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2:12 pm, July 25th, 2009 - 89 comments
Categories: assets, bill english, economy, privatisation - Tags:
Bill English says he doesn’t much care whether monopolies or businesses with monopolistic power are owned by private companies or the Government does. He doesn’t care whether power companies are publicly or privately owned because he thinks he can make the electricity sector competitive. He’s dreaming like he was in the 1990s.
Monopolies are a fact of life in any economy. Some sectors are ‘natural monopolies’ – railway networks, electricity, to a lesser extent land-based telecommunications, airports, seas ports, roads, public transport- basically things that require huge capital investment and provide a low-cost commodity-type service create an unassailable barrier to entry into the market for potential competitors (that’s nothing controversial, it’s 5th form economics).
English seems to think he can convert the natural monopoly of electricity into a competitive market. Well, we’re still living with the consequences of the last time he and his mates tried that by splitting up ECNZ and selling Contact. The result has been the creation of an oligoploy of companies that still exercise considerable monopolistic power leading to underinvestment, misplaced investment, prices that are too high, service that is too unreliable, and the stupidity of companies (most of them owned by the government) spending millions on advertising trying to sell exactly the same electricity to you.
Now, monopolies and quasi-monopolies or oligopolies (like the power cos) do have a lot of power in their market and that’s not good. They can charge ‘super-profits’, make more money than they could under normal supply and demand, because consumers have nowhere else to go. Given their power and the fact that monopolies sometimes make sense, who should own them? The public, of course. Only public ownership can ensure that any super-profits that are made are not ultimately lost to the consumer but are returned via government spending on public services which benefit the consumer.
Why would we want to sell monopolies off to (inevitably foreign) owners? They would be relatively unrestrained by government policy, the profits would flow offshore, they would not have the incentive to provide a reliable and effective service or make investment. The history of selling monopolies (think Telecom, NZRail etc) is they asset strip, they put up prices, they fail to invest, and pretty soon we’ve lost far more money offshore than we made from the sale.
English might be hoping some pixie dust will turn up that will turn natural monopolies into competitive markets but it’s not going to happen. That being the case, those monopolies must stay in public ownership.
Its nice to see the media during a recession focus the work/life balance for Key ignoring the real people struggling to get by who have been made redundant.. Nice one stuff..
You deride “the creation of an oligoploy of companies that still exercise considerable monopolistic power leading to underinvestment, misplaced investment, prices that are too high, service that is too unreliable…” and admit that all these companies are owned by the government…
and then demand that they stay in public ownership? Doesn’t appear to make much sense.
Electricity transmission is a natural monopoly. That’s why Transpower is regulated by both the Electricity Commission (which approves transmission upgrades, so we don’t pay too much for stuff that is unnecessary) and the Commerce Commission (which sets the price band that Transpower can charge to pay its capital outlay). Over the next few years Transpower won’t even pay a dividend to the government because it’s been told to reinvest all profits (small as they are anyway) in new investment.
So is electricity distribution. That’s why lines companies are again price controlled by the Commerce Commission.
Electricity generation and retail are not natural monopolies. Consumers cannot switch transmission companies (there’s only one set of lines and one company) but they can switch retailers – and they do. The wholesale and retail markets are not perfect. No market is.
But nobody has come up with a better way. A wholesale market ensures that least cost new generation is built only when it is needed (as opposed to massive overbuild and massive expense under ECNZ and its predecessors). There IS competition in the retail market – look at Mercury recently competing hard on price down south against Contact, who have lost thousands of customers, and are paying people up to $200 to win them back.
fully government owned and no pretense to make a profit – it’s a much better way and what we used to have before we decided that everything needed to make a profit.
that might work under a govt. of the left? but what about a right wing govt.? Say they didn’t privatise, they’d just run the service as cheaply as possible so they wern’t seen to be making money, or they’d spend too much on it. I believe in public ownership of natural monopolies as making better economic sense, but you’re also entrusting our natural monopolies to political whim.
The other example you ignore is Contact, which is privately owned. Are they relatively unrestrained by government policy? How?
Do they not provide a reliable service (compared to, say, Genesis – think recent problems- or Mighty River Power – think Muliaga family…)
They don’t have an incentive to make investment? Well, Contact has literally billions of new generation on its booked, lined up to be built over the next few years….
As for profits flowing offshore, this is just economic illiteracy. Contact makes money in New Zealand dollars. New Zealand dollars that flow offshore can’t be spent offshore – the money has to be spent in New Zealand.
“As for profits flowing offshore, this is just economic illiteracy. Contact makes money in New Zealand dollars. New Zealand dollars that flow offshore can’t be spent offshore the money has to be spent in New Zealand.”
