Now you see it

Markets need institutions to help them work properly - things like a practically enforceable rule of law, well defined property rights, and the likes of our Fair Trading Act and 'weights and measures' provisions to prevent misrepresentation and deceit and to foster trust in commercial exchange.

All that orthodoxy said, the Fair Trading Act and its companions, worthy though they are, have never greatly floated my boat, and I'm relieved that it's someone else pinging (for example) the back-of-a-truck ratbags selling overpriced tat to poor people.

But during the week I came across an interesting new piece that raised my opinion of the impact Fair Trading enforcement can have. It's from the States, and it looks at the impact of making the airlines disclose the full price of tickets, including all taxes.

By way of background, we don't have rules that require all-inclusive pricing. Back in 2012 when consumer law was being updated, the Commerce Commission argued for all-inclusive pricing to be mandatory, as it is in Australia. MBIE however didn't see an issue, so the Commission's proposal died the death. A pity: I have a lot of sympathy for Consumer New Zealand and its "sneaky fees" campaign. As they say here,

our research shows the problem is real and, with the rise of online trading, looks set to get worse. When goods and services are bought online, we’ve found extra fees may only be revealed near the end of the purchase process.

Not only does the practice mislead consumers, it also makes it difficult to compare prices and gives the retailer an unfair advantage over companies that are upfront about costs. All-inclusive pricing rules would ensure consumers can easily identify the price of a product.

What I didn't know, before I read this American research, was how big the impact of fully disclosing the total price might be.

The paper, published last month, is 'Hidden Baggage: Behavioral Responses to Changes in Airline Ticket Tax Disclosure', and was published in the discussion paper series of the Fed. I came across it, by the way, thanks to the very useful Brookings Briefs which trawl for interesting papers across a variety of issues. Here's what happened.

From early 2012, the US Department of Transportation brought in "full fare advertising rules", or FFAR, which required airlines to show the ticket price including various flight-specific taxes that had previously not been shown until you went to pay. Finding out what those taxes were, by the way, was very difficult in the pre-FFAR regime, assuming you even knew that there were extra taxes and that they varied quite a bit from flight to flight.

On the very large database of  international flights the two authors looked at, the average price was US$750 and the taxes were a sizeable $100, with quite a lot of variation (standard deviation of $45). As the authors show (on pp7-8 and in Table 1) it would have been very easy to pick a flight that looked cheap on a pre-tax basis, but which turned out to be an expensive option on a full-disclosure basis.

And what happened when buyers could see the full price?

First of all, consumers ended up wearing much less of the taxes, and the airlines absorbing much more of them. This is the bit of tax economics known as "incidence", which looks at who actually ends up paying taxes (or receiving subsidies), as opposed to who formally pays them - they can be quite different. You might think, for example, that subsidies to first home buyers will go to the formal home buyer beneficiaries: typically, they won't, and will actually be trousered by housebuilders.

In this case, pre-disclosure, the airlines correctly reasoned that what you can't see or can't be bothered about, we'll dump entirely in your lap. Post-disclosure, consumers were more sensitised, and to keep their custom airlines had to sharpen their pencils and cut their base fares. Or as the paper says (p21)

Three-quarters of every dollar in ticket taxes are thus borne by the airlines in the post-FFAR period, in marked contrast to the pre-FFAR period when  consumers bore the entire tax.

The researchers also found, by the way, that the pattern of pass-through varied with how competitive the route was. If there were lots of competitors (as measured by a lowish HHI index) pass-through by the airlines was higher, which is what theory predicts (low profit margins in a competitive market don't leave much room for sellers to absorb costs in base prices). And it was lower in low-competition markets: "Following the adoption of tax-inclusive pricing ... pass-through rates for unit taxes are shown to drop most sharply in more highly concentrated (i.e. "duopoly") markets" (p28).

