Energy pricing

 Economics  No Responses »
Feb 192014
 

The last year has seen much discussion about the price of energy. Nuclear plants, wind turbines, fracking, price caps and green subsidies are a staple part of the news and political vocabularies. And as usual with politics, most of the arguments make no sense when you examine the economics.

Externalities

But before I get into that I need to cover an important economic concept, the idea of externalities.

In a perfect free market, competition ensures that the price of an item or service falls to the ‘correct’ price, which is the price of producing it plus the smallest profit margin necessary to persuade the producer to bother. The monetary cost of production is the cost of paying people for their time and skills in building things, digging stuff out of the ground, writing code or whatever. However, there are other potential costs – air pollution from a factory; noise from a mechanics; increased road traffic from delivery lorries. The producer often doesn’t have to pay these costs. If I open a curry house in my living room I don’t have to pay my neighbours compensation for the smell. These costs are called externalities (specifically negative externalities in this case, as it’s also possible to produce positive side-effects you aren’t paid for).

The effect of negative externalities is that goods and services are cheaper than they ‘should’ be. There is an amount of money I could pay my neighbours to appropriately compensate them for the curry smell, thus internalising the externality. My costs are now higher so I have to charge more, and my neighbours are happy. If I can’t make a profit with this extra charge then I should shut down and re-open the business in a location with less picky neighbours.

Schemes exist to account for externalities in many areas. Congestion charging in cities during the day encourages people to drive at night, or pay for the inconvenience they cause. High taxes on cigarettes and alcohol pay the costs of hospitals and police cleaning up the mess (although I assume this isn’t the primary reason for these taxes).

The point is that if all externalities are ‘internalised’, businesses can do anything they want to make a profit, safe in the knowledge that they are paying for any damage they are causing.

Carbon trading

So what does this have to do with the price of energy?

Most of our energy is produced by burning fossil fuels. Burning things produces carbon dioxide which contribute to climate change. Climate change is likely to cause humanity major costs in the future, due to increased extreme weather events, rising sea levels and the like. This is a prime example of a negative externality, unless the future costs of releasing carbon dioxide are included in the price of the energy.

There is an attempt to do just that with the EU Emission Trading Scheme. A limit is set on the amount of carbon that the regulated industries can produce, and the limit is shared between those industries in the form of tradeable emission permits. Businesses that reduce their emissions can sell their permits to high polluters. Highly polluting businesses aren’t a problem in this system – it’s more efficient to pay someone else to reduce emissions than to reduce their own, so goods remain cheap while overall emissions go down. Compare this to the less efficient system of flat caps – cleaner industries get no benefit, and goods from dirty industries get more expensive as they take expensive measures to clean up.

That’s the plan, but unfortunately due to political issues there are too many permits available. In 2008 permits sold for €20/tonne of C02, but in 2013 they could be picked up for €2.81/tonne. One of the major problems of externality charging is working out the correct price that should be paid. The true future cost of climate change is not known, but it seems likely that €2.81/tonne of CO2 is too low, and provides very little incentive to clean up.

Renewables and nuclear

Renewable (and nuclear) energy is more expensive than energy from coal and gas. One of the big arguments the Government has made in favour of fracking for shale gas is that it could reduce energy bills (although they’re playing this down now). This is short-sighted because it doesn’t take into account the externality of climate change.

Cheap fossil fuel energy now is like taking a loan to be paid back with considerable interest in 50+ years. It defers the cost of clean up by many decades. Renewables have little cleanup cost beyond dismantling them at end of life, so almost all costs are included up front. Nuclear has significant cleanup costs for decommissioning and waste storage, but these costs are known and again factored into the up front cost.

Taking loans isn’t always a bad idea. Governments and businesses frequently run up debt. As long as spending the loan produces greater returns than the interest on it then you can still come out ahead. With energy we have two options – take the loan for cheap energy now, or pay everything up front. If the increased economic growth from cheaper energy means it’ll be comparatively cheaper to fix the damage from climate change in the future then it could make economic sense. I’m no expert but personally I doubt that’s the case.

 Government energy schemes

All of this doesn’t change the fact that energy is becoming a real strain on less well off households (and likely to get even more so). In fact I’m making it worse by advocating more expensive bills. Politicians have come up with a few schemes to try to help:

1. Ed Milliband’s price cap. Energy companies may be forced to keep their prices fixed for 20 months. This is plainly a terrible idea. It makes very little difference to people’s wallets and inhibits investment.

