition with them, driving the price (and the seller's profits) down.

Barriers to entry can arise in various ways, one of which is where the government grants a firm an exclusive right to sell the good or service. Patents are a good example of this type of barrier to entry. The existence of a patent means that only the patent holding firm can sell the patented good, and other firms can't compete by selling the same product (although, they might sell similar products).

Another way that the government can create a barrier to entry is through occupational licensing. There are some occupations (dentists, doctors, nurses, teachers, etc.) where you have to be licensed in order to operate (literally, in the case of surgeons). While this doesn't create a monopoly, it does grant some degree of market power to those who have licences, because it prevents unlicensed people from entering the market. Unlicensed doctors or dentists would face stiff penalties for offering their services without a licence.

So, part of this article (probably gated) from the National Business Review yesterday struck me as surprising:

A KiwiSaver provider is concerned the new licensing regime for financial advice will reduce the number of advisers and therefore make it harder for people to access those services, as has been seen in other countries.

But the Financial Markets Authority said there is no indication the changes have, or will, result in a reduction in advisers, with the sector “fully embracing” the changes.

On Monday, a new licensing regime went live requiring anyone who gives regulated financial advice to retail clients to either hold, or operate under, a Financial Advice Provider licence.

Just because there has been no immediate effect on the number of financial advisors, it doesn't mean that there won't be fewer of them long term. The new rules have created a barrier to entry into the financial advisor market, because advisors must now be licensed. Whatever the merits of the licensing regime, it is highly likely that the result is fewer financial advisors, charging higher fees for their advice.

Financial advisors is one occupation where licensing might provide a net benefit for society. Clients don't engage with their advisors very often and financial literacy in the general population is not great (e.g. see here), so many clients won't know whether they are getting good advice, or bad advice. And the consequences of getting bad advice, in terms of reduced savings or retirement income, are likely to be quite high (and there are no do-overs). However, not all occupations are like that. For instance, it beggars belief why some countries require licenses for beekeepers, fortune tellers, dog groomers, or librarians. But, in all cases, occupational licenses reduce the number of people working in those occupations, and increase their market power.

The mallpocalpse is here - will mall operators respond?

The demise of the mall has been predicted for years in western countries (it's even been referred to as the 'mallpocalpyse' - see here and here, for example). And despite that, in New Zealand we have seen lots of mall development (for example, see here). However, retail has been decimated by the COVID-19 lockdown, and as the New Zealand Herald reported this week:

...online retail sales are up 350 per cent under Alert Level 3, but overall sales are down by about 80 per cent on average.

As New Zealand comes out of lockdown, and some semblance of normality starts to resume, you might think that retail will bounce back fairly quickly. However, there is good reason to worry, especially for large malls. And that has to do with network externalities.

As I discuss in my ECONS101 paper, malls are an example of a platform market (or a two-sided market). The mall exists as a space where buyers and sellers can meet to exchange goods. The mall doesn't actually sell anything, other than access to this space, for which they charge retailers an annual rent (in theory, the malls could also charge consumers an entry fee, but in practice none do).

The reason that malls attract retailers, and the reason that malls attract consumers, is network externalities. A network externality exists when the value of the good (or service) depends on the number of users. To a retailer, the value of locating in a mall depends on the number of consumers who visit the mall. The more visitors, the more customers will see their products or services on display, and the more sales revenue they will generate. To a consumer, the value of going to the mall depends on the number (and quality) of retailers and other service providers located in the mall. The more retailers and service providers, the greater the value of going to the mall. Both sides of the market produce an externality that affects how much the other side of the market values the mall. The consumers visiting the mall (and spending their money) creates value for the retailers, and the retailers create value for the consumers. Everybody wins.

Now, consider our post-COVID-19 recovery. If consumers are reluctant to interact with other people for fear of infection risk, the mall is one of the last places they are going to want to go. If you're anxious about visiting the supermarket, then the mall is really going to freak you out. Even those who are not overly cautious might opt for online purchases, which have been forced on us in recent times, but which many people have become habituated to (if they weren't already).

Fewer consumers visiting malls means that the value to retailers of locating in the malls reduces. If the malls don't reduce rents in response, then some retailers may opt to close down (if they haven't already). That simply exacerbates the number of closed retailers, by building on the numbers that did not survive the lockdown.

Fewer retailers in the malls reduces the value of going to the malls to consumers, so on top of any anxiety, fewer consumers will see the value in going to the mall. Can you see that all this is creating a death spiral for malls?

The only way that this can be avoided (or at the least, delayed), is by keeping the mall retailers open for long enough that mall visitor numbers recover, and the network externalities start moving in the right direction again. Mall owners have a vested interest in this outcome, of course. Will they realise that one of the few things that they can do is to lower rents to their retailers, to keep them operating through the lean times? Watch this space.