Deregulation needs to be designed


The Consumer Utilities Advocacy Centre has just released a report on Improving energy market competition through consumer participation. The report looks at the Victorian retail energy market and notices that a lot of consumers have been disengaged from the market. Despite the price caps on tariffs for small residential consumers being removed in 2009, many consumers have just stayed with their pre-existing energy suppliers. While not documented in the report, it appears that some, if not most, of these consumers would be able to get lower priced energy if they did switch.

Is this a case of the market not working? The report looks at a variety of so-called non-neo-classical economic explanations for the lack of consumer engagement. My reaction is more simple. What were the policy makers who designed the electricity deregulation thinking?

Of course most people (including me) stay with their pre-existing supplier. It takes time and effort to search around for a cheaper energy tariff. And the tariffs are complex, making it hard to compare them. As the report notes, often websites that supposedly help consumers don’t help. And it appears that retailers can price discriminate–providing better prices to those consumers who are engaged in search.

This is completely predictable. Any basic model of market behaviour where:

  1. some consumers have search costs and others do not;
  2. consumers are initially allocated to a retailer and need to search to move to an alternative retailer; and
  3. retailers are able to price discriminate on the basis of revealed search costs

will lead to this sort of result.

In most markets, consumers with low search costs provide a positive externality to those with high search costs. Because retailers cannot distinguish between low and high search cost consumers, the retailers set prices to compete for the marginal consumers who tend to shop around. (Think simple Bertrand competition if you want a formal model). Most consumers just free-ride on these marginal consumers – the marginal consumers drive prices lower and all consumers benefit. In contrast, deregulation of the Victorian energy market appears to have been set up in a way to ensure that most consumers cannot free-ride on the marginal consumers with low search costs.

So what could be done? When similar reforms were introduced into telecommunications in the 1990s, consumers had to choose. There was a ballot between the two options at the time; Telstra and Optus. While this sort of forced choice is not optimal (and the ballot favoured Telstra), it created consumer awareness and helped educate consumers about phone prices.  Subsequent competition suggests that it worked better than Victoria’s energy reforms.

Alternatively, the market rules could prevent price discrimination. For example a rule could state that a consumer who remains with their ‘default’ energy retailer must be provided with that retailer’s cheapest tariff (if tariffs involve non-linear pricing this would involve a basic calculation – any decent billing system could do it). This rule could last for a fixed period of time or until a consumer chooses to change providers.

I’m sure there are a bunch of other alternative policies that are probably better than the two above. But the report seems to blame the failure on poor economics. I protest! It is not poor economics but poor design of deregulation that is at fault.

One Response to "Deregulation needs to be designed"
  1. Microeconomic analysis changes enormously if cognitive and time constraints on personal learning; and the perceived advantages and disadvantages that motivate learning are taken into consideration. These provide limits of organisation quite generally where the costs of regulation are part of the mix.

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