2. George Osborne’s lifting of green levies on energy. This does exactly the opposite of what I’m talking about with addressing externalities. Applying additional levies on fossil fuels is a way of ensuring that energy costs the ‘correct’ amount. Removing these levies makes the situation worse.

3. Energy company profits. Ministers have been making noises about increasing competition and reducing profit margins. While more competition is good, this is a bit of a red herring. Average long term profit margins are around 5%, so even if profits were reduced to zero this would have very little effect on total bills.

4. Winter Fuel Payments. The elderly are entitled to an annual payment of £100-£300 to help with fuel bills. This is actually a good policy for a couple of reasons I’ll come to.

So what else would an economist do to try to help?

The ‘correct’ fix

The problem with attempting to reduce energy bills for all is that most people can afford to pay the bills already. It may mean cutting back on some luxuries as bills continue to rise, but as we’re steadily using up all the cheap fuels (North Sea gas, easily accessible oil wells etc) we have to accept that energy is just expensive, and adapt. A better approach is to target those in need specifically, and this is where the Winter Fuel Payment is a good model.

Firstly, it targets a group particularly in need of help – the elderly with low incomes. Targeting help at small groups is cheaper than attempting to help everyone, as the help goes to those who need it.

Secondly, it may actually reduce energy consumption. You could give ‘energy vouchers’ that can be redeemed to pay bills, undoubtably helping that person. Or you could just give cash (which is what actually happens). The recipient can then make more efficient use of the money by spending it on whatever they want. They may just spend it on the bill, and that’s fine. Or they might instead spend it on upgrading their boiler or insulating their home, reducing their usage permanently. It doesn’t matter that it’s not spent directly on energy – the cost of the scheme is the same, but the money can be used more efficiently than the equivalent in vouchers.

Using tax revenue to subsidise energy prices and keep bills low for all (which is what vote-winning energy policies tend to boil down to) is inefficient. Far better to let energy be priced at its correct level and redistribute the savings as cash to those who need it. Then as prices rise, everyone has both the incentive and the opportunity to reduce their own usage.

Unfortunately this kind of approach is a much harder sell, and wins fewer votes, than making vague promises to bring down bills. But I’m pretty sure more long term good would come from rational economics-based energy policy than any of the vote-grabbing gimmicks that are currently being thrown around.

Help to Buy madness

 Economics  No Responses »
Aug 022013
 

[This is a bit more opinionated and political than I would normally post, but I think it’s important. I don’t care which party runs the country as long as it’s run fairly and honestly, according to logic, reason and evidence. Unfortunately that sounds hopelessly naïve. This contents of this post are hardly controversial, but it’s just a part of my small attempt at giving people a greater understanding of the world and enabling them to spot when others aren’t acting according to honesty, reason and evidence.]

I really don’t understand the logic of the Government’s Help to Buy scheme.

In the first part of the scheme, buyers of new homes only need a 5% deposit and can borrow a further 20% of the value of the house from the Government. This portion of the loan is interest-free for five years, after which fees are applied. The homebuyer then only needs to find a 75% mortgage. This can only do damage in the long run. Let’s look at an example:

The normal situation

Alice has a good job. With her deposit and mortgage she has £160,000 to spend on a house. Bob has a reasonable job, and he can spend £140,000 on a house. Chris can only afford to buy a house for £120,000. Two identical new houses have been built – what happens?

In a scarce market where there isn’t enough supply to go around, the price is set at the margin of availability. Bob is going to get a house, and Chris isn’t. Therefore the houses will be sold to Alice and Bob for somewhere between £120,000-140,000. (With a larger example there would be more people willing to pay £121k, £122k etc, so the price would be more finely defined.)

The end result is that two of the three people own a home, and paid not more than £140,000. The Government sees this and thinks it can do better, because Chris still doesn’t have a home. Seeing that Chris was only just priced out of the market (the houses go for slightly more than he can borrow), they decide to offer an extra loan to Chris so he can now afford the £140,000. Let’s see what happens:

With help to buy

Chris gets the additional loan of £30,000 so he can now afford to pay £150,000. Alice can still afford a house. Bob, however, is now set to miss out, so he also takes an extra loan of just over £10,000. Both houses sell to Alice and Bob for just over £150,000.

