Three strikes, and you're - still going....

In a previous post I mentioned that Australia's Competition Policy Review had put a torpedo into the side of 'national champions' - requiring or allowing mass consolidation of an industry to produce what will supposedly be a more internationally competitive player.

And last week, I'm pleased to say, the drifting hulk took another blow as Australia's Productivity Commission got it amidships with another one.

The occasion was the Commission's report on dairy manufacturing (pdf) - the latest in an industry series on 'Relative Costs of Doing Business in Australia'. There's lot of interesting stuff in the report, including the short but informative Appendix B down the back on 'Economics of dairy markets',  but for me the highlights were the bits where the Commission responded to submitters arguing that Australia should go the Fonterra route (these are all on p3):

the Australian dairy industry is a price taker on global markets and has no capacity to alter this, irrespective of the structure of the industry. A belief that any single Australian dairy company could exert market power is not consistent with market realities

the emergence of a dominant manufacturer is not a prerequisite for developing distinctive Australian branding for dairy products

there are potential risks associated with highly concentrated industry structures if the overall performance of the industry is linked with one company

Fonterra-like arrangements are not necessary to ensure that scale benefits at the plant level are realised — indeed, there is considerable evidence that Australian dairy manufacturers are taking advantage of scale benefits where it is profitable

And the Commission wrapped it up on p8 with this:

...industry participants are best placed to balance the various tradeoffs and commercial considerations they face (such as between scale and transport costs). Other than where legitimate competition concerns are relevant...the most beneficial dairy industry structure for Australia will be determined by the market place. Attempts by governments to ‘second guess’ market outcomes to achieve a particular industry structure are fraught with difficulty, and likely to impose net costs on the industry and the community more generally. It does not require much imagination — or experience with price setting by government — to envisage highly problematic judgements in setting an Australian price (or prices) for guaranteed domestic milk supply, as occurs today in New Zealand.

The Commission also quoted (pp115-6) from a recent speech by Rod Sims, the head of the ACCC, where he said:

We are seeing a return to calls for ‘national champions’ in Australia. It is, of course, terrific when companies out compete their rivals and take on the world. The concern is when they call for restrictions on competition at home so they can better compete on the world stage. The argument is a contradiction: if you cannot beat your rivals at home how can you hope to do so overseas? Firms involved in cosy oligopolies or oligopolies in Australia are unlikely to succeed on the world stage.

So it looks as if the old rustbucket SS National Champion has now taken three hits in a row. Unfortunately, if past experience is any guide, it will manage to struggle back to port, get patched up, and in due course set out again on another hopeful journey.

The Law of Supply and Demand

The principle of supply and demand is one of the most important concepts in microeconomics. It helps us understand how and why transactions on markets take place and how prices are determined. To learn more about supply and demand we mainly need to look at consumers and producers.

Consumers

In this case, consumers are all the economic units that are potentially willing to buy a certain good or service. The actual demand for said good or service depends on different variables (as we will see later). For now we will focus only on the most important one, the price. For most goods and services we can say that demand will increase as the price falls and vice versa. This actually seems pretty obvious: Just think about how many people would buy a Ferrari if they were not that expensive.

Producers

Producers on the other hand are the ones that are potentially willing to produce and sell a certain good or service. The actual supply again depends on multiple variables, yet as we did before we will focus only on the price for now. For most goods and services this implies that supply will decrease as the price falls and vice versa. Again the reasoning behind this is rather simple: If you were to sell ice cream you would probably try and sell as much as you could if prices were high, because you could make a good profit. However, if prices were to fall (maybe even beyond your production cost) it would not be profitable to sell ice cream anymore and you would produce less.

Illustration

Now these relationships are a lot easier to understand if we look at a simple illustration (see below). The x-axis of this graph represents quantity (Q) and the y-axis stands for price (P). 