Are you saying that profits earned in NZ and repatriated off shore are a neutral factor in terms of our balance of payments?
That’s what they’re tying to say – yes.
It’s funny, while at Uni I had a professor of economics tell me that the smaller economy may be worse off (they are, he put up a chart proving it) due to foreign investment but the world economy would be better off. He really couldn’t understand that the smaller economy would still be worse off. Yeah, it’s colloquially known as the “trickle down” effect.
PS. It’s a rule of thumb of foreign investment: larger economies invest in smaller ones and not the other way around simply because the smaller economy can’t afford to invest in the larger.
NZ’s deeply unfavourable current account deficit is almost entirely due to our massively negative ‘Net International Investment Position’. (About $180b).
This is the main reason why NZ interest rates are so high compared with the rest of the world.
Yes. Simply because everything in the BoP is neutral in that for every debt there must be a credit. The BoP sums to zero.
It sums to zero yes. But that’s not the same as saying that profits repatriated aren’t ‘flowing offshore’, or that every item is neutral. FFS. If there’s a negative, there must be a positive somewhere, but that doesn’t make negatives or positives ‘neutral’.
If those profits weren’t flowing offshore, would our BOP position change, all other things being equal?
I have to share PB’s exasperation here. In general the excessive flow of ‘negative investment income’ (ie profits and interest) out of NZ is balanced by overseas investors placing short-term cash into the country because we have such high interest rates. Which in turn creates a future liability to pay yet more interest; a compounding process that ultimately leads to the total interest liability exceeding our ability to pay, and the country defaults on it’s total overseas debt. At that point the value of the NZD crashes dramatically and the country is plunged into a crisis. While all along the BoP remains ‘neutral’.
Or are you telling us that because the BoP is ‘neutral’ we can rack up as much external debt as we like with impunity?
I struggling to grasp what you mean by such an anodyne claim that “The BoP sums to zero.”. Well so does a company’s annual balance sheet, but that fact alone tells you nothing about whether the company is profitable, or about to be bankrupted. It’s the nature of the line items that counts.
I’ve always like this one from Noam Chomski: “Privatisation does not mean you take a public institution and give it to some nice person. It means you take a public institution and give it to an unaccountable tyranny.”
Anti Spam: necessities.
Perhaps it’s trying to tell us something. LOL.
You’re arguing the experiment in partial privatisation and attempting to create a market in among the generator/retailers has worked? No it’s been a disaster.
They should have acknowledged that the market is a natural monopoly, should have continued running it as such, and kept it all in public hands.
And it is a natural monoploy. There have been no private entrants into the market – except tiny Nova gas – all the players are just articifical government creations. That shows there is no real market, just a poor attempt to create one using privatisation pixie dust.
Natural monopolies are determined by the natural of their cost functions, ie they are subadditive, not by the amount of entry or exit. I don’t see why power production need be a natural monopoly, natural oligopoly may be. But that’s as far as it goes.
Lol. It IS in public hands – Meridian, Genesis, etc are all owned by the government!
You haven’t engaged with the points I have made.
Trustpower entered the market as well – and they are a fairly big player. So wrong on that too.
if it quacks like a duck it’s still an oligopoly
The idea that competition is a healthy thing when it comes to the provision of an essential service is a fallacy. The imposition of the artificial landscape within the New Zealand electricity sector has impoverished the nation and filled the coffers of foreign-owned multinationals. Who can forget that National Inc’s smirking Minster of Energy, one Max Bradford, and his comment that his artifice would lead to reduced electricity prices? Its a flashing neon warning sign to New Zealanders when we see the same players playing the same game nearly twenty years later. And its to the country’s shame that we let them get away with it.
The only reorganisation needed in the electricity sector is the dismantling of the contrived “retail” sector, the consolidation of the industry into one, government owned body that supplies electricity at cost plus, say, 30 percent, smoothed out so that all New Zealanders pay the same amount. Business can pay another 10 percent on top of that..
We need the ability to sell home generated electricity to the grid
It is not in power generators interest to let that happen it is also not in their interest to preach power conservation as they obviously make money out of selling power.
We are a small country that had one of the most efficient generation/supply situations in the world Bradford came along and fucked it up
Won’t these Tory fuckers ever learn ?
Genesis have a system of rewards: the more you use, the more ‘brownie points’ you get. And we own the company!!
And home generation won’t solve the problem of highest prices for the poorest people…unless somebody wants to supply the poor with the tools to home generate. It would help the middle class I guess.
OK I can hear the screams.
You are simply parroting rightwing (and some leftwing) trash.
Surely the test of an operation is whether or not it works, and surely if it works, profits are an integral result.