Then end result is that Alice and Bob still own houses and Chris still doesn’t, but houses now cost at least £150,000. This is obvious from the beginning – if you have two houses and three buyers, only two people can successfully buy, no matter how the money is distributed.

Maybe the problem is actually that there aren’t enough houses? It’s a bold claim, I know. Let’s see what happens:

Building more houses

Assume that these houses cost £120,000 to build. By building one more house, Chris could pay £120,000 and the house builder would still make £20,000 profit. The end result is that Alice, Bob and Chris all have houses, and they paid at most £120,000 for them.

An aside: where does the money go?

House prices are much higher compared to wages than they used to be 10+ years ago. So what is the money paying for? House building is a competitive business and there is no shortage of labourers looking for work, so it’s unlikely that house building are making large profits. And indeed, the construction sector has been struggling recently.

The bottleneck in the housing supply is land for development, due to our strict planning laws. While building a house doesn’t cost a huge amount more than it used to, buying the land does. The increase in cheap mortgage lending by banks enabled this boom in land prices last decade, because people with more money are able to spend more to outbid others for scarce resources (i.e. land for housing).

When you sell a house you realise the increase in the value of your land, but you spend it again on your new house so you’re no better off. Follow this through and it’s apparent that any increase in the money supply to buy new houses goes straight into the pockets of the landowners who sold the land. None of it stays with homeowners or builders.

Part two of the scheme

The potential damage from part one of the Help to Buy scheme is limited by the fact that it only applies to new builds. The price can’t be pushed up too far because you can always buy a cheaper old house instead, for which the money supply hasn’t increased. However, this is set to change.

In January 2014 the mortgage guarantee part of the scheme will launch. In this scheme, buyers will only need a 5% deposit to get a mortgage. Banks like large deposits because in the event of a default, repossession and auction, the sale will bring in more than the outstanding debt. With a small deposit there is a danger that the bank may lose out, so with this scheme the Government guarantees 15% of the mortgage, thus enabling banks to offer ‘safe’ (from their point of view) loans to people with tiny deposits.

What this will do is increase the money supply available to buy all houses, not just new builds. There are still the same number of houses, and there will be even more buyers competing for them than currently. An exercise for the reader: repeat my first example in this case and work out what will happen.

If you said that prices are likely to increase across the board, and no more people will get a house than would have done before (except that they’ll pay more for them), well done.

The wider point

Most of the population have (understandably) very little knowledge or care about economic principles. That shouldn’t be a problem because we should be able to trust that the people making economic policy do understand. Unfortunately it seems that governments exploit this lack of knowledge to pass policy that is actively damaging to the economy but serves political ends. If you can’t afford a home and suddenly you’re offered a cheap extra loan, you’re likely to be pleased and support the policy, even though it’s nonsensical to all economists.

In another example, austerity was heavily sold as being vital for maintaining the UK’s AAA credit rating. We were told that reducing the deficit makes lenders less likely to think that we’ll default, therefore maintaining the AAA rating, therefore keeping interest rates on UK bonds low. This is deliberate misinformation – nobody cares what the credit agencies think (after all they gave AAA ratings to all the subprime mortgage packages that caused the crisis in the first place), and a low risk of default isn’t the primary reason why bonds are cheap. It’s a small part, but the main reason is that our economy has been doing so badly, with such a slow recovery, that even getting a measly 2% for ten years is more attractive than investing the money elsewhere in the economy.

My hope is that we eventually get a critical mass of people, both in the general public and the media, who have a reasonable understanding of economic principles and statistics. Governments will no longer be able to get away with easily-refutable claims, dodgy statistical usage and illogical policies. Only then will we get governance based on what is best for the people of the country, and not damaging policies purely designed to  win votes.

Economic lessons of Eve Online

 Computer games, Economics, Games  4 Responses »
May 142013
 

I’ve been playing Eve Online on and off since 2006. It’s a very complex game with 500000 active accounts, all playing on the same server. What this means is that it has the most interesting economy of any game out there due to the huge number of interacting players, complex supply and manufacturing chains and a complete lack of market regulation.

This makes it a great sandbox for observing economic behaviours and principles from the real world, manifesting in its virtual economy. Here I’ve picked a few interesting or important things that I’ve come across.

