Ofgem Economics: Simple Tariffs

Ofgem have announced that Energy suppliers must simplify their tariffs. Under the new proposals Ofgem will set a fixed standing charge and the supplier will determine a unit rate.  This blog entry will explore that decision.

Consumer Irrationality

One of the key problems that Ofgem has been working on for a number of years is the customer switching rate. 40% of people have never switched supplier and of those that have, only a fraction will switch supplier on a regular basis. For a classical economist this is perplexing indeed. Why would someone pay more for a commodity than less? Switching supplier can be done within 20 mins on the internet and save hundreds of pounds a year, yet most people won’t switch in any given year.  For Ofgem, who would need constant switching in order to create an effective market place, they need to know why people don’t switch. The answer lies in a branch of economics called Behavioural Economics. 

Behavioural economics is all about why people behave in a suboptimal utility maximising way, or in other words, why people are not rational.

In the case of power and gas, the tariff structures can be confusing and complicated. There are lots of different types, fixed, trackers, online and standard. Also, the tariffs are calculated in different ways. Some offer different unit rates for trenches of consumption whilst others offer a standing charge and a variable rate. Some have different rates for day and night, while others have day, night and a seasonal price. In all this confusion it is little wonder that consumers can make suboptimal decisions

When a consumer face a great deal of complexity and uncertainty they are likely to make wrong economic decisions. This is because their rationality is said to be bounded. That is, people want to be rational, however due to lack of information or limited computation ability they might not necessarily achieve it. For a regulator this might be a case to intervene in the market.

Ofgem has recently announced that it wants all suppliers to simplify their tariffs and have set out a standard to which all retail energy suppliers must follow. This will mean the removal of several types of tariffs and there will be fewer products available on the market. 

Whilst tariff simplification will help the problem of Bounded Rationality, there are limitations to the efficacy of these changes.

Status quo basis

The reason why people are not switching may be in part due to Bounded Rationality, but it is most likely it’s to do with their Status Quo Basis.

In the 1990s in two US states, as a part of a law reform of car insurance, policies were made void and their consumers were offered two types of new car insurance. One allowed them to sue for medical damages and the other, which was cheaper, did not. If no decision was made then they would default to whatever the state nominated as the default policy. Both States adopted different default insurance, and in both states most consumers went with the default category.

The same is true with electricity and gas supplies. Most people when they move into a new home will continue with whatever supplier they inherit.

When it’s possible to save hundreds of pounds for less than 20 minutes work, it is not rational to keep with the status quo. In this respect simplifying tariffs will have no effect on those who simply stick with the status quo.

For argument sake let’s assume that simpler tariffs will increase switching rates and help the market become more efficient.

Rocket and Feathers

Improving market efficiency will provide new challenges for an Industry Regulator in an Oligopolistic market.

If all consumers switched to the cheapest tariff available to them, it would change the behaviour of the firms in the market. If a supplier knew that a price increase would result in all customers leaving, then they would think twice before doing so. Equally if the supplier reduced its price and became the cheapest, it would gain all the customers. Obviously the other suppliers would not allow this to happen and so would respond immediately. Since the supplier knows that the others would respond to any price decrease, it does become logical to lower their tariffs and prices tend to become stuck. Prices can become particularly stuck in the downward direction, with a price decrease there is a sacrifice of revenue and profit. What would be the point of cutting prices and not gaining any customers?

Prices can shift up however when costs jump. If one large player is bold and raises their prices in response to increasing costs, the others will cautiously follow. So long as all major firms are obedient in their prices movements all firms can enjoy decent margins. This effect is known as Rocket and Feathers, Prices rocket up in response to costs but floats down when costs fall.

Ofgem realise this and are continuously producing market reports which try to evaluate the competitiveness in the market. So far in all of the market probes, apart from a few bad practices, show the market is competitive. Margins, until recently, have been reported as small and prices are low compared to that on the continent. Ofgem want more small suppliers in the market to deter the Big 6 from making huge profits. In fact, Chris Huhne tried to blame the Big 6 for deterring entrants with their overly competitive prices (after criticism the Big 6 gladly stopped this pricing policy).  However neither Ofgem or the government need be concerned, as small suppliers will become attracted to the market should the profitability increase.

How to get a girlfriend/boyfriend using Economics

Economics can play a part in every aspect of all of our lives, even in relationships. This week’s blog will focus on the application of one part of economics, Game Theory.

Game theory

Game theory is a branch of economics, which is concerned with how people make decisions based on what other people are doing, and in turn, how other people will make decisions based on what you’re doing.

Game theory can be applied in any circumstance where there is human interaction, from socialising with your friends to debates in parliament.

An example of one, which you may have herd of, is called the Prisoners’ Dilemma.

Two prisoners sitting in individual cells have been accused of collaborating in a crime. They have no way of communicating with one another and are asked to confess to the crime. If both prisoners confess they will each receive a sentence of 5 years, if neither of them confess then they will only receive a sentence of 2 years. However if one confesses and the other does not then the confessor will go to prison for 1 year and the one who does not will go to prison for 10 years. Both prisoners are made aware of the prison terms.

If we put our selves in the position of prisoner A for a moment, we can soon realise the outcome of this game. Since we know that people hold their own interest first before others, we know that prisoner B will try to go for 1 year sentence (confess). We also know that Prisoner B will be thinking that the same thing about us and so will not risk a 10 year sentence (denying). The result is that both prisoners will confess to the crime even though it was in both their interests to deny the crime.

This is a good example of game theory in action, where both players were considering the actions of each other when making their decision.

The Game

The game of romance is significantly more complicated than that of the above example.

Often we think of males and females having different objectives in their relationships but fundamentally they are identical. Both men and women want the best partner that they can get. However there are some key problems to this.

