My impression is that Telecoms rivals want two things to continue happening:

1. Telecom to be ineligible for broadband subsidies that they are getting from government,
2. Telecom to be regulated in a way that:  Reduces Telecom’s ability to increase downstream costs.  Likely increases Telecom’s marginal costs in retail markets.

As a result, is this really surprising?  By increasing the relative marginal costs of a competitor, you can improve your own profitability in the end.  I wouldn’t really trust Telecom’s competitors as an objective analyst of how telecommunication policy should take place in NZ

Source.

At first glance this seems weird, they are charging different prices for the same thing!!!  However, as anyone with experience of vending machines and universities knows, these puppies provide a lot of service to students late at night.  In fact, it is typical for sections of the machine to sell out before nightfall.

As we know that the first people to the machine will pay the lower price, we can also say that once the cheap chips sell people will have to pay more.

Now, given that the local tuck shop will be closed by night time we know that the number of substitutes to the vending machine falls at night.  As a result, this pricing system ensures that the owner of the vending machine can charge more for the same chips at night time (assuming of course that the cheaper chips will sell out during the day time when substitutes are available) – when people value them more highly and are willing to pay more.

Excellent stuff.

However, in the same way I don’t believe the difference in these games is just the product of “framing”, I am not sure if the call to arms against using interest rates as a focal point is necessarily that compelling.

On quantity and price competition

Back in the 19th century some economists called Cournot and Bertrand came up with separate models of firm oligopoly behaviour.  In the Cournot model firms picked quantities, and they kept some market power – albeit less than in the monopoly case.  In the Bertrand model firms picked prices – and we got this crazy result that merely having two firms in a market provided perfect competition.

As a result, economists became concerned.  We had two models, one which seemed to fit data better (Cournot) and one which had assumptions we felt were more realistic (Bertrand).  A multitude of ex-post imperfections could be introduced to a Bertrand game to create “supernormal profits”, such as heterogeneous goods, transaction costs, and imperfect information – but there was still the problem that, if we had only two firms competing and they decided to “play” in prices instead of quantities we had a different outcome.  Given that the demand curve is the thing along which both price and quantity were picked, and given that the firms in both cases were seen as equivalent, this didn’t seem consistent.

Eventually economists realised that there was something else at play here.  The Cournot and Bertrand firms were not equivalent at all.

In the Cournot game the question is:  if I LIMIT myself to producing a quantity how will other firms react – and given that reaction what level of quantity would I want to limit myself to.

In the Bertrand game the question is:  I have an unlimited ability to produce.  As a result, if I set a price how will other firms react – and given that reaction what price would I charge for the produce I will be able to make.

So in the Cournot game you build things first, set the price later.  In the Bertrand game you set your price and immediately satisfy this demand.  As a result, economists realised that the Cournot game was simply a Bertrand game with capacity constraints.

What in the hell does this have to do with the point on monetary policy!

I was getting there.  Fundamentally, in the same way that Cournot and Bertrand games were discovered to only give different results because they were fundamentally different, I believe that any difference between an interest rate target and other targets only differs if “effective policy” is different – I don’t believe in a framing issue persee (although framing explanations can be funky).

Now I don’t disagree with the idea that just talking about the nominal interest rate would be silly.  But central banks don’t just talk about a nominal interest rate – they also discuss an inflation target, which anchors inflation expectations.  In essence the current “focal point” for policy is the real interest rate.

Furthermore, since they control a real interest rate, and have anchored inflation expectations, they can print money which in turn increases demand for goods and services.  As Nick states:

And most of the power of a central bank comes from its ability to influence people’s expectations of the future. Like governments, police, armies, and referees, most of central banks’ power comes from belief in their power

The fact that inflation expectations are anchored implies that people believe they know the future price level, given that a significant portion of any nominal increase in income will be confused for real income – leading to extra spending activity.  That is the very power of an inflation target – an inflation target that is easy to communicate and explain to the public by discussing interest rates.

Targeting arbitrary variables that are positively related to an economic recovery, but not appropriately related to “monetary policy” seems both sort of aimless and potentially dangerous.  A central bank can keep discussing interest rates and its inflation target, and even at a “zero bound” it could stimulate activity by printing, printing, and printing.

Finally, I think it is important to note that this subject only really matters in the rare occasion that it really matters .  Outside of zero interest rates and a steep, depression like, drop in demand the interest rate (or some indicator of “monetary/financial” conditions) is an amazingly effective tool for communication.