Opportunity Cost

This is probably the most basic and misunderstood concept in Eve, so it’s likely misunderstood in real life as well. The opportunity cost of doing something is the price of not being able to do something else instead. For example, you’ll frequently come across advice in game like “mine your own minerals to increase your profit margin on manufacturing.”

Sounds sensible, but it’s completely wrong. Mining minerals may be a worthwhile thing to do, but it doesn’t increase manufacturing profits. They are two independent activities, and should be treated as such. Profit calculations for manufacturing should use the market value of the input materials, and not how much it personally cost you to acquire them. This is because you could have sold your mining output instead of using it. The opportunity cost using your minerals is that you can’t sell them (although there are other reasons why you might want to produce your own inputs, e.g. avoiding transaction taxes, or saving time selling and transporting, or just for fun).

Here’s a real world example. Suppose you need to clean your house, but you also have the option to work some paid overtime. You may think you can save money by doing the cleaning yourself, but if the overtime pays more than the cost of a cleaner then you’re better off working and paying someone else. The opportunity cost of doing your own cleaning is that you can’t be working at the same time.

Emergent market hubs

The design of Eve includes no central trade areas. Anyone is free to sell or buy anything anywhere in the galaxy. What is interesting is that a series of market ‘hubs’ have spontaneously emerged, with one main super-hub in the solar system of Jita. Many years ago, when there were less players and no major markets, some systems with slightly better facilities and connections were more densely populated that others. This meant slightly more market activity in those systems which attracted new players looking for markets, which grew the market even more. The result is a positive feedback loop, with the end result being that if you now want to buy or sell something quickly you go to Jita (or one of the smaller ‘regional hubs’ that grew along the same principles, but to a lesser extent).

There are a few downsides of basing your Eve industrial business in or near a popular hub. One is the rental cost of corporation offices (required for efficiently managing your industrial activities), which are much higher in popular systems. Another is availability of factories – these are limited and you can wait many days for a slot around trade hubs.

There are analogous factors at work in the real world, affecting where people and businesses base themselves. There are bigger markets and trade opportunities for London-based companies, but the rents are huge. Smaller cities have reduced costs at the expense of available markets and potential workforce. Different companies weigh up these factors and choose an appropriate location.

I found some statistics about the populations of the most popular systems in Eve, so I thought I’d compare it to the sizes of the largest UK cities. The results are quite striking:

Normalised populations of the 30 most populous Eve systems and UK cities

Comparing the normalised populations of the top 30 systems and UK cities, you can see a large degree of similarity in the distribution. There is one super-system/city (Jita/London), followed by a few large ones (Amarr/Birmingham, Rens/Manchester, Dodixie/Liverpool), followed by lots of much smaller ones.

The relative proportions are very similar. This suggests that similar price/opportunity trade-offs may be being made in Eve as in the real world, leading to a similar distribution. Eve populations seems to favour the larger hubs while the UK population is spread slightly more evenly, which could be explained by there being stronger non-economic reasons for living in a certain place in the real world than in Eve.

Edit:

Here’s a more technical version of the above graph – log of population against log of rank. You can see they both follow a power law (very high R² value means the linear trend line is a good fit), even though the absolute population numbers in solar systems are very small so are prone to noise (or large passing fleets). The drop off in population is indeed faster in Eve as I mentioned above. Further analysis is left as an exercise to the reader 🙂

Log(population) against Log(rank), with least-squares trend line

Price vs Convenience, and Time Is Money

There are many ways of making money in Eve, and the one thing they have in common is that they take time. Time is the limiting resource of both Eve players and real-world workers. Travel in Eve is also slow, and flying around for fifteen minutes to save a few ISK (the in-game currency) is inefficient, as you’re paying the opportunity cost of not doing something more profitable.

Similarly, coffee shops in busy station charge a huge markup compared to a café you could find ten minutes walk away. It’s inefficient to use your time to save a pound if it takes a sizeable chunk out of your working day.

This inefficiency creates market opportunities. Ammo and other consumables are generally priced much higher outside of trade hubs, leading to higher profits, in the same way as station coffee shops. (Well, actually it’s the people renting the space to the coffee shop that make the profit, but as there is no shop rent in Eve the producer can keep it.)