Clearly the electricity farce is not working, despite the rorting of approx $700billion from consumers.
It is not true to say that people have choices and can move from supplier to supplier. In many parts of the country (I live in one of them) there is NO choice, and it is unreal what the companies do in such places.
Hopefully when some of you guys grow up you will learn that there is a difference between practice and theory, and maybe you will also learn from experience. And the world didn’t begin in the 1970s or ’80s.
This is in no form a personal attack. It’s a simple statement of a lot of years of observation and experience.
But I suppose you all have to reinvent the wheel
Lol. It IS in public hands Meridian, Genesis, etc are all owned by the government!
While this is true in one sense, it is also true that they are SOE’s who are required by statute to act as if they were private companies.
For many, many decades the electricity system in this country was run as a public service, wholly owned by the Govt, designed and operated by engineers for the wider benefit of the community. Worked perfectly well, NZ had some of the lowest cost electricity in the world. If it had been allowed to develop naturally as a single organic whole, we would have been gaining real synergies from the application of advanced automation technologies that have come on stream in the last decade.
Instead it’s all cut up into little bits that play games with each other.
And those games add about 100% to the total cost.
Home generation though would help ease some expected supply problems it is generally clean energy and the ability to sell back to the grid ones excess power would be a great incentive I take your point about benefiting the middle class but it would help small scale community generation projects
No argument from me. Just pointing out anomolies; that’s all…as usual <:-)
Competition is inherently more expensive than monopolies. This is ok for some things where substitution can take place and the competition can bring some benefit. Electricity (and telecommunications, and hospitals, etc) isn’t one of them. You need electricity and there’s only one type.
The supposed dead weight loss that monopolies bring are actually brought about by people trying to maximize profit. This has been proved (google Steve Keen, economist). As the government doesn’t need to make a profit that dead weight loss doesn’t exist. The best solution is a part subsidy from the government (taxes) and the rest paid at an individual level. The part paid at an individual level is to remind people that there is a cost and that it’s not free.
Monopolies are actually more efficient than competition due to several factors: Economies of scale and having only to deal with itself and the customer (rather than several independent competitors and the customer) being the most notable. Bill English can’t make the electricity “market” more competitive and cheaper simply because making it more competitive will make it cost more and, on top of that, it will also have the dead weight loss of profit.
Bill English is, quite frankly, talking from the POV of delusional ideology.
The link you may have been thinking of.
You’re absolutely right. In this paper Keen blows the deregulation/privatisation idea right out of the water.
“The supposed dead weight loss that monopolies bring are actually brought about by people trying to maximize profit. This has been proved (google Steve Keen, economist). As the government doesn’t need to make a profit that dead weight loss doesn’t exist.”
I know I’m only an economist but the statement above is just plan wrong.
The reason, as we explain to every stage 1 class, for a deadweight loss is that output is below the perfectly competitive level of output. The reason for output being below this level doesn’t matter. Whether the firm is maximizing profits or not there will still be a deadweight loss. For example assume that the perfectly competitive level of output is 10, the monopoly level of output is 5. The any level of output between 5 and 10 will not maximise profits for the monopolist but will result in a deadweight loss. So not maximising profits does not mean no deadweight loss. What results in no deadweight loss is producing the perfectly competitive level of output.
Note also that both monopolists and competitive firms maximise profits. But only one results in a deadweight loss.
Oh read the whole paper before cherry picking the bits that don’t fit with your preconceived notions.
He is just plain wrong in what he said. That’s not cherry picking, that just making a very simple but important point.
You have not had time to do anything more than skim read the paper. You’ve taken one para that conflicts with your existing ideas … and rejected the entire thing.
No I have just pointed out that the argument I quoted is wrong. Please note I have said nothing about the bits I did not quote thus how can you logically get to the conclusion that I have “rejected the entire thing”?
His argument is still wrong.
RL, you might want to defer to a practising economist on the definition of a deadweight loss. Paul Walker wasn’t stating an ideological position, unless you believe that all orthodox economic theory is right-wing.
How’s the joke go?
How do you get 200 hundred answers to a single question? Ask 100 economists.
I’m going to send a copy of this thread to steven keen and see if he wants to explain his understanding of the monopoly situation. hopefully he replies!
Point me at a perfectly competitive economy.
Draco. A longer response to your comment is available here.
“Bill English is, quite frankly, talking from the POV of delusional ideology.’
is that the same as talking out of his arse?
It could be, yes. Although I tend to think that if he was talking out his arse the result would at least be cleaner and biodegradable.