Consumers also wised up. Before FFAR, they could see base fares (disclosed), non-tax charges (disclosed) but not ticket taxes (undisclosed). They reacted as you'd expect to the first two (buying less when the cost went up), but paid little or no attention to the taxes, which, as noted, they consequently ended up wearing. Post FFAR, they became sensitised to all elements of the cost:

Adoption of FFAR, however, is associated with significant de-biasing [i.e. responding to all components of costs the same way], such that when base fares, unit taxes, and non-tax charges are all included in total fares in an equally salient [transparent] manner, consumers respond to each equally - consistent with the standard theory of (attentive) consumer behavior (p23, square brackets are my explanation of some of the terminology)

The airlines got hit in a couple of ways. They had to cut base fares to accommodate their new share of the taxes, and were faced by more price-sensitive customers. All up, it made quite a big difference:

The combined impact of reduced ticket tax pass-through and reduced passenger demand (in relation to the portion of the tax still born by consumers) together imply that a $5 increase in unit taxes is furthermore associated with a 2.4% reduction in airline ticket revenue (p30)

As the authors say, "These represent large potential losses in ticket revenue ... and lend strong justification for the U.S. airline industry's intense and persistent efforts to reverse FFAR through lobbying and public relations campaigns" (p26). Best I can tell, a Bill which includes a provision to reverse FFAR has got through the US House of Representatives, but hasn't yet got through the Senate. In Trump's America, though, if you're an airline CEO, you've got to fancy its chances of going all the way.

Maybe the airlines weren't hit as badly as they looked: "it is also possible that carriers may have compensated for lower base fares and ticket revenue through increased reliance on product unbundling and the use of less heavily regulated add-on fees, such as baggage and check-in fees, seat upgrades, in-flight meals and service, etc., whose costs to consumers we do not observe in the ticket data" (p26).

If so, mandating FFAR (and full price disclosure more generally) in New Zealand "should be tempered by the possibility of fostering unintended consequences" (p30) like extra fees for this, that and the other. Me? I'd go for it. These are big bucks being transferred from consumers to producers solely because of off-the-radar treatment. Looks to me as if efficiency and equity point the same way.

As a final thought, it was great to see empirical methods being applied to an issue like all-inclusive pricing. It's all very well running in-principle arguments before Select Committees, but facts are trumps. Big data got by, for example, 'scraping' online prices (as in this paper), are increasingly going to inform what otherwise would be semi-philosophical debates. About time, too.

Now you see it, now you don't

Yesterday's inflation data held no great surprises. Everybody expected a pretty low number for inflation during the September quarter and for the year to September, and they got it: 0.2% for the quarter, 0.2% year on year.

Cue for hand wringing over the Reserve Bank yet again allowing inflation to stay too low.

But here's the thing.

We know the overall headline rate of 0.2% can be split into two bits, the bit that happens in the 'tradables' world of exports and imports, and the 'non-tradables' bit that happens in our own economy, the likes of the local authority rates, the doctor's bill, or the school fees. And we know that the overall 0.2% outcome was made up of tradables prices falling over the past year by 2.1%, while non-tradables prices rose by 2.1%.

The Reserve Bank has sod all influence over the tradables bit, except to the extent that it might manage to control the exchange rate, which influences how much of the world inflation rate comes through to us. But it (and any other central bank) tends not to be able to steer exchange rates terribly well, so in practice whether the Reserve Bank is on top of things comes down to whether it is steering non-tradables inflation to where it needs to be.

So let's have a look at that non-tradables inflation in more detail. Here it is.

The blue line is annual non-tradables inflation, which is running at 2.1%. So remind me again how the Reserve Bank hasn't got inflation back up to 2%, the midpoint of the 1% to 3% band it's supposed to be focussed on?

But (you'll say) that 2.1% rate of non-tradables inflation isn't all it's cracked up to be. It's not really 2.1%. It's inflated, innit, by the housing market. And you're right, it is. But if you take out the cost of new houses, you get the green line, non-tradables ex housing. It's running at 1.8%. That's not too bad, either, if you're supposed to be aiming at 2%.

Course (you'll reply), there are other housing-market-related things still being counted in that non-tradables ex housing line, in't there? Rent. The cost of keeping the house in good running order. The rates. And again, you're right. So let's purge the non-tradables inflation of every damn house-related thing - the cost of a new house, the rent, yadda yadda yadda.