However, my belief is that this effectiveness continues even in the extreme conditions.

The aim of the intervention is to reduce electricity demand and hence avoid the need to build new power plants to meet this demand. In this sense, the Commission perceive the building of power plants to be a negative externality, presumably as the cost of building is reflected in the per-unit price of electricity for all users.

I take issue with this ‘externality’. For example, if a lot of consumers suddenly started demanding ‘Thierry Henry is God’ t-shirts, such that the price increased, should I feel aggrieved that the action of others is affecting the price I must pay for such a worthy product? No, that is how the market works.

Putting aside my scepticism, let’s assumes that the externality is a genuine one. What might be a superior way of discouraging consumption?

Bans are a blunt tool. From an economic efficiency perspective, you should first try and use prices to incentivise behaviour. High demand for electricity is only ever a problem over relatively short periods. For example, in New Zealand the peaks occur on weekdays in the morning as people wake up and in the evenings as people go home. In hotter climates, the peak typically occurs at the hottest part of the day as air-con works its magic. Hence one might try to charge higher prices at times of high demand to discourage consumption (and hence avoid the need to invest in new power plants). There are electricity meters that are capable of facilitating such differentiated pricing and indeed they are being rolled out in California as we blog.

Under the differentiated pricing scenario, consumers are paying the ‘true’ cost of electricity, so even if they continue to consume at high levels, one should be indifferent to building a new power station as the externality has been internalised.

The obvious perverse incentive that arises from the ban is that consumers will simply purchase their televisions out of state, knowing that they can get a better range of TVs to better suit their individual needs at more cost-effective prices.

It is far more preferable to keep consumer choice open and simply make consumers fully pay for their choice through efficient pricing (assuming that an externality exists in the first instance).

Most banks are only interested in making as much money as possible out of their current customers, Kiwibank chief executive Sam Knowles says.

Now the actual stuff Sam Knowles says, for example the context of the above quote is really that Kiwibank is trying to build market share (since there is a significant transaction cost for consumers moving around the market) while the other banks are satisfied with their share, and so will be extracting surplus – in other words Kiwibank is keeping prices lower now to “invest” in the future.  Furthermore, I agree with him when he says:

New Zealand should work towards customers having a bank account “for life” and if they want to change banks “you can go and get it done” without any hassle,

As this would improve competition.

However, I just thought it was funny that the quote at the start of this post was the first paragraph in the article.  It is as if the newspaper thought there was something novel in the fact that banks act like everyone else.

If people want to eat enough and put on some weight that is their decision. After all WTF is an “obesity epidemic” – I didn’t realise people could gain weight just from looking at me after I’ve eaten

Say that there is an externality from obesity – well then we should try to solve that, not regulate the supply of food. No the idea of an externality may lead to a “fat tax“. Poor information for consumers might drive us to label foods in better ways. But there is no value to be gained from refusing to allow competition in supermarket sales.

Truly, these people that focus on obesity DO NOT CARE about the happiness of people – they only care about the fact that they don’t like obesity. It makes me sad

And if you try to defend these claims on a basis similar to “people don’t know what’s good for them” I suggest you just write down what you just thought and read it …

Fundamentally our firm is all about “maximising profit”, that is what it wants to do, that is its objective. Say that the firm (and all its competitors) only tries to do this ONCE. This is a situation where Steve said standard firm theory fails, so even though it is unrealistic it will work for our purposes.

To figure this out we need to ask “what is a measure of this objective”. For this we need our firms profit function:

So this tells us that profit is equal to revenue minus cost, where revenue is price times quantity, and where the price is a function of the amount produced by all n firms in the industry.

Now, we want to find where profit is as high as possible right. To do this we need to realise that our firm (firm 1) chooses and nothing else – this is their choice variable. As a result, they want to find what value of will make this profit number as big as possible!

To work this out we differentiate firm 1’s profit function with respect to their choice of output. Why? Well given that we assume that the profit function is concave in the firms quantity (or that profits increase at a decreasing rate as the firms choice of quantity rises) and that profits in the industry are positive for at least 1 level of output, we know that at one of the points where the slope of the profit function is zero we have maximum profit.

First let us take a standard static Cournot game. In this we work out the firms marginal profit for given levels of output. This tells us how a firm will set output given its expectation of other firms output.