Marty. For future reference, what your 5th form economics didn’t tell you is that the actual definition of a natural monopoly is an industry (firm) which has a subadditive cost function. This is, c(x+y)<=c(x)+c(y). It is this that results in the fact that the most efficient form of production is to have a single firm doing all the production. But as to the actual outcome in the market you should consider ideas like, for example, contestability, auctioning of a monopoly franchise or intermodal competition. Regulation of even a natural monopoly may not be needed. Sometimes going beyond 5th form is useful.
grow the fuck up Paul. I’m describing the situation of a typical natural monopoly for a general audience in a few words.
1. A fundamental feature of a contestable market is low barriers to entry and exit. In a market with very high capital costs like electricity and high barrier to entry, notion of contestability is not applicable.
2. In markets where the lifetime of assets like power stations, substations and transmission lines is much longer than any plausible periodic ‘franchise auction cycle’, creates a massive incentive to undermaintain assets. Again not usefully applicable to the electricity market.
3. Intermodal competition. Fancy notion, but again what exactly what alternative ‘mode’ do you have in mind?
Actually thinking about this some more, I’m not sure power production is a natural monopoly. Natural oligopoly may be, but not natural monopoly. But I haven’t seen any studies on the cost structures of electricity production. Do you know of any?
Here’s two: one nuclear and the other Green .
Yeah, you’ll notice I use the terms monoploy, monopolistic, oligopoly. I’m using monoploy as shorthand for monopolies and quasi-monopolistic markets. Because this isn’t an economics essay, it’s a few hundred words for a general audience on the fact that there are markes were real competition can’t be achieved and that privatisation in those markets simply means the privatisation of super-profits.
Again I refer you to Steve Keen. Competition is more expensive than a monopoly and people need to be aware of that.
1) What do you think the statement “Competition is more expensive than a monopoly” means. Seriously I can’t see it has any economic meaning. The cost structure of monopolies and competitive firms could be the same. In fact in the standard graph we use to show the difference between the output levels of monopolies and competitive firms, the cost curves are exactly the same. What differs is the level of output each produces.
2) Your argument that I quoted is still wrong. Even Keen would tell you that.
1.) It uses up more actual resources – something that economists seem to think irrelevant.
2.) Reality disagrees with you and, as Keen has the proof that what I said was right, I’m pretty sure he’d agree with me.
I will take a guess and say you are talking about the use of inputs. As perfect competition and monopolies produce different levels of outputs, that they use different levels of inputs is not surprising. Competitive firms will use, in total, more inputs than a monopolist because they produce more output.
And your discussion of deadweight loss is just wrong.
Perfect competition wouldn’t as any competition that exceeded the costs of any of the other competition would be immediately removed from the market as it would no longer be able to compete. What you describe is imperfect competition which is what you find in the real world.
And my description of dead weight loss is spot on – it is profit.
“Perfect competition wouldn’t as any competition that exceeded the costs of any of the other competition would be immediately removed from the market as it would no longer be able to compete.”
The result of this is that all firms in the market will have basically the same cost structure. This is what is assumed in perfect competition.
Have a good wank, did you Paul? Now, with all that mighty convolutin’ learnin’ in your inflated noggin (and with apologies to Finlay McDonald), here’s one for you:
About what I’d expect.
Ideology or evidence? We report, you decide.
The empirical evidence shows us that private ownership is by and large superior to state ownership, Nellis (“Privatizationâ€”A Summary Assessment”, Center for Global Development Working Paper Number 87 March, 2006.) for example, summaries this evidence as
“The vast majority of economic studies praise privatization’s positive impact at the level of the firm, as well as its positive macroeconomic and welfare contributions. Moreover, contrary to popular conception, privatization has not contributed to maldistribution of income or increased poverty – at least in the best-studied Latin American cases. In sum, the technical picture is generally positive.”
The following comes from the summary of chapter 4, ‘Empirical Evidence on Privatization’s Effectiveness in Nontransition Economies’, from William L. Megginson’s book “The Financial Economics of Privatization”, New York: Oxford University Press, 2005,
“The 87 studies from nontransition economies discussed in this chapter offer at least limited support for the proposition that privatization is associated with improvements in the operating and financial performance of divested firms. Most of these studies offer strong support for this proposition, and only a handful document outright performance declines after privatization. Almost all studies that examine post-privatization changes in output, efficiency, profitability, capital investment spending, and leverage document significant increases in the first four measures and significant declines in leverage.
The studies examined here are far less unanimous regarding the impact of privatization on employment levels in privatized firms. All governments fear that privatization will cause former SOEs to shed workers, and the key question in virtually every case is whether the divested firm’s sales will increase enough after privatization to offset the dramatically higher levels of per-worker productivity. Three studies document significant increases in employment [Galal, Jones, Tandon, and Vogelsang (1992); Megginson, Nash, and van Randenborgh (1994); and Boubakri and Cosset (1998)], but most of the remaining studies document significant-sometimes massive- employment declines. These conflicting results could be due to differences in methodology, sample size and make-up, or omitted factors.