Illustration 1: Supply and Demand

If we look back at the behavior of the consumers, we said they were willing to buy more (i.e. a higher quantity) of a good or service if the price falls. So for every price there is a quantity demanded, which will be higher the lower the price is. Now if we plot all these quantity-price combinations we get a graph called the demand curve (D).

Now we can do the same thing for the producers. But since they are willing to produce less (i.e. a lower quantity) as the price falls, the graph we receive is somewhat similar to a mirror image of the demand curve. We call this the supply curve (S).

The point where both curves (D and S) intersect is called the market equilibrium (E*). At this point (and price) the consumers are willing to buy exactly as much of a good or service as the producers are willing to sell, and the market clears. This is the best possible situation for all actors, thus they will always tend to get to this outcome. This means the two curves will keep shifting until the equilibrium quantity and price are reached. 

In a nutshell:

Consumers are willing to buy more of a good or service as prices fall, so they are represented by a downward sloping demand curve. Producers are willing to sell less of a good or service as prices fall, so they can be represented by an upward sloping supply curve. The intersection between the two curves is called the market equilibrium. It determines both the equilibrium price (p*) and equilibrium quantity (q*) and is the optimal outcome for all actors.

Do We Really Need Economic Growth?

The principle of economic growth has become quite controversial in recent years. While many economists perceived the necessity of growth almost as a dogma, critics have become increasingly numerous. Since the global economies are continuously overexploiting natural and non-renewable resources, the idea of unlimited economic growth seems to be doomed to fail at this point.

Before getting into more detail here, we need to define from what perspective we are looking at the issue. Since we want to explore overall economic growth (i.e. on a global scale), we will use a macroeconomic approach. However, please note that the issue of growth is at least equally important for firms on a microeconomic level (don't worry, we will look into that later). For the following paragraphs, we will define growth as the changes in overall real output (real GDP) of the entire economy over time.

So if we look at the issue, the most basic question is: Do we really need economic growth? To answer this right away: Yes, we do.

Now, let me explain. The conclusion above is mainly based on the following aspects.

1) "More is always better"

As we have discussed in an earlier post, peoples wants are essentially unlimited. They generally want to get as many resources as they can. This may not seem like a convincing aspect as it stands, but it builds the foundation for the upcoming arguments.

2) Standard of living

The economy needs to grow because population grows. If the economy grows at a slower rate than the population, the standard of living will decrease. To illustrate this you can think of wealth as a cake. If more and more people share this cake but the cake itself does not grow, everybody gets a smaller piece.

3) Distribution of wealth

Wealth is distributed amongst the population in a certain way. Some people have more of it and others have less. This is inevitable for the most part, but we should still try and shorten the gap between the rich and the poor. However since the rich generally will not want to give up part of their wealth, redistributing the cake will be easier if we can simply give a greater share of additional pieces to the poor (rather than taking existing pieces from the rich). Thus we need a bigger cake.

4) Technological Development

Last but not least, economic growth also correlates to investment and technological development. More efficient production and new technologies enable new growth opportunities. Furthermore, when looking at the overexploitation of non-renewable resources, new technologies can help improve the situation and lessen the impact of economic activities on natural resources. A good example of this are electric cars, they open up new business opportunities while lowering CO2 emissions of traffic.

Disclaimer:
It is important to note that this line of argumentation does not mean economic growth should be pursued at all cost. There are many other variables, that need to be taken into account. For instance, wealth and GDP do not necessarily reflect a populations well-being (see also Limitations of GDP as an Indicator of Welfare) and increased economic activity still often has a negative impact on the environment. We will cover some of these aspects in later posts.

In a nutshell:

Economic growth is necessary in our economic system because people generally want more wealth and a better standard of living. Furthermore it is easier to redistribute wealth and advance new technologies while an economy is growing. We must however be aware that after all economic growth is a means to an end and not an end in itself.

The Importance of Economic Models

Models are a very important tool when it comes to understanding economic principles. Yet they are often subject to criticism, mostly because many of them are said to be simplistic and far away from reality. Because of that the importance of economic models is often underestimated.