Setting this to zero and solving for gives us as a function of the output choices of all other firms in the industry. This is a best response function.

To proxy for our firms “expectation” of other firms output in a consistent way they conjecture the output of other firms based on this same premise (working out their best response functions). Putting them all together we get a Nash equilibrium, where all firms choose output based on their best responses.

However, Steve has posited that he prefers it when we treat the other firms choice variables as direct functions of our firms choice variable. He does not like the Cournot Conjecture (essentially that firms act as if the other firms output level is given when they choose their own).

Ok so lets do this realising that the other firms choice of output are functions of our firms choice of output :

Now for our purposes this makeup is unnecessarily messy. We can say that where this is our “revenue function”. In that case our derivative is:

What does this tell us in english? Well the maximum profit is at a point where the additional revenue from a small increase in production is the same as the additional cost from increasing production. Here there is a change in revenue from our own output changing, and from other firms reacting to our firms change in output – this in total is our firms “marginal revenue”. This is what I meant before when I said that economists do use MR=MC and it is appropriate.

However, depending how we conjecture these reactions our results will vary.

Steven specifically conjectures our firm’s response to other firms’ output as “the choice variable”.

But what does this function stuff mean?

Now what does it mean when we go and make the other firms choice variable a function of our own when making a choice? Well, it means that more than “we are taking into account the other persons incentives”. Why? Well a normal Cournot game (the static one we first did) works out a “best response” given the other firms own “best action”. It finds the point where both our firm and other firms are acting consistently, and where we (and others) have no incentive to “deviate” from our current actions. This is a Nash equilibrium.

Explicitly stating that the other firms choice of output is a function of our own choice of output BEFORE determining our best response (which is what we did by finding the derivative above) implies that the other firms will OBSERVE our level of output and then REACT to that observation.

This matters because it implies that a firm can COMMIT to producing a level of output that would not be credible in the static game to get a competitive advantage. For this commitment to work we need the other firm to be able to see it happen – if the firms output is unobservable (a pretty damn realistic assumption) then this way of modeling is incorrect.

Economists call the type of guy that can do this commitment a Stakelberg Leader.

In the Cournot game we do not have a Stakelberg leader, no-ones output is observable, and so any push to “commit” to a level of output that doesn’t set marginal profit to zero given your expectations of other firms reactions will be a dominated strategy. It is true that if all firms reduced output their profit would increase (that is collusion) – but that doesn’t stop it being a dominated strategy in a static game.

The fact is, in a static game you can’t react to output “changes” (relative to expectations) from another firm. And in a dynamic game economics ALREADY estimate the value of these factors (eg ) when solving for the firm’s optimal strategy.

Conclusion

I am unsure whether Steve simply does not realise the assumptions behind the different economic models (and the degree of sophistication that has developed in a lot of these models past his “straw men”) or whether he realises but just likes insulting other economists.

If the government acts as a monopoly we will still have dead weight loss, as it comes from the “loss of surplus” relative to the situation where “surplus” is as large as possible (given demand and the monopolies cost structure).

But if government blatantly sets price equal to the marginal cost of the last unit dead weight loss will melt away. This does not imply that profit is dead weight loss in any sense of the word, and it does not tell us that the solution will be “dynamically efficient” (where is the incentive to invest, to develop), but it does tell us that a government that is behaving this way could achieve the “perfectly competitive” price and quantity.

However, this is all 100 level stuff that I don’t particularly care about. My interest lies with the “debunking of microeconomics” that Steve tries to achieve on Paul Walker’s blog.

His critique of “standard micro theory” is two-pronged:

1. Perfect competition is wrong because there are strategic interactions,
2. The cost structure of a monopoly and a “perfectly competitive industry” are likely to be different.

Perfect competition and “strategic interactions”

Straight off the bat here let me say that parts of this may step up to 200 level economics here, so lets hope my aging mind can keep me on the straight and narrow (Steve’s paper on the issue is here)

Now, BY ASSUMPTION perfect competition is the study of a situation where there are no strategic interactions between firms. There are “many firms”, many is a not particularly technical way of saying that each firms individual choice of quantity has a practically no impact on the market price. No matter how much additional milk a farmer produces the “market price” for milk is unchanged – and as a result the production decision of one farmer does not change the production decision of other farmers.