However, it is more likely that the studies reflect real differences in post-privatization employment changes between countries and between industries. In other words, there is no “standard” outcome regarding employment changes.
Perhaps the safest conclusion we can assert is that privatization does not automatically mean employment reductions in divested firms, though this will likely occur unless sales can increase fast enough after divestiture to offset very large productivity gains. Since the empirical studies discussed in this chapter generally document performance improvements after privatization, a natural follow-up question is to ask why performance improves. For utilities, the need to introduce competition and an effective regulatory regime emerges as key, but there is no “silver bullet” answer for what makes privatization successful for firms in competitive industries. As we will discuss in the next chapter, a key determinant of performance improvement in transition economies is bringing in new managers after privatization. No study explicitly documents systematic evidence of this occurring in nontransition economies, but Wolfram (1998) and Cragg and Dyck (1999a,b) show that the compensation and pay-performance sensitivity of managers of privatized U.K. firms increases significantly after divestment. Studies that explicitly address the sources of post-privatization performance improvement using data from multiple nontransition economies tend to find stronger efficiency gains for firms in developing countries, in regulated industries, in firms that restructure operations after privatization, and in countries providing greater amounts of shareholder protection.”
Sunita Kikeri and John Nellis write in their article, An Assessment of Privatization, “The World Bank Research Observer”, vol. 19, no. 1 (Spring 2004)
“This article takes stock of the empirical evidence and shows that in competitive sectors privatization has been a resounding success in improving firm performance. In infrastructure sectors, privatization improves welfare, a broader and crucial objective, when it is accompanied by proper policy and regulatory frameworks.”
Mary M. Shirley and Patrick Walsh write in “Public versus Private Ownership: The Current State of the Debate”, Working Paper, The World Bank,
“Our review found greater ambiguity about ownership in theory than in the empirical literature. In the debate over the effects of competition, theory suggests that ownership may matter and if so, that private firms will outperform SOEs. The empirical studies squarely favor private ownership in competitive markets. Theory’s ambiguity about ownership in monopoly markets seems better justified, since the empirical literature is also less conclusive about the effects of ownership in such markets. Theories that assume a welfare maximizing government suggest that SOEs can correct market failures. In contrast, public choice theories are skeptical of the benevolent government model. Corporate governance theories suggest that even well intentioned governments may not be able to assure that SOE managers do their bidding. The empirical literature favors those skeptical of SOEs as a tool to address market failures. In studies of industrialized countries, where we might expect more developed political markets to motivate greater government concern with welfare maximization or better information and incentives to overcome corporate governance problems, private firms still have an advantage. The private advantage is more pronounced in developing countries, where market failures are more likely.”
You know, Paul, there’s not a bit of hard science in anything you have said. You have couched it in seemingly logical wordiness, and not once have you (apparently) thought about the effects of your presumptions on what you are saying and imparting to our kids, let alone the influence you are having on our childlike politicians.
RL, you might want to defer to a practising economist on the definition of a deadweight loss. Paul Walker wasn’t stating an ideological position, unless you believe that all orthodox economic theory is right-wing.
We’ve crossed our wires somewhat . Paul was specifically refuting a statement by Draco, whereas I’m referring to Keen’s paper that I linked to and Paul appeared to be replying to.
Nonetheless Keen’s paper is highly relevant to this discussion. (And yes I know what the definition of ‘deadweight loss’ is.)
Marty. Check out Sappington and Stiglitz’s “Fundamental Theorem of Privatization”. What it shows is that even with a natural monopoly you can get the result that the outcome with a privatized monopoly and a state-owned monopoly is exactly the same. The government can get a private firm to produce any level of output it wants. Shapiro and Willig and Shleifer and Vishny have similar neutrality theorems.
Seriously I can’t see it has any economic meaning. The cost structure of monopolies and competitive firms could be the same. In fact in the standard graph we use to show the difference between the output levels of monopolies and competitive firms, the cost curves are exactly the same. What differs is the level of output each produces.
This is exactly one of the points Keen addresses.The general situation is that monopolies use larger-scale production facilities while competitive firms
use smaller scale ones. In the electricity industry a monopoly operator has the opportunity to install larger, potentially more efficient units, schedule production and transmission assets with more flexibility, access capital at lower risk and cost, consolidate back-office functions and overheads and so on.
In general I would assert that larger scale operations are more efficient and productive than smaller scale ones.
