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Setting prices

• Evan Davis | Vital Statistics |
• 8 Jan 08, 03:41 PM

What determines a price in a market?

Competition? Regulation? The whims of politicians? Illegal collusion between suppliers?

Looking through history, you'll find examples of all four playing a part in setting the price that consumers pay.

But these days we tend to think competition is the best of the lot.

And as a result, for gas and electricity, we introduced it. We got the regulator out of price-setting, we left politicians to do other things. And we have strict laws against cartels and collusion.

For several years it gave us low energy prices and we never complained. But now we are apparently unhappy.

My instinct is to assume that we consumers are an inconsistent bunch. We like competition if it delivers low prices, but grumble if it delivers the bad news that prices need to go up.

But in fact, it isn't that simple… there are issues in energy markets.

If you eye-ball the graph of the wholesale price of gas and the retail price over the last three years, you wouldn't think another retail price hike is now due. In fact, if anything, it looks as though we might have expected bigger cuts in prices early last year.

Wholesale gas accounts for about half the cost of domestic gas, and you'd think that retail prices are not massively out of line with where they were three years ago, but they will be if prices rise again.

Which raises the question: is competition failing? Are we being ripped off?

Well, a good rule of thumb is that competition doesn't usually fail, it just operates a little clumsily. And its imperfections have long exercised economists.

In this case, it all comes down to the word "oligopoly". It's a lovely word, and applies to many many parts of the economy - including energy. Oligopoly is defined as a market dominated by a smallish number of suppliers. And it has spawned a myriad of different theories as to how prices are set in practice...

One theory that goes back to the 1930s - one that A-level students might recognise as the curve theory - observes that in oligopoly, prices are often sticky.

In essence, suppliers don't like to upset things by pricing aggressively. It's not that they are crooked or anything... it's just market logic. If you cut prices to gain new customers, you'll fail as other suppliers will soon cut prices too, and so no new customers will come. Ergo - don't cut prices unless someone else does.

In energy markets, this could be the case, reinforced by the fact that most of us can't be bothered to switch supplier anyway. If one company cuts prices, the others will have plenty of time to follow them before their customers get off their backsides and make an effort to switch supplier.

In this world, companies will also be reluctant to raise prices because their competitors might not follow. Or competitors might delay rising for a few weeks to follow with their own price rise, hoping to gain some switchers in the meantime.

Being a price-hiking first-mover is an uncomfortable position.

It's the possible asymmetry of competitors' reactions to an initial price cut or price hike that might account for price-stickiness. Companies will only raise prices when they have to as their costs are too high. All one can say is that given the frictions in the energy market, it would be odd if prices weren't a bit sticky, especially sticky downwards.

Of course, the real issue facing us is not whether competition is perfect; it isn't.

It's whether you want to improve it with occasional divine intervention from regulators or MPs. Unfortunately, over the long term, in a complex market, that's a very tall order. You can get the price wrong if you try to influence it, and in the long term if there is free entry into a market, oligopoly can work more competitively.

Best advice - if you're paying too much, don't write to your MP - shop around.

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