That gives you the red line, non-tradables less anything to do with a house. On that basis non-tradables inflation is running at 1.25%. That's short of the Reserve Bank's 2% focus, so you could beat them about the ears if you felt like it. On the other hand, it's at least crept back into the 1% to 3% band, and it's clearly headed in the right direction. Every one of these measures has been on the rise all year.

One of the big mysteries of macroeconomics recently has been, where's the inflation gone? Why hasn't it come back like it used to when things pick up? That's a big topic, and everyone from Janet Yellen at the Fed to Philip Lowe, the new governor of the Reserve Bank of Australia have been having a crack at it, and I'll come back to it one of these days.

My thought today, though, is this: maybe it's actually come back, and we haven't noticed.

Are the rates out of control?

Last week's write-up of the latest CPI by Stats NZ included this graph. It showed how the prices of various components of central and local government charges have been behaving since 2006.

The colours aren't that easy to tell apart, but the top line is local authority rates, which appear to be on an inexorable rise, through good times and bad. The line that drops sharply at the end is 'other private transport services', where you see the big impact of recently lower ACC levies on the cost of licensing your car.

That remorseless rise in the rates bill got me thinking, so I've done a little bit of research, and here is how the rates, average weekly total earnings, and overall inflation have behaved over the same period, all rebased to 1000 in mid 2006, and all seasonally adjusted. Over the whole period, prices in general rose by 20%, weekly earnings rose by 35%, and the rates - well, the rates rose by 60%.

Maybe we shouldn't be worried. The rates, after all, are subject to some sort of political discipline, and presumably the voting citizenry either don't mind what's happened, or even asked for it, if they felt (for example) that councils finally needed to get on with building adequate local infrastructure.

But I can't help feeling that there's an argument that the electoral discipline doesn't look very binding. At a national level, it's true that politicians can generally no longer get away with bribing the electorate with its own money - there's a great deal more transparency about the costs of lolly scrambles - but is the same scrutiny as effective at local authority level? And even assuming that all is politically hunky dory, did councils really deliver a 33% real (above inflation) increase in services to us all over that period? Doesn't feel like it. And I don't see any efficiency dividend from Auckland amalgamation in the rates graph*.

I don't have the answers, but I do have a question: are rates rises out of control?

*Addendum Oct 28 - Subsequent (separate) comments have pointed out that Auckland has had one of the lowest increases in rates since 2006, and that total rates collected in Auckland have fallen since 2009, so there may be an efficiency dividend after all.

A peek behind the veil of ignorance

Last week's post about a paper that documented the remarkable level of economic ignorance amongst New Zealand's business managers seems to have hit the spot, going by page views and comments.

Comments have been somewhere on a spectrum between head-shaking bafflement and outright incredulity, with a soupçon of "how can people this ignorant stay in business?". And, mostly, I'm somewhere in that range myself.

But one commenter pointed me to something that shows managers' beliefs in a modestly less awful light. It's an earlier paper by largely the same people, 'How do firms form their expectations: new survey evidence', an NBER working paper from April of this year. The abstract is here, but the whole thing will cost you US$5 unless you 're in academia or the media or a developing economy: us common or garden bloggers have to pay up, and I did. Oh, and the NBER is funny about copyright, so here it is - © 2015 by Olivier Coibion, Yuriy Gorodnichenko, and Saten Kumar.

What this paper found is that managers may be terrible at estimating the current or likely rate of consumer inflation - no better than the populace at large, which seems rather strange for people at the business coalface - but they are rather better at knowing what producer prices are doing in their industry. Here's the graph that shows it.

The left-hand panel A shows the distribution of managers' estimates of various recent macroeconomic data - the inflation rate in their own industry, inflation overall, GDP growth, and the unemployment rate. Negative values mean that the managers' estimates are too high relative to the real number.

Managers aren't too bad at getting their own sector's inflation rate right: on average, in fact, they're bang on, though there's still quite a big dispersion around the right answer. They're reasonably good at the unemployment rate (they have it a little higher than it really is), but not so hot at GDP growth (they have it about 1.5% - 2.0% higher than reality, from eyeballing the graph). And as my previous post said, they're really bad at the CPI inflation rate, being well off the mark on average and with estimates all over the shop.