This is true as long as you have a natural monopoly. It is not true when you don’t. And I’m not sure that electricity production is a natural monopoly. More likely a natural oligopoly. If the minimum efficient scale is small then multiple firms are the most efficient way of producing output.
I don’t know Paul, we seem destined to talk past each other. I’m looking at the industry from an engineer’s POV. As products go electrons are the ultimate commodity, the only differentiators are price and security of supply (a rather secondary consideration for most customers).
From an engineering perspective there are many good reasons why the larger your operation, the more opportunities you have to reduce your average costs. The largest possible operator in this industry, a monopoly, will have the lowest possible cost of production.
Moreover a transmission grid is not only a means of shifting electricity from production to consumer, but is also a means of mitigating the ‘security of supply’ risk. A single monopoly operator can achieve this risk mitigation far more efficiently than does the current operator of the grid (Transpower) who is required to operate a totally artificial ‘market’ governed by an almost insanely complex set of rules. (I’ve seen an overview of them once, for a nation of 4m people, it was a mindboggling document.)
By contrast your POV as an economist, while I am sure is internally consistent and logical to you, seem’s to me disconnected from the industry we are talking about.
The lowest cost producer will be determined by the relationship between demand and the position of the average cost curve. If the demand curve cuts the average cost curve to the left of the minimum of average cost then yes a monopoly will be the lest cost producer. If on the other hand demand cuts to the right of the minimum then it may not be.The further to the right is the demand curve the greater the number of firms in the industry.
That is simply not valid.
Because, when prices go too high, those who cannot afford to buy are forced to drop off the end. They don’t actually disappear. They just tough it out on the fringes–unless of course, they die of cold.
See what I mean about scientific rigour?
Actually read what I wrote. What I was talking about was the least-cost way of producing. That is, how many firms will there be in the industry to achieve the least-cost method of production? Nothing at all was said about the retail price of the good. The retail price will depend on supply and demand. What was being talked about here was just the cost structure that underlie supply.
But note that it is the *least-cost* industry structure that is the concern. That should help make the good or service the most affordable. Any other industry alignment would raise cost and thus lead to the possibility of higher retails prices.
The lowest cost producer of electrons could be you and I. If we had true competition, we would be allowed to use our photo-votaics to pump back into the grid and make some money.
This would save massively on transmission costs.
Of course no private operator with a monopoly of power supply would allow us to do that, would they? That would be too much competition for them.
“From an engineering perspective there are many good reasons why the larger your operation, the more opportunities you have to reduce your average costs. The largest possible operator in this industry, a monopoly, will have the lowest possible cost of production.”
Consider the following very simple example. Average cost is given by 4.x+20/x where x is output. Minimum AC is (I hope!) where x=square root of 5 with AC=8.sqroot(5). If output less than sqroot(5) a monopoly is the least cost producer. Consider however an output of 25 units. Monopoly AC is 100.8 while if we have 5.sqroot(5) firms each producing sqroot(5) units, the AC is only 8.sqroot(5). So multiple firms have lower costs than a monopoly.
Lets deconstruct your formula;
The 4.x term is essentially the marginal cost; ie for every one unit x produced, it has 4 cost units (dollars if you like) associated with it.
The 20/x term represents fixed costs, ie the firm has overheads of 20 units which can be divided by every unit of production to yield the contribution of overheads to average costs.
So our firm produces 1 unit, the total average cost = 4 + 20/4 = $9
If our firm produces 1,000 units the average cost = $4,000 + 20/1000 =$4000.02
In other words in the example you have given is a company who for any realistic level of production has an average cost almost exactly the same as its marginal cost.
Real-world firms, including electricity producers, do not have the cost structures assumed by economic theory, with the result that setting price equal to marginal cost would cause the vast majority of
firms to go bankrupt. There are good practical and theoretical reasons why most products are not produced under conditions of diminishing marginal productivity, so that in practice marginal costs are constant or falling and well below average costs. Keen
In highly capital intensive industries (and most are) the marginal cost is well below the average cost. For hydro geberation the marginal cost of producing one more kwhr may well be zero, whereas the total overheads such as operations, maintenance, finance and return on capital to the owners are by far the dominant items on the company’s balance sheet.
In the water supply industry, the marginal cost of producing 1m3 of potable water at the treatment plant is typically 5 -8 cents, whereas the average wholesale cost that is charged to the consumer is around ten times that…. because fixed costs are by far the dominant item.
Again I would assert that the minimum average cost for complex, capital intensive industries like electricity would be for the largest possible producer. This is not an original thought, some have taken it to it’s logical conclusion.
The total cost function is 4.x^2+20 so marginal costs are 8.x. Given this, marginal costs will be below average costs for all output below sqroot(5) and greater than AC for all output greater than sqroot(5). So no, marginal costs are not the same as average costs.
