The case for free market price caps

Every introductory textbook teaches that the price of a good or service is established by supply and demand. When a price of something is set not by these impersonal forces but arbitrarily by politicians through a cap, the usual expected result is inefficiency, distortions and, ultimately, a loss of welfare. The people who the government wants to help end up getting hurt.

Think of some developing world authoritarian decreeing that the price of petrol, bread or some other staple must not be sold above a certain price to ease the pressure on the people's cost of living. Such interventions have not tended to end well.

So doesn't that logic imply that the energy price cap introduced today by the government will be counterproductive? Isn't this a classic case of ministers ignoring the lessons of economics and history? Maybe not. There are times when introductory textbooks and horror stories of populist economic incompetence are an inadequate guide.

Last year Botond Koszegi, a highly respected economist at the Central European University, presented a theoretical paper at the Royal Economic Society conference in Brighton suggesting that regulatory price caps should not, in fact, always be anathema to economists and policymakers.

Koszegi showed that in certain rather complex markets, which require a high level of research from customers to get a good deal, price caps can be effective both in helping the less well off and also in boosting competition.

Koszegi posited that if consumers who have limited time and attention can do less "study" (defined as scanning the small print of a particular contract offering) they can spend more timing "browsing" for better offers. The key is to regulate the "secondary features" of contracts - for instance capping the charges for additional data in a mobile phone contract - so that consumers can be reasonably confident that they are not going to be ripped off, even if they spend less time studying.

Does this model apply to UK domestic energy markets? It's not a precise fit, says Koszegi. Those 11 million UK households languishing on private energy companies' notoriously expensive "standard variable tariffs" (SVTs) are likely to be totally disengaged from the market. They're neither studying or browsing - they've simply ended up there through inertia.

Yet other aspects of Koszegi's modelling, looking at what can happen in a complex market in which some consumers are sophisticated and some are naive, does apply.

"We would predict that new entrants attract away switchers, and legacy providers are therefore left with many non-switchers," he explains. "This change in the customer base of legacy providers leads them to concentrate on exploiting non-switchers so that competition is actually detrimental to non-switchers."

That sounds like a good description of British Gas, the legacy provider which still has around 3 million customers, many of them less well-off and elderly, on its SVT.

Koszegi and his colleagues conclude that the government's price cap on the SVT is not a regressive move.

"We're sceptical that a cap on the SVT would be harmful," he says. "Although this is ultimately an empirical question, our sense is that the cap would not harm competition much, as the switchers are choosing not between the SVT and another tariff, but between different non-SVT tariffs. And even if the cap lowers competition somewhat, it makes sense from a distributional point of view."

The 19th century man of letters Thomas Carlyle was not enamoured with economists. As well as inventing the term "dismal science" he once scoffed: "Teach a parrot the terms supply and demand and you have an economist."

Perhaps there's some truth in that. But some, at least, are singing a more nuanced tune.

The energy market is broken but customers stubbornly refuse to be liberated from their tariffs

In a new book James Kwak describes the curse of "economism". This is the tendency for people to engage in public debates about economic policy brandishing nothing more than a supply and demand curve and a conviction that all government interventions in markets are inevitably destructive. 

Purveyors of economism treat all markets as simple and identical. They disregard context and assume perfect information from participants. They reason as if they have read only the early chapters of an introductory economics textbook and that they never grasped that the models described in those chapters are useful abstractions, not descriptions of the real world.

There's been a lot of economism in the debate about the Conservative proposal for price caps on certain residential energy tariffs (just as there was when Labour under Ed Miliband promised an overall price freeze two years ago). Fearful outcomes apparently range from a collapse of investment in new supply to a Venezuelan-style social collapse.

The first challenge to the simplicities of economism is detail: an analysis of the characteristics of the market in question. Around 70 per cent of UK households, despite much prompting from ministers and advertising from switching websites, are not getting the message that they could save money by changing suppliers when their fixed-term contracts come to an end. 

Now this could be because they enjoy paying over the odds for their energy, which seems unlikely. It could be because they love their existing supplier too much to ever think about changing, which again seems somewhat implausible. Or, more likely, it could be because they are baffled by the artificial complexity of the tariff contracts offered and feel too intimidated and confused by the concept of a market in domestic energy to switch.

Of course, a third of people do switch supplier, leading to complaints that capping the standard variable tariffs of the non-switchers will undermine this functioning element of the market. Yet this brings to mind the polite curate who told his host that his boiled egg was "good in parts". It's difficult to argue that a market is functioning only in parts.

If a majority of customers don't switch, that undermines the pressure on providers to provide a good service to anyone. It's no coincidence that the heart sinks at the thought of having to ring one of the major providers to question a bill - and that the "big six" come out notably badly on customer satisfaction surveys.

Another solvent for economism is some history. Electricity was once provided, in the majority of areas, by local authorities as a kind of public good. There followed a national monopoly after the Second World War.

And controls were only last month re-imposed by the regulator on charges on pre-payment metres (which are a common feature of the homes of the poorest). Intervention and tight regulation have been the norm in the residential energy sector for most of its history.

It is now seventeen years since the residential energy supply market was liberalised. But most people stubbornly refuse to be liberated. One can take the view that further effort is required to nudge them into the switching habit.

Or another, reasonable, conclusion is that domestic energy may simply never be the fast-moving and competitive market that was once envisaged and that some form of limited price control is now justified to put a stop to the egregious gouging of vulnerable customers by complacent private incumbents.

In his 1953 poem The Solution Bertolt Brecht satirically lamented that the people had forfeited the confidence of the government and that the time had come to dissolve the people and elect another. We should beware the temptation to blame customers for letting down the residential energy market.