The authors show that you can explain the managers' ignorance of the true rate of inflation in terms of 'rational inattention' - life's too short to be on top of everything, and if it's not important to you, you don't bother. Equally they show that managers who think inflation is important for their business do a better job of tracking it, and as we've seen in the graph above, managers stay on top of their industry's inflation pretty well, given that they've got both the incentive and the opportunity. And the paper's authors also show that if you give managers some additional information on actual and forecast data, they improve their estimates. Managers, in sum, aren't the complete ignoramuses you might have imagined when (for example) you see their level of ignorance about the basics of what the Reserve Bank does.

But it all still leaves that basic question: why do so many managers think inflation isn't important to them, and hence or otherwise get it so wrong?

There'a clue in the right-hand Panel B. It takes the (badly overestimated) inflation estimates in the left-hand panel, and breaks them out by the sector of respondent. You can see that there's a decent proportion of people in manufacturing and trade who have an accurate idea of inflation (though even then there's a tail of people with shots that are too high). But there isn't even a semblance of getting within cooee of the right answer for the average managers in professional and financial services firms, or in construction and transport businesses.

So here's my interpretation, not the authors' (though there are also bits of the paper that point the same way, such as the bit that shows managers in businesses with more competition pay more attention to inflation). That sectoral breakdown in Panel B is pretty much along tradables/non-tradables lines. Managers in tradables sectors have to be reasonably okay at getting inflation right, as there are enough competitors (domestic and overseas) who will eat their lunch if they're systematically bad at it. And managers in non-tradables sectors don't have to be, because there aren't.

I've thought it before, and I'm thinking it again: there are a lot of businesses in non-tradables sectors who can coast on a cost-plus mentality, and I doubt if we're going to make much inroads on our national productivity issues until stronger competitive pressures are brought to bear on them.

Another blast from the past

Statistics NZ's Twitter feed just posted this fun item:

It has a link back to a piece that Stats published in 2012, 'Delving into the clothes basket - tracking women's and men's clothing in the CPI', which went back to 1924 to look at what men and women and children wore.

It's fascinating - today's girls will be pleased that they don't have to wear the woollen bloomers of 90 years ago, and today's women will be pleased they don't have to make their own clothes - and it's one of a terrific series of time capsules that Stats have unearthed and published. Last time I wrote about them, in 'The way we live now', I said that this analysis of past CPIs was "almost a complete social history in itself". It's also a great timewaster, so cancel an hour, head to my post, and follow up the links there to the various Stats publications.

For me - and here I stress this is my take, not Stats' view or interpretation - the clothes basket piece fortuitously showed the potential benefits of trade liberalisation. From the late '80s onwards, tariffs and quotas on clothing imports were lowered or abolished. The results were that clothes prices have risen much more slowly than prices more generally (as the first graph below shows) and people have been able to buy much more (as the second one shows).

And the "cost"? - "the number of jobs filled by paid employees in the clothing and knitted product manufacturing industry fell nearly 60 percent – from 9,550 to 4,120". Four million people, give or take, got a large benefit, while 5,500 people, give or take, lost their jobs. And I put "cost" in apostrophes because many - maybe all - of those people will have found other jobs, and in activities that the community values more highly than keeping a small-scale rag trade going.

It's also very likely that liberalising clothing imports was a progressive move (in the tax policy sense of "progressive" as opposed to "regressive"). At home, the household budgets of lower and middle income families, and particularly those with children, will have had one of their bigger costs reduced. And overseas, people in poorer countries will have got real jobs, instead of aid, and started down the road of economic development that will make them better off and, along the way, better customers for our exports. That's a pretty good outcome all round.

Outrageous fortunes

Yesterday I posted some data showing the profitability of different sectors of New Zealand business, based on Stats' brand new release of the Annual Enterprise Survey for 2013. And based on a quick squizz at the data I concluded that "you start thinking deep, dark thoughts about whether there are strong enough competitive pressures at work to constrain the profitability of some lines of activity".
I've done a bit more fossicking in the data, and I've ended up thinking even darker thoughts about the state of competition in parts of retailing - and the supermarkets in particular.