Profit vs Volume

In an efficient free market it’s possible to either make a large profit per item sold, or to move large volumes of items, but not both. Where large volumes are shifted (trade hubs, busy shopping streets) you will find other businesses in competition and high prices will be undercut. In the ‘convenience’ market described above (backwater systems, small village shops) less people can be bothered to fight for the meagre sales so there is less competition and prices can be higher.

One example is manufacturers who sell their own goods. It is worth putting a few items on sale at the place of production, at inflated prices, to pick up passing trade, but manufacturing ability far outstrips these sales volumes. The bulk of the items will need to be sold at trade hubs where turnover can be huge – a smaller markup per item but higher overall profits.

You can see this with farmers markets and farm shops. Volume is small, but profits per item are much higher. The excess has to be sold to bulk buyers (e.g. supermarkets), but the additional profits from direct sales provide a nice additional income.

Fluid markets from professional traders

In the real world, if you want to buy or sell shares or a commodity then it is nearly always possible to conduct the trade immediately. It doesn’t require waiting for another person who wants to buy exactly the same amount of shares that you’re selling. This is good because it enables more trades to take place quicker, which means more benefits to those trading. The market is said to be fluid.

Fluid markets are enabled by professional traders – if you go to a foreign exchange they will buy currency at slightly below the average price, and sell it at slightly above. Therefore there is always a reasonably priced seller or buyer for your currency. The same principle applies to shares, commodities and other goods. The higher the potential profit (total traded volume multiplied by markup) the more competition will be attracted, and the buy and sell prices will converge.

Professional trading can be seen in action at trade hubs on almost all of the 6000-odd different items available in Eve. You will see buy and sell orders for huge volumes of items that could never be for personal use. High value items like ships attract a lot of competition and will have margins of 5-10% between the highest buy order and the lowest sell order. This means that whenever you want to buy or sell a ship, you can do so immediately with very little financial loss – you’re effectively paying the traders for convenience.

A weakness in the market can be seen by looking at some of the less popular items, where you’ll see 100% or more markup between the buy and sell prices. The volumes just aren’t there to support more competition – bringing the buy and sell prices closer together would mean it’s not worth the bother of trading, given that there are plenty of other things to do in game.

Barrier to entry, monopolies and cartels

An important principle in economics is the barrier to entry to a market. There are two reasons why the profit margin on an item may be high, but only one means you’re being ripped off:

  1. Sales volumes are low, so high margins are required to make it a worthwhile business.
  2. There are high barriers to entry, so it’s hard to compete with existing businesses.

To tell if you’re being taken advantage of, look at how hard it is to set up a competing business. If it’s easy then you’re probably not being ripped off and it’s just hard to make a profit. There are lots of examples of barriers to entry, from government restrictions (e.g. pre-privatisation utilities), to long professional training requirements (lawyers, doctors), to prohibitive startup costs (building a supermarket).

You can see these in operation in Eve. One interesting development was the creation of OTEC – the Organisation of Technetium Exporting Corporations – founded on the same principles as the more familiar OPEC. Technetium is a vital component in the manufacturing chain of many items in Eve, and is only found in one area the galaxy under the control of a small number of corporations. The barrier to entry here is nearly absolute – getting into the market would require overwhelming military force and months of warfare. Hence it was practical to set up a price fixing cartel and reap the resulting massive profits.

Another historical example was the breaking of the monopoly on Tech2 goods (these are better ships and weapons than the standard ones). Originally, the ability to manufacture these goods was distributed via lottery to a few lucky individuals. The one I’m most familiar with is the Damage Control II component, where I made most of my ISK.

With no competition, the first of these things were selling at 200+ million ISK each.  After a couple of years a game mechanic called Invention was introduced which allowed anyone to make them,  but less efficiently and with a significant up-front investment required for tools, skills and materials (in the order of 500 million ISK, and several weeks of in game training time). When I jumped in, prices had dropped to around 2 million ISK/unit, with about 60% of that as profit.

Over the next few months the initial investment price dropped and now it’s possible to enter the market with a few tens of millions. Profits are right down to something like 300,000 ISK/unit, and it’s approaching the “worth it” line where I need to decide whether it’s worth carrying on production.

Thus enabling competition has successfully brought the cost of a good right down to theoretical minimum of the cost of production plus the minimum profit required to make people bother. Economics in action!