Why our prices are so high

Yesterday I posted about some interesting research that Victoria's Norman Gemmell had done on how our tradable and non-tradable prices compared with the rest of the world, and mentioned that he would be following up with some analysis and explanation of the patterns.

Which he has now done - his latest paper (with co-author Rodney Falvey of Bond University and with assistants Cherry Chang, formerly at Vic, and Guanyu Zheng of our Productivity Commission) is available from the Productivity Commission, where there's also a summary and an infographic (I'd expect it will shortly be available on Vic's Public Finance Working Papers site, too).

It's getting a fair bit of airtime anyway, so I'll very briefly summarise. The Falvey-Gemmell ('FM') model is an aggregate theory of non-tradables prices: in it, non-tradables prices are higher when a country's stock of capital and stock of unskilled labour is higher, and are lower when the population is bigger and the stock of skilled labour is larger. Originally - the model has been out over the fences in the past - the model basically took tradables prices as a given: in this version the FM model has been extended a bit to explain the part of a country's tradables prices that is down to the amount of non-tradable input costs.

It works pretty well, fitting assorted country databases. But guess what - it can't explain (or explain well enough) the relatively high level of New Zealand's tradables prices. Look at this.

The left hand box shows New Zealand's non-tradables prices relative to America's (7.5% lower). But most countries have even lower non-tradables prices, compared to the States, than we do, whether you look at a 79-country set (2nd red bar) or a 43-country developed economy set (3rd red bar). Our non-tradables prices are relatively high. Still in the left hand panel, the same data for tradables prices: ours are substantially higher (35.5%) higher than America's, and again higher by a wider margin than in most other countries.

The right hand box shows the success of the model in explaining the difference between our prices and America's. The model's not too bad at getting a handle on non-tradables, especially in the first four ways of modelling things, but there's a large unexplained lump of tradables inflation. The model can't adequately replicate the high tradables prices we've actually got.

Of course, one possibility is that if our domestic non-tradables prices are relatively high, our domestic tradables producers will have to charge higher prices because they have to use those expensive local inputs. What happens if you look at tradables prices once the effect of domestic non-tradable input costs is stripped out? Do New Zealand's apparently high tradables prices come back into the pack?
No. Quite the opposite: the margin over US prices widens. As the authors put it,

Based on "adjusted" tradables prices that removes the "cost share of non-tradables" element, NZ's tradables prices are around 6th highest in the 43 country OECD-Eurostat sample – behind such countries as Iceland, Norway and Japan (see Figure 6). These are also countries relatively distant from many of their key markets. (For Japan at least, other protectionist measures may also be relevant). However, Australia is ranked 19th out of 43 countries in its adjusted tradables price, suggesting that to the extent that there are "disadvantages of distance", Australia manages partially to avoid or overcome these.

Here's the Figure 6 mentioned in the quote. It's a graph of those tradables prices when the domestic non-tradables cost contribution has been stripped out.

And there we are, way over on the left hand, relatively high price side. The paper mentions that the countries over there are typically smaller, more remote places (ex Japan), so again you're potentially looking at tyranny of distance, diseconomy of scale kinds of explanations.

So where do we go, from a policy point of view?

Part of me bristles at the possibility that in some respects we're back to square one - the idea that being a small economy miles from anywhere lumbers us with tradables costs we can't do much about. It might be true. But even if it is, it doesn't mean we're helpless. You'd rather think that we might deliberately steer more towards activities where scale and distance matter less (a gold star to the first reader who thinks, Lord Of The Rings) or where isolation and emptiness might even be a comparative advantage (tourism).

I also wonder whether we haven't got a rickety distribution system. I don't think it's any accident that we've got Japan as a near neighbour in the graph above. Maybe some of Japan's high tradables prices are down (as the paper surmised) to Japanese protectionism. But I can tell you that the rest of it will have a lot to do with a notoriously inefficient, multi-layer distribution sector, consciously designed to protect the Mom and Pop corner store and the guy with the one delivery truck, by (for example) obstructing the scale of supermarket you find practically everywhere else in the world. I wonder how efficient our distribution system is?

And even if we're stymied to some degree on the tradables side, there's a lot we could do on the non-tradables side. We could look at building up the stock of skilled labour for a start, which would be a good move from other perspectives in any case.

I was also struck by the result I showed yesterday, which showed very large differences in relative expensiveness between different non-tradables sectors (dentists expensive by international standards, for example, but vets cheap). I strongly suspect (well, I would, wouldn't I?) that the intensity of competition has something to do with this, including the role of occupational gatekeeping.

Admittedly, all these results are based on 2005 data, and competition conditions will have moved around a bit since then (2degrees has rolled out its mobile network, for example), and you'd want to update the findings before you went on a lack-of-effective-competition witch hunt. That said, if I were the Productivity Commission or the Commerce Commission or the Treasury, or indeed anyone minded to get that burden of expensive non-tradables costs off the economy's back, I'd re-run the numbers, and then take a very hard look indeed at the competitive state of the non-tradable sectors that still have unusually high prices.