Here is what has been happening to the pre-tax rate of return on equity (ROE) in the main sectors of retailing. I've taken the data back to 2009 (which is where Stats started publishing more detailed sub-sector breakdowns), which helps to sort out whether any high recent ROEs are just a cyclical artefact of the recently strong economy rather than evidence of structurally limited competition.

There is no credible explanation for the high ROE of the "supermarket, groceries and specialised food" sector other than limited competition.

This is not a sector where you'd expect high ROEs because of the exercise of scarce, highly specialised skills. And it's not a "high beta" sector exposed to a high degree of cyclical risk - unlike the car yards (who made no money in the tough market of 2008-9) or the sellers of consumer durables (who lost money in 2008-09). If anything, the supermarkets' profitability increased in the tough times.

Let's be clear - the supermarkets are fully entitled to these ROEs. There's nothing wrong with charging what the market will bear. And if you were a duopoly behind reasonably formidable barriers to entry, you'd expect to coin it, too.

But the sooner a hard nosed, low priced Costco or Aldi comes along and upsets their apple cart, the better off we'll all be.

Why these big price increases?

The Ministry of Business Innovation and Employment, MBIE, has come out with new estimates of retail electricity prices. One of them is a unit value measure - the $ amount that retail customers paid for electricity, divided by the amount they consumed - and the other is a quarterly survey of what a 'typical' household would pay, if it took up the lowest available offer in its region.
Here is an excerpt from the quarterly survey: to save a bit of space I've shown just the North Island results.

As you can see, MBIE has split out the total retail bill into an electricity lines component and an "energy and other" component, which we can assume will be dominated by the cost of the electricity itself.
I'm struck by some very high percentages increases (highlighted in yellow) in the lines component of people's electricity bills. If it's all down to price increases allowed by the Commerce Commission, fine. But if it isn't, what on earth is going on?

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.

Good news all round. Except when you hear the dial tone

The Commerce Commission's latest annual monitoring report on the telecommunications markets is a good read (press release here, whole report here). I like the way it's prepared to take an educated guess at the reasons for the trends it sees, and I also like the way it's prepared to take a stab at how things will evolve next. I'm on board with its overall conclusion that "consumers are getting far more – data, texts and calling minutes – for their money, particularly in the mobile market". And I'm right behind it when it says (p39), "Dropping prices and an improved quality of service are more likely to occur in a sustainable competitive environment. We will continue to monitor the state of competition in broadband markets in case regulatory intervention is needed".

The whole sector is an object lesson in what happens when a vigorous new competitor (2degrees in this case) rolls out its own infrastructure. I'm not saying that 2degrees is always and everywhere going to be an angel itself, but boy has it shaken up the status quo. Quite apart from the choice and price effects, the dynamics of three players compared to two has disrupted some of the behaviours that can happen in two-network markets. For instance, we used to have cheaper pricing for 'on-net' (within the same network) mobile use, and substantially higher 'off-net' pricing if, for example, you had the temerity to ring a Vodafone number from a Telecom mobile phone (or vice versa). That's been undermined by the existence of a third network, and the semi-punitive off-net prices have come tumbling down, as this graph shows.

All I'd add about falling prices, and I know it might read a bit churlish, is this - it's about time. And it hasn't happened enough in the fixed line broadband market, the kind most of us use for our broadband access. That's not the Commission's fault, by the way: it's been one of the good guys when it's come to rolling back the historical legacy of expensive copper line phone pricing.  But expensive it remains. If you want chapter and verse on how expensive, it's 'over the fold', as they say.

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.

New Zealand's high prices

Professor Norman Gemmell at Victoria has done some really interesting work on how New Zealand prices compare with those overseas. This has been done primarily for the Productivity Commission, which is interested in issues such as the degree to which expensive domestic inputs might be hobbling our export competitiveness, but it's also been a long time research interest of Norman's.

