The visible hand in economics

Defending the Bank’s attack on “prices”

Posted on: December 11, 2008

Yesterday I said that I thought the Bank’s speech on bringing down the price level was ridiculous. Not only is asking for a decline in prices a strange thing for a central bank to do, the mentioning of “oil companies” was slightly off the mark – given that they have slashed prices in the face of falling crude oil (although to be fair the Bank was just asking them to keep going – it was the Dom Post that exaggerated it – or maybe I was being generous!).

Now I am going to defend it.

Say that we have a situation where firms in the economy are all oligopolies, and all set prices as their “‘choice”. When demand was rising these firms increased prices, and furthermore managed to implicitly collude to some degree (tacit collusion).

Now, when demand falls, each firm still has their “high” price but their output declines markedly. These firms realise that they each face a “relatively elastic” demand curve – such that they can cut the price they charge and the increase in revenue they experience will dwarf any increase in costs from having to produce more (especially as they will have capacity for this extra production, given that they were previously producing at an even higher level). So it is in the individual firms interest to decrease prices!

However, the firms in the industry realise that this incentive also holds for all the other firms. As a result, they know that if everyone acted on this incentive the demand that a specific firm faces would decline (as the price of substitutes would fall) and overall they would EARN LESS than if the whole industry kept prices up.

So we have a prisoner’s dillema, if the firms can co-operate and keep prices up they are all better off. However, there is the incentive for an individual firm to “deviate” by cutting prices.

As a result, we could be in a situation where, given the history of competition, firms in these industries are still “tacitly colluding”, and are thereby holding up prices in the face of falling demand.

When the Bank then tells people that prices are unfair, they increase the elasticity of the demand curve near the current price by even more – as people value “fairness” and they inform the consumer that things are unfair – this increases the incentive to deviate. Also, by doing so they make the firms feel bad – which further increases the incentive to deviate.

Once one firm has deviated, the collusion is likely to collapse like a pack of cards – as a result it may only take a small push by the RBNZ to get us from the collusive equilibrium to another equilibrium with lower prices and higher output.

This is my defense of the speech against the railing criticism I raised yesterday.

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12 Responses to "Defending the Bank’s attack on “prices”"

Come on. Didn’t you just post that petrol prices are (as expected) competitive? And didn’t Bollard just take a completely unwarranted swipe on petrol companies? Don’t we already have a competition commission?

“Come on. Didn’t you just post that petrol prices are (as expected) competitive? And didn’t Bollard just take a completely unwarranted swipe on petrol companies? Don’t we already have a competition commission?”

Yes, yes, and yes. Hence the first paragraph.

Even so, I wanted to TRY to justify what the Bank was doing for something to do – also, I like industrial economics and wanted to see if I could still put together some sort of arbitrary argument :P

To be honest, I’m pretty embarrassed about the speech – the swipe and petrol companies was ESPECIALLY ridiculous, but the attack on other types of retailing was still silly. If he is really concerned about inflation he should do something about it – instead of looking for scapegoats.

Seems to me Roger Kerr the analyst not BRT man was close to it when he said it was a sign that the methods of managing inflation the RB had were not working. It did seem a muddled, populist and slightly desperate speech.

I should add that I’m hearing stories the govt is going to lean on SOEs to be more efficient and generate more cash. What does that say for where prices might go?

“Seems to me Roger Kerr the analyst not BRT man was close to it when he said it was a sign that the methods of managing inflation the RB had were not working”

I would say that they didn’t fully apply their method for controlling inflation when it was required – in 2003. If they had we wouldn’t be worrying about it now.

They’ve realised this now, but the global financial crisis is preventing them from doing anything to try and make up for it – in that sense the speech could be construed as desperate.

However, I don’t even think the speech was necessary – it just hurts the Bank’s credibility, as it makes it look like they depend on firms to control inflation, rather than being the strong body that can anchor expectations which they should appear to be

“I should add that I’m hearing stories the govt is going to lean on SOEs to be more efficient and generate more cash. What does that say for where prices might go?”

Be more efficient – that should see “shadow” prices for whatever the hell the SOE produces fall.

I don’t know about the government sector – it is definitely a strange one

I’d also add more, that if we are to get new electricity generation to meet increased demand, then that to me implies prices have to rise to provide the return needed to justify building more expensive plant. This is based on the assumption that generators sequence their building from the cheapest or best value plant to the most expensive. Surely Bollard understands this?

This is why I don’t understnad successive energy ministers promising to build more AND cheaper power. Why would you overbuild firstly, and secondly why would you collapse prices? They set silly expectations then rant when they are not delivered and undermine confidence in markets overall as a result. Personally I blame Max Bradford :-)

Insider,

Spot on – energy policy is not a government strong point :)

The best thing the government can do is reduce the uncertainty surrounding the investment – rather then prattling on with popularist jargon.

[…] Yesterday I said that I thought the Bank ’s speech on bringing down the price level was ridiculous. Not only is asking for a decline in prices a strange thing for a central bank to do, the mentioning of “oil companies” was slightly off …[Continue Reading] […]

What bugs me the most about this speech is the motivation he’s offering – to paraphrase, “we need to see rates/ fuel/ power prices come down so that inflation will fall… then we can top it up again with rate cuts”. These price rises are bad not because they increase the cost of living, but because they prevent Bollard from looking like the hero.

If just further fuels my suspicion that Bollard sees his role as to keep interest rates as low as possible within the constraint of the inflation target – meaning that 3% average inflation is not the maximum but the minimum, as there’s no incentive or pressure to aim for anything lower.

“If just further fuels my suspicion that Bollard sees his role as to keep interest rates as low as possible within the constraint of the inflation target”

Indeed, I suspect that the Bank is giving people that feeling – how can inflation expectations fall below 3% if the Bank isn’t interested in getting medium term inflation down in the first place :P

While Americans must “save more and spend less,” Mrs Clinton said Asian countries should base their long-term growth on “stronger and broader-based domestic demand” instead of just relying on exports to fuel their economies.

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