Tuesday, 27 May 2014

Catching up with forty years of ignorance

You know how it is - you nod off during one lecture at college and for the rest of your career you have to go and look up which one is Cournot and which one is Bertrand. And I was more than a bit prone to nodding off during microeconomics lectures, as I found a lot of the micro stuff overly theoretical and otherworldly, as opposed to the then heavily empirical and accessible bent of macro. Oddly enough, today's economics students apparently feel the exact opposite, and that it's the macro that has become the algebraic refugee from the real world.
In any event I'd always put down my rather sizeable ignorance of how changes in input costs get translated into changes in retail prices - the general topics of incidence and pass-through - to one of those lapses of attention.
So the other day, as I was thinking about possible links between the state of competition in a market and the relative ability or incentives of players in a market to lumber consumers with high prices (a rumination that followed on from this post where I was wondering about competition and prices in New Zealand), I thought it was high time that I went back to the books and filled in my knowledge gap.
And I found this really excellent resource on the topic - 'Cost pass-through: theory, measurement, and potential policy implications', a review published by the (now defunct) Office of Fair Trading in the UK.
Turns out my ignorance wasn't down (or at least, not only down) to my tuning out forty years ago. There's less known about the theory and empirics of pass-through than you might imagine. I had a vague memory of one factoid - that monopolists will pass on half of any cost increase - but it turns out to be a special case. As the authors say in the Executive Summary, "Many theoretical models indicate that pass-through of industry-wide cost changes increases with the intensity of competition...Significantly, however, a wide range of pass-through rates is possible even for the extreme cases of monopoly and perfect competition...Empirical work on cost pass-through issues in industrial organisation settings is relatively new, and analysis that attempts to quantify pass-through rates in this context is scarce. Most notably, we have identified few studies that shed light on the relationship between cost pass-through and market structure and competition".
So I didn't get the clearcut answers on the relationships between the competitiveness of a market and the degree of pass-through that I had been looking for.
But what I did get was a very thorough and extraordinarily well written literature review, and I highly recommend it as a resource if you're interested in this topic. If, for example, you've ever thought that the petrol stations are rather trigger-happy with their price increases but rather slow to reach into their pockets for the price reductions, the empirics cited in this review would say, you're probably right, but that there can be benign reasons for it, and also that the pass-through rates eventually work out much the same over time.
What struck me most, though, was the readability of the thing. The authors have taken great care to explain the intuition behind the graphs and the equations, and to illustrate most points with worked examples. This really is a model of its kind. I looked the authors up - they are from the specialist competition consultancy RBB Economics, headquartered in the UK, and I discover from the 'Careers' part of their website that "Strong written and oral communication skills – and in particular the ability to explain complex economic concepts to non-economists – are mandatory". It shows.

1 comment:

  1. "And I was more than a bit prone to nodding off during microeconomics lectures, as I found a lot of the micro stuff overly theoretical and otherworldly, as opposed to the then heavily empirical and accessible bent of macro. Oddly enough, today's economics students apparently feel the exact opposite, and that it's the macro that has become the algebraic refugee from the real world."

    That was me during macro! One of my stories is that it wasn't until I had been working for two years that I discovered the difference in definition between medium and long term - even though it was a core part of what we were taught in 2nd year macro.

    Nice looking paper though, I'll have a peek in the weekend ;)

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