“[…] so that in practice marginal costs are constant or falling and well below average costs”
This is true in my example for output below sqroot(5). The above condition is just a sufficient condition for a natural monopoly. If MC<AC the cost function will be subadditive. If MCAC, but normally only for a small range of output greater than the point where MC=AC.
The point of my example was just to show that if demand is large relative to the minimum of AC then the natural monopoly conditions are not satisfied and thus having more a one producer is cost minimising.
So the actual number of firms in the industry will be determined by the relationship between costs and demand. Not just costs.
Paul, you are sounding very learned. Didn’t somebody write, ‘a little learnig is a dangerous thing’. Yes the correct quote IS learning. NOT knowledge.
You are extrapolating from extrapolation based on THEORIES. Not science, becausre the maths used by economists are built on sand: simple linear arithmetic which cannot and does not work, and never will work..
The variable is people. You know, 2-legged animals with big skulls.
So many (apparent) economists blogging here, yet not one has justified his maths. I find this unsurprising, because you cannot do the maths (that includes you, paul,, though your formula is mathematically accurate as taken from the textbooks).
But all these maths are based on many assumptions which have been proved faulty…and the more extrapolation anybody makes results in conclusions that are even further from the truth than the original assumptions. Error compounds error exponentially
Its all just a game to Paul – a game where human beings are reduced to unchanging mathematical patterns of behaviour. Resistance is futile.
Its all very dismal and soul destroying, really.
Exactly what Keen says and what I’ve come to understand over the last 8 years I’ve been studying economics.
Draco is correct and Paul Walker has some reading to do.
In a nutshell, the mathematical argument behind the Marshallian argument in favour of competitive firms over monopolies is based on two mathematical fallacies.
The first is the proposition that a competitive firm faces a horizontal demand curve at the market price. The fallacy behind this under the conditions assumed in the Marshallian model was pointed out by George Stigler in 1953 (see PERFECT COMPETITION, HISTORICALLY CONTEMPLATED Vol 65 p. 8 footnote 31), but as usual:
(a) economists don’t refer to papers that contradict their beliefs; and
(b) Stigler, who was a staunch champion of neoclassical economics, believed that he found a way around this conundrum in any case in the argument to which the footnote was made–that though Price does in fact exceed Marginal Revenue for a competitive firm, the equating of Marginal Cost to Marginal Revenue means that Price will converge to Marginal Revenue as the number of firms rises towards infinity.
This argument is perfectly correct, but there’s a twee problem: the behaviour Stigler assumed, of equating Marginal Cost to Marginal Revenue, which economists call “Profit Maximising Behaviour” does not in fact maximise profits.
The actual profit maximising formula is:
MR-MC = (n-1)/n * (P – MC)
where n stands for the number of firms in an industry, and the other terms have the obvious meanings.
I’ve pointed this out in a number of academic papers that are available on my website, including:
(2004). “Deregulator: Judgment Day for Microeconomics’, Utilities Policy, 12: 109 125.
(2006) (with Russell Standish, UNSW) “Profit Maximization, Industry Structure, and Competition: A critique of neoclassical theory’, Physica A 370: 81-85.
The second fallacy is the one relating to comparing the aggregated marginal cost curves of a competitive industry to the marginal cost curve for a monopoly, something which neoclassical economists blithely do in their textbooks without ever asking themselves under which conditions such a correspondence would be true. Mathematically there are two cases where it will apply–where marginal costs are constant and identical, and where marginal cost is a function of the number of firms in an industry in such a fashion that a way that a small firm would actually have a cost advantage over a monopoly if it could produce at the same scale.
As pointed out in one study I cite in that Utilities Policy paper and referred to here, there are good reasons why a monopoly might be expected to have a lower marginal cost function than a number of smaller firms operating in its stead.
The easiest response is to refer you to Matt Nolan’s posting at TVHE: Deadweight loss, debunking, and strawman micro. A second response would be : Auld, M.C., 2002. “Debunking Debunking Economics’. Working Paper, University of Calgary. Available at http://jerry.ss.ucalgary.ca/debunk.pdf.
Gotcha. Pity he’s not a good mathematicion, or if he is , why doesn’t he use his maths as tools based on ethics.
I won’t say what I think should happen to him among a few others. On the other hand…10 years trying to survive on $17.000 a year might give him/them an insight. Gosh! That would be terrible!!! They wouldn’t be able to gamble on the stockmarket> He/they’d have to content themselves with Lotto instead, as long as the kids could go without breakfast for a few days.
Ethics!! C’mon, storm, that is just soooooooooooo last century As far as today’s academics are concerned Ethics is an English County.
(grump) Last century OMG I forgot.
