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.

Dictionary - Accounting Profit

Definition

A company's total revenue minus its total explicit costs.

Example

Assume a carpenter produces 1'000 chairs, which he then sells at a price of $100 each. His total revenue will add up to $100'000. If he faces total costs of $60'000, accounting profit will amount to $40'000 ($100'000 - $60'000).

Relevance

As the name suggests accounting profit is an essential part of accounting. It is used to provide a true and fair view of the results of a company's operations. However it is important to note that accounting profit does not include implicit costs (such as opportunity costs), as a result it is usually a bit higher than economic profit.

Dictionary - Adverse Selection

Definition

A situation where asymmetric information (between buyers and sellers) causes unwanted results, because the unobserved attributes lead to an undesirable selection from the perspective of the uninformed party.

Example

A good example of adverse selection is the market for health insurance. In this market, the buyers know more about their health issues than the sellers. However both buyers and sellers know that people with health problems are more likely to get insurance than healthy people. Therefore the price of insurance will be set higher than necessary for average customers. As a result this will discourage healthy people from getting insurance and thereby intensify the adverse selection.

Relevance

Because of its self-reinforcing nature, adverse selection can have significant negative effects on markets or entire industries (such as the insurance industry). Without interventions it results in a vicious circle of increasing risks for sellers or decreasing quality of goods and services for customers.

Dictionary - Business Cycle

Definition

Often irregular and mostly unpredictable fluctuations (i.e. expansions or recessions) in economic activity experienced in an economy over a certain period of time. 

Example

As the economy expands, unemployment decreases while income and as spending increase. Once the expansion reaches its maximum, productivity starts to decline which results in higher unemployment, lower income, and lower spending. The economy falls into a recession. 

However after some time, the productivity will slowly rise again, which will lead to lower unemployment and rising income again. Hence, the next business cycle begins.

Relevance

Knowledge about the different states of an economy and their timing is a crucial aspect for governments and other policy makers. By analyzing historical patterns of economic activity, the possible effects of government interventions can be assessed more precisely and future economic developments can be predicted more reliably.

Dictionary - Positive Consumption Externality

Definition

The positive effects on unrelated third parties that originate during the consumption of a good or service.

Example

A possible example could be your neighbor’s flower garden. She most likely cultivates the plants solely for her own pleasure, yet everybody can enjoy the beauty of the flowers whenever they walk by.

Relevance

Without any regulatory influence, positive externalities will not be taken into account by the causers. This results in a market failure and an undersupply of beneficial behavior, because the suppliers produce less than in an efficient market. Hence, regulations are needed to provide incentives and internalize the externalities.

A meeting of minds

Last week Australia's Competition Policy Review came out with its excellent draft report (report here, my high level reaction here).

I said I'd come back to some specifics in the report, and there's one in particular that stands out as relevant to us here in New Zealand - and that's the Review's conclusion on s46 of the Aussie Competition and Consumer Act (CCA), which is the equivalent of  s36 of our Commerce Act. Most people following this blog won't need a refresher on what s36 is, but just in case it's the bit in our Commerce Act that says

36 Taking advantage of market power
...
(2)A person that has a substantial degree of power in a market must not take advantage of that power for the purpose of—
(a) restricting the entry of a person into that or any other market; or
(b) preventing or deterring a person from engaging in competitive conduct in that or any other market; or
(c) eliminating a person from that or any other market.

The thing is widely seen as a waste of space as it stands, partly because of the language of the section, partly because of how the New Zealand courts have interpreted it, and all against a background of being an intrinsically difficult thing to police in the first place.

Earlier this year our Productivity Commission, in chapter 7 of its report on Boosting Productivity in the Services Sector (available here), said (p135) that "The Government should review section 36 of the Commerce Act 1986 and its interpretation", that "The review of s 36 should take account of the review of competition policy in Australia, with a view to achieving a consistent approach", and that

The review of s 36 should include consideration of the merits of:

 a more flexible approach where courts do not rely on a single counterfactual test for
an abuse of monopoly power [this is a reference to the, shall we say, idiosyncratic approach of the New Zealand courts];
 more of an “effects” approach to gauge whether conduct has harmed dynamic
efficiency, and
 providing for an efficiency defence in cases where the conduct of a firm with substantial market power fails a primary test that it is harming competition.

Lo and behold, that's pretty much exactly where the Aussies have fetched up.

They agree that the language of the section is off kilter, for two reasons.

One is that "take advantage" bit: as they say (p208), "Both the courts and the legislature have wrestled with the meaning of the expression ‘take advantage’ over many years. Its meaning is subtle and difficult to apply in practice".

And then there's the wording of the "purpose" bit. As the Review says (p210),

Presently, the purpose test in section 46 focuses upon harm to individual competitors — conduct will be prohibited if it has the purpose of eliminating or substantially damaging a competitor, preventing the entry of a person into a market, or deterring or preventing a person from engaging in competitive conduct. Ordinarily, competition law is not concerned with harm to individual competitors. Indeed, harm to competitors is an expected outcome of vigorous competition. Competition law is concerned with harm to competition itself — that is, the competitive process.

So they've suggested (p210) skittling "take advantage" completely - excellent - and rewriting the rest of it with more of an "effects" approach (as our Productivity Commission suggested was worth looking it) so as

to prohibit a corporation that has a substantial degree of power in a market from engaging in conduct if the proposed conduct has the purpose, or would have or be likely to have the effect, of substantially lessening competition in that or any other market

As they say, do that, and then s46 becomes

the standard test in Australia’s competition law: purpose, effect or likely effect of substantially lessening competition. The test of ‘substantially lessening competition’ would enable the courts to assess whether the conduct is harmful to the competitive process

And finally they've come up with much the same sort of backstop defence for a business that our Productivity Commission flagged, namely

the primary prohibition would not apply if the conduct in question:
• would be a rational business decision by a corporation that did not have a substantial degree of power in the market; and
• would be likely to have the effect of advancing the long-term interests of consumers.
The onus of proving that the defence applied should fall on the corporation engaging in the conduct

Currently MBIE are beavering away in the background on a review of s36, after their Minister, Steven Joyce, picked up on the Productivity Commission's recommendation to have a rethink.

Save the time and money. I say we send the Aussie Review members a thank you note and a couple of cases of our best Pinot Noir, declare victory, and go home.