To be fair, the critics may have a point. The models are indeed simplistic and not always close to reality. But that is exactly what makes them great. To keep things short, they have two very important functions.

1) Models simplify reality

There is no point in creating a model that describes every detail of a certain object. For example, there is no need to build a model of a car that is 100% identical to the actual vehicle. In that case we could just look at the car itself.
Instead a good model will omit certain details and build on certain assumptions. This will make it much easier for us to examine it and actually learn something.

2) Models guide our attention to certain topics
The second function is very much connected to the first one. By omitting certain details while keeping others, the model automatically guides our attention in a certain way. Depending on what we are trying to learn, the model can put the focus on different topics. At this point it is important to note that including different details will dramatically change the quality and purpose of every model. 
Now that has implications for our car example. If for instance we are trying to figure out how an engine works, we need to include all the relevant rods, wheels and pins into the model. The bumper design however is not relevant and can be omitted. Naturally these relevant details are entirely different if we are trying to create a new design for our car and so on.

In a nutshell

Models are very powerful tools that help us comprehend economic principles by simplifying reality and guiding our attention to specific features of an object.

Looking at economic models the right way will come in handy as we are learning more about economics. Sometimes even looking at what is not included can help us understand what a topic is all about.

Macroeconomics vs. Microeconomics

The study of economics can roughly be divided into two branches: Macro- and Microeconomics. For the sake of completeness, there are certain other branches as well, but differentiating between those two will be good enough for us (for now).

The two disciplines look at the economy from different perspectives. While macroeconomics can generally be described as the study of the economy as a whole, microeconomics is often referred to as the study of small economic units (such as households, firms, specific markets, etc.). However, it is important to note that the two are still interdependent in many ways.

To see why we should not treat the two discipline completely isolated from each other we need to examine them in a bit more detail.

Macroeconomics
As the name suggests, the field of macroeconomics looks at the economy on a very broad scale. It analyzes the behavior of the entire economy. To do this it often makes use of aggregated variables, such as aggregated demand or aggregate production, and so on. The goal is then to find relationships and interdependences between those variables. 

Some of the topics that are covered in macroeconomics are:

• Monetary and fiscal policy and its effects
• Taxes
• Interest rates
• Economic trends (booms and recessions)
• Economic growth
• Trade and globalization

Microeconomics
Again the name implies that microeconomic studies look at the economy on a small, detailed scale. It analyzes the behavior and decision making of individuals and companies within an economy. By doing so, it builds the foundation for many macroeconomic studies, as it provides the data to calculate the aggregate variables mentioned above.

The topics that are covered in microeconomics include:

• Consumer behavior (decision making, utility maximization)
• Profit maximization of firms
• Supply and demand (for individual markets)
• Externalities
• Labor economics

In a nutshell:

Macroeconomics is the study of the economy as a whole (from a broad perspective) and microeconomics is the study of small units (from a close perspective). Even though they cover different areas of economics, they are still highly interrelated and should not be isolated from each other.

A brief Introduction to Economics

Economics can be defined as the study of the production and distribution of goods and services within a society. However this is a very broad definition that may seem little helpful for understanding what economics is really about, especially for beginners. 

In order to comprehend the given definition we first need to be able to think like an economist, at least to a certain degree. Thus, to start off it seems useful to take a look at some of the most basic economic principles, before diving into the world of fancy definitions and technical terms. 

Since this is supposed to be a brief introduction we will focus on the three most fundamental principles here.

1) Scarcity

There are not enough resources for everyone's wants. Most resources are limited and there is only a certain quantity available for distribution. However people essentially have unlimited wants for those resources and hence try to get as much of them as possible (In other words: more is always better).

2) Trade-offs

Because of the scarcity mentioned above, people are forced to make choices, since they cannot get everything they desire. This may be obvious when it comes to money (i.e. "Should I spend those 2$ on ice cream or on an apple?"), but holds true for all decisions we face in our life. For Example: On a sunny day you could either spend the day at the beach, or have a nice barbecue with your friends. If you chose the barbecue you obviously can't go to the beach at the same time.