It freaks me out that such people are engaged in teaching our young a flawed and incomplete philosophy and set of maths based on probabilities, likelihoods, and balance of opinion.
It’s not possible to predict the weather with any certainty, yet these people purport to predict the futures of the entire populations of the world. As I said, OMG
And who cares whether a market is natural or not? Surely the way it delivers to consumers is the test. They should be thinking about natural justice rather than natural monopolies. That’s a natural application of Occam’s razor.
With thanks to Steve Keen.
The easiest response is to refer you to Matt Nolan’s posting at TVHE: Deadweight loss, debunking, and strawman micro. A second response would be : Auld, M.C., 2002. “Debunking Debunking Economics”. Working Paper, University of Calgary. Available at http://jerry.ss.ucalgary.ca/debunk.pdf.
Who me? All I did was give you a D for your response to the really important question – I ignored everything you said after that. I suspect you meant to post your reply above here. Typical economist, you were nearly right.
“Who me? All I did was give you a D for your response to the really important question I ignored everything you said after that. I suspect you meant to post your reply above here. Typical economist, you were nearly right.”
You’re right the reply was in wrong place, have reposted. Thanks.
The response to your D would be here.
hehehe – fair nuff.
I wonder if you’ve noted that the LSE’s answer to Her Majesty QEII’s question: “how did all this (i.e., the current global Depression) happen?” was: “hubris, ma’am”. 🙂
As a non economist I’ve learned a lot reading this thread. Wouldn’t it be nice if more discussion on political blogs (this one included!) could be conducted at this kind of level…
My critique of neoclassical pricing theory has been published in Physica A, long after that exchange with Auld. The maths passed the scrutiny of physicists, who leave economists in the dust when it comes to mathematical reasoning.
As usual, neoclassical economists refuse to acknowledge flaws in their own logic, and I’ve long ago given up trying to debate with them. Point blank, the Marshallian theory is mathematically false. I wish I’d get even one neoclassical economist to concede this, but while physicists confirm my maths is correct, neoclassicals refuse to even acknowledge the point.
Furthermore, though the Cournot-Nash is mathematically correct, the Nash equilibrium is meta-unstable: independent competitive behaviour will lead instrumental profit maximisers to diverge from it without collusion. The only way to maintain the equilibrium is to presume competitive firms have “perfect knowledge” of each other’s strategies, which makes a nonsense of the concept of competition to agree with.
Further furthermore, a myriad of empirical studies have found that marginal cost is constant or falling for 89-98% of firms (depending on the survey–see Alan Blinder’s Asking About Prices for the latest such research and Fred Lee’s Post Keynesian Pricing Theory for a comprehensive survey of the other 140 or so studies that have reached the same conclusion.
Neoclassical micro–especially as taught to undergraduates and as forms the basis of competition policy–is empirically irrelevant and intellectually defunct.
Finally, I wrote a post on your blog this morning pointing out the error in Matt’s reply to me which has yet to appear on your blog–any chance of it being posted there???
For those on this blog, what Matt wrote was:
“MR-MC = (n-1)/n * (P – MC)”
As perfect competition assumes “many firms” (read infinite) n-1 converges to n, implying that P=MR.”
This is the formula for an individual firm, not the economy as a whole. The convergence Matt notes applies because the firm output “q” in the MR formula for the single firm (MR(q)=P+q*dP/dQ) must go to zero if the number of firms in an industry goes to infinity.
I have computer simulation models in my paper where I have (say) 100 firms that are instrumental profit maximisers–vary output up or down and change direction if profit goes the wrong way–and those firms collectively converge to the “monopoly” output level rather than the alleged competitive output level.
Perfect competition is and always has been a crock that has stopped economists from actually confronting the real world. Though I despair of ever getting neoclassical economists to realise this, I hope that non-believers can appreciate this and start to ignore the irrelevant theories of neoclassical economists. If you want to read something useful on competition policy, read Michael Porter’s The Competitive Advantage of Nations.
Steve in answer to this bit:
“Finally, I wrote a post on your blog this morning pointing out the error in Matt’s reply to me which has yet to appear on your blogany chance of it being posted there???”
Can you repost? I don’t moderate comments at all, so if it hasn’t turned up then I guess its a technological problem which I can’t fix.
More detailed response to what I think you are saying here.
One more thing, What has your response to do with what I was attracking in the first place: Bastard’s comments:
“As the government doesn’t need to make a profit that dead weight loss doesn’t exist.”
And “Monopolies are actually more efficient than competition due to several factors: Economies of scale and having only to deal with itself and the customer (rather than several independent competitors and the customer) being the most notable.”
And “And my description of dead weight loss is spot on it is profit.”