Strictly speaking, the work examines how relative prices in New Zealand compare with elsewhere. The distinction between absolute, what-you-see-in-the-shops prices in New Zealand, and relative prices, is important. You can't be sure how the absolute level of prices in New Zealand looks, compared to prices elsewhere, because the Kiwi dollar goes up and down all the time, and it makes our prices look temporarily cheap or temporarily expensive in foreigners' eyes as a result.

Norman explains the distinction in the paper, but here's my version of it.

Suppose that a pint of beer costs US$5 in a bar in Chicago, and it costs NZ$8 in a bar in Auckland. And let's suppose for convenience that the current exchange rate is 62.5 US cents. The cost of a beer won't look expensive or cheap to the US drinker on holiday here: at 62.5 cents, he's paying exactly what he would have paid back in Chicago. If the Kiwi dollar were to soar to 80 US cents, the NZ$8 price will translate into US$6.40, and will look rather expensive to the US visitor. And if the Kiwi were to slump to 40 US cents, the pint of beer in Auckland, now the equivalent of only US$3.20, will look very cheap indeed.

The point is that prices in the bar, and in the shops more generally, will appear cheap or expensive, compared to prices overseas, wholly as an artefact of moves in the exchange rate. Some days the beer may look cheap, other days it may not. You can't be sure that beer is genuinely more expensive, in some entrenched or long-term or real way, in New Zealand.

But suppose that, when the exchange rate is 62.5 cents, most things in New Zealand look about the same price as they do in US$ terms back in Chicago, but beer still looks expensive. Then you've got a case that beer is in some sense unusually expensive in New Zealand. Or if (because of the vagaries of the exchange rate) everything in New Zealand looks expensive to our visitor from Chicago, but beer looks even more expensive again, then once more you're led to the conclusion that beer looks permanently expensive here.

And that's the approach Norman uses. He looks at how prices compare relative to that 62.5 cents rate where most things look a reasonable buy (the 'purchasing power parity' or PPP rate), or, if everything looks expensive (because the actual, market exchange rate is above the PPP rate), then he looks at which things are even more expensive than others. He does it both against the OECD as a whole (or the 30 countries that make up most of it) and against Australia. And just to avoid the "aren't things awful in New Zealand" trap that some of the media are prey to, I'd add that his work also identifies things that look cheap here by international standards.

Here's a flavour of the results. If you like tables, the table shows his summary results of the tradable and non-tradables that look most expensive here compared to the rest of the OECD. And if you like graphs, the first graph shows how specific non-tradables compare with either the OECD or Australia, ranked from most expensive through to cheapest, and the second does the same for tradables.

This may be a bit tragic, but I could pore over these results, and all the other ones, for hours (and have, come to think of it). The patterns are fascinating.

Why are dentists so expensive here, but vets so cheap? Why are the big components of investment (construction and capital equipment) so expensive, with potentially serious ramifications for New Zealand industries? Why is lamb cheap, bread reasonable, cheese on the pricey side, and eggs outright expensive? Why are most transport items expensive (other than your own car, where you'd think cheap second-hand imports have been keeping the price down)?

For some things, there seems to be a prima facie explanation - relatively high excise taxes on booze and bakkie, for example - and for others some suspicions, benign or less so. For lamb, Norman wonders if it could be the benefit of comparative advantage , which is down the benign end, but he also thinks less benign thoughts about transport, where there could be competition issues. As he says,

"Notably ‘passenger transport by air’ is especially highly priced in NZ (at 0.4 or 40% above OECD-30 average prices) but it is even higher in Australia (at 0.66 or 66% above the OECD-30). The lack of a genuinely internationally competitive environment for this so-called ‘tradable’ travel category in NZ-Australia seems a plausible candidate explanation for the high price differences". 

I'd suspect the degree of workable competition is an explanation in other sectors, too.

In short, you keep coming back to why, why, why - and hopefully this is where the second leg of Norman's work will kick in. I can't unfortunately be in Wellington today for Norman's speech at Vic, where he's going to go into some of the plausible reasons for these patterns, but I'll blog again when he's let us know.