3) Opportunity Costs

This term describes the value of what has been given up in order to get something else. Again this does not necessarily have to be a monetary value. In our example above, the opportunity cost of having a barbecue would be not being able to be at the beach at that time. In other words, opportunity costs are the possible benefits you could have received by taking an alternative decision.

In a nutshell

People can't get everything they want because resources are scarce. Thus they have to take decisions and deliberately forgo certain things. Those things are then called opportunity costs.

Keeping these three simple principles in mind, we can now look at the world in a different way and think more like economists. This will make it easier to understand economic behavior as it gets more complex (and even more interesting).

No national champions, please

In earlier posts (main one here, follow-up here) I've commended the wonderful work done by Australia's Competition Policy Review. They've systematically taken a pro-consumer, pro-competitive approach without wandering off piste into anti-business populism.

They didn't get stampeded, for example, into "doing something" about the concentrated Aussie grocery business, noting that "While concentration is relevant, it is not determinative of the level of competition in a market...competition between supermarkets in Australia appears to have intensified in recent years... consequently, few concerns have been raised about prices charged to consumers by supermarkets" (p181). If there are issues of the big supermarkets strongarming their suppliers ("unconscionable conduct" in Aussie competition-speak), well they are before the courts, "where they are best considered" (p182). And if the arrival of the big chains tended to deal to the traditional mom-and-pop high street shops, "Undoubtedly these changes can damage individual businesses. However, consumer preferences and choice should be the ultimate determinant of which businesses succeed and prosper" (p183), and "While the Panel is sensitive to these concerns, they do not of themselves raise competition policy or law issues" (p184).

Along the way I wrote about some of the ridiculous anti-competition regimes that the Policy Review uncovered - notably Western Australia's bizarre potato regulations and New South Wales' monopoly organisation of the rice market, and I had some reader feedback that perhaps here in New Zealand we weren't much better, given the way we've allowed the creation of Fonterra.

As it happens, the Aussies looked at the "national champion" issue, too, and again took the pro-competition road. They had a bit (Box 15.1 on p196) specifically about Fonterra, and said that it wasn't in fact the kind of "national champion" monopolist that some Aussies were promoting. "The [Fonterra establishment] legislation included provisions and obligations on Fonterra designed to provide for domestic competition and prevent harm to consumers and farmers as a result of the merger. Concerns were raised that the farm-gate price would be depressed due to Fonterra's dominance as a buyer. These were addressed through a combination of regulation and incentives...To achieve domestic competition in the sale of milk products Fonterra had to divest several brands to competitors and is obligated to supply them on competitive terms". And they quoted Bill English as saying, "Sometimes they think in Australia that we've got a monopoly and it works, but we don't and having one doesn't".

Then they turned to the general issue of whether creating "national champions" is a good idea, as there's always someone lurking with a cunning plan along those lines (our meatworks industry is a plausible candidate for the next one). As far as I'm concerned, these next couple of paragraphs (from p195) ought to be carved in stone and erected outside any government departments or agencies thinking about going along with a bit of "national champion" industrial planning. The added emphasis is mine.

From time to time there are calls for competition policy to be changed to allow the formation of ‘national champions’ — national firms that are large enough to compete globally. While the pursuit of scale efficiencies is a desirable economic objective, it is less clear whether, and in what circumstances, suspending competition laws to allow the creation of national champions is desirable from either an economic or consumer perspective.

Porter and others have noted that the best preparation for overseas competition is not insulation from domestic competition but exposure to intense domestic competition. Further, the purpose of the competition laws is to enhance consumer welfare through ensuring that Australian consumers can access competitively priced goods and services. Allowing mergers to create a national champion may benefit the shareholders of the merged businesses but could diminish the welfare of Australian consumers.