Do strategic interactions matter when looking at the actual performance of a market, hell yes! But the purpose of perfect competition isn’t to “describe a certain market” – it is to illustrate a situation where “surplus” from the market is maximised so that we have something to compare the market (and other counterfactual markets) too.

The cost structure of a monopoly and an infinite number of tiny firms is different

Yes, yes it is. And if someone was actually planning to split the industry into an infinite number of firms this would be important

But again, the purpose of perfect competition is to give us an idea of the “highest surplus” in the given market. The cost structure we should look at IS the monopoly cost structure. By doing this we can compare the outcome of the “monopoly” to an outcome where the monopoly aims to maximise total surplus in the economy.

Conclusion

Attacking perfect competition because it doesn’t represent an actual market is a strawman for attacking microeconomics.

Strategic interactions do matter, they do have an impact on the quantity in the market, and the size of any “deadweight loss”. But hell, industrial and microeconomics have been using this knowledge forever.

Steve’s idea that MR=MC is wrong is in itself wrong. Why? Well in the case of strategic interaction (in individual demand) the MR is a function of the other firms response to any change in quantity by our firm, as it all occurs through the “price level”. Deep down marginal revenue is just the extra revenue associated with a very small increase in firm output – the reaction of other firms to this change in output impacts on the price our firm gets and so is part of the “marginal revenue”

To take his own words he says firms are profit maximising when:

He says that this illustrate MR>MC as he believes (as it is with a monopoly). However, lets split out his equation a bit by looking at the change and assuming that we have reaction functions – such that where new is a function of . In this case we find:

where is the quantity produced by other firms.

When we frame it this way we can see that all that matters is how the other firms output impact on the price our firm faces – it is still part of what I would term the “marginal revenue” calculation.

The MR here is larger than the one we would have gotten from his previous equation (as both the inside terms are negative), but it is still the marginal revenue.

Update: Paul Walker discusses a paper that criticises these ideas further.

Update 2:  Paul Walker discusses a critique that Steve provides of a comment I put on Paul’s blog.  I would note that the individual firms behavioural relationship is the correct thing to look at – and although a bunch of things converge to zero as the number of firms tend to zero economists blatantly assume that “strategic interaction” term converges to zero more quickly.  If it didn’t, the equilibrium of the game often wouldn’t be stable as either the choice to enter or what to produce often would not converge.

Update 3:  BK Drinkwater also shows some skepticism regarding Steve’s claims.

This action is in response to falling demand for chardonnay and sparkling pinot noir wine, both domestically and internationally. Chardonnay exports reportedly fell 12-14% last year alone. The culprit? Chardonnay’s fairer sister, sauvignon blanc. Apparently we are seeing a significant supply-side ‘correction’, as producers respond to a structural demand shock – consumers’ changing tastes and preferences. Indeed, last year sauvignon blanc overtook chardonnay as New Zealand’s most consumed white wine.

Try as they might, Pernod Ricard have not been able to sway the mighty consumer to stick with the product they have contracted for, despite “new product development, innovative packaging, capital investment and changes in wine style”.

I know at least one TVHE author that might be a little disappointed seeing his favourite varietal taking such a pounding. As for me, well I’ll stick with my reds thanks.

However, I had to say something about this recent Westpac article on bank funding (ht Rates Blog).

At the end Westpac says that it, and other banks, have been pricing at average cost instead of marginal cost – so they have been pricing based on the cost of credit to them, not the cost of sourcing additional credit to make loans.

Now, according to Westpac the average cost is higher than the marginal cost, and all banks have seemingly agreed to do this even though since the marginal cost of credit is below the current “price” an individual bank could “defect” and make some money. Is it me, or has Westpac blatantly admitted to collusion here?

Westpac has said that it, and other banks, have implicitly agreed to set interest rates at a higher level than marginal cost – which I presume must be closer to the collusive price than marginal cost as otherwise it wouldn’t stick.

Now I didn’t think the banks were colluding, but if Westpac is willing to go ahead and admit it then …

[Note: to be fair I think long run marginal cost, which banks would actually need to set fixed rate loans based on, will be higher than marginal cost - and this would explain much of the difference. However, this isn't what Westpac said.  Also, I've ignored market power and the prevalence of fixed costs - again if they wanted to make these arguments go ahead, but do they really want to say that they used market power to keep prices above the marginal cost of credit ]