1)      You don’t know how attractive to the opposite sex you are compared to others.

2)      Given how attractive you are, what attractiveness can you achieve?

In the diagram above let’s assume guy and gal go on a date, both of them are trying to find out the same things. How attractive am I compared to average woman and how attractive is he compared to the average man and is this a good catch given my attractiveness?

After the date both will consider their relative attractiveness to one another. That is:

Relative Attractiveness = Male Attractiveness Score / Female Attractiveness Score

If the relative Attractiveness score is = 1 then they are a perfect match, they are equally attractive as each other. If the score is greater than one then the male could do better but the female has hit the jackpot. If the score is less than 1 then the female could do better but the male has hit the jackpot.

e.g. assume the average attractiveness = 100

Ra = 100 / 50 = 2

In this scenario the average male goes on a date with a bottom quartile woman. For the female, he is a catch for the male she is a waste of time.

The game therefore is to convince the other player that the Relative Attractiveness score is in their favour but at the same time assess whether the potential partner is the best that they can get.

This is more easily said than done.

Will you marry me!?

Let’s imagine you’ve just been on a date, which went quite well, you’re still not sure on the relative attractiveness score but you think it’s worth another date. Then you get a text message asking you to marry them.

The potential partner has dropped a clanger. She has signalled that the relative attractiveness score is such that you are the jackpot to them, which means you can do much, much better.

Obviously this is an extreme case, but when communicating after a successful date it is crucial that you do not signal a relative attentiveness score that could damage your chances of a second date or a relationship. Equally if you do find a potential partner that scores well on attractiveness you may wish to pursue a second date, but if you signal that intention, you will in turn have an adverse effect on your relative attractiveness score, and this is where game theory comes in.

If both players are aware that they need to signal a higher attractiveness score and at the same time want to go on a second date then there really is a conundrum.

First Mover Disadvantage

Given that communication could adversely affect your relative attractiveness score; there is a serious disadvantage to being the first to initiate communication after a date. In this respect it is best to wait for them to be the first. However if both players are thinking this then neither will ever communicate, which could be a waste if they are a perfect couple for one another. This part of the game is a bit like a game of chicken, where the one who is prepared to sacrifice a second date the most, will come out on top. 

If communication is carefully done so that scores are not affective then you will secure a second date and potentially a relationship.

Don’t go mental!

If you think you have secured a good catch, it is important to act as if you are equals. Don’t talk about baby names, weddings or give any indication that you have considered a lengthy future together in the early days of the relationship. This will send a signal that the partner has made a mistake in his estimation of relative attractiveness nad they will promptly back out.

 Good luck and good gaming singletons!!

Success (part 2): The Role of Chance

Last week’s blog looked at how everyone is in charge of their own destiny. That if we work hard and really apply ourselves, we can succeed at almost anything.  However this is only really telling one side of the success story, for there is a fundamental law of the universe that we all must observe…chance.

The Uncertainty Principle

The universe is fundamentally uncertain; we cannot know where particles are and what their velocity is at the same time. In other words, we cannot predict the future.  To map out our future we can only use probabilities.  

Chance itself though, has a profound effect on all of our lives; from the millions of sperms that could have beat you to the egg, to the place you live, what parents you have and what school you went to, all have shaped and made the person you are today. If there are so many random elements to our lives are we really in control of our own destiny, or are we passengers on a road trip though randomness?  

Right place & right time

In the previous week we saw how Matthew Syed had practiced for thousands of hours to become the UK men’s champion at table tennis. However we failed to focus on the real points that made him successful, we simply concluded that the hours of practice he did made him successful.

But what if Mathew had been born 5 years earlier? He would not have had an older brother to practice with, he might not have had a 24 hour club to practice in, and he may have never started playing table tennis in the first place. 

You might be thinking “ok, so he had a lucky start, but it was his own efforts that got him to where he is”. But think again, what was it that made Matthew so devoted to table tennis?

Initially he played table tennis with his brother because he enjoyed it. By being fortunate to have an older brother and a table to practice on, by the time he went to senior school he had already accumulated a massive head start, from that he was encouraged to go further. This encouragement started a positive behavioural feedback loop, where the more Matthew trained the more positive feedback he received from his coaches and so the more he trained.

Mathew did not wake up one morning and say “I’m going to be a table tennis star and nothing is going to stop me!” he simply went along with the flow and ended up as one.

RGH

Another way of looking at how chance plays a role in our lives and particularly in successful business, is through the Random Growth Hypothesis (RGH ).

The best way to illustrate the RGH is through a simple coin tossing example.

Ten million people enter a coin tossing competition, they all pair up and a toss a coin to decide who will go through to the next round. So after one round there will only be 5 million people left. The eventual winner will have correctly guessed 24 consecutive coin tosses.

To the outside observer it is obvious that the eventual winner has won by chance, but to the individual who won, they will believe that either they have a natural ability at guessing heads or tails or they will believe they have found a pattern for guessing it. (And why wouldn’t they, after all the probability that they just won by chance was 1 in 10 million.)  The theory states, “The eventual winner will be writing books on how to win at coin tossing!”

We often look up to the likes of Alan Sugar and Richard Branson as fantastic business men. But are they good at making business decisions or are they just tossing coins and getting the right answer?

Take the example of John Grisham, his first manuscript A Time to Kill, was rejected by 26 publishers. He was still completely unknown until a bootleg copy of The Firm, found its way into the hands of a director, who brought the rights to make a film on it for $600,000. Once he had some recognition for his work, his future works began to fly off the shelf. Nowadays, John Grisham can write a fairly average book and it will still become a top seller. There are probably far better writers out there, but they have just not been found yet. John may well give lectures on how to be a successful writer but in truth he’s famous because he got lucky.  John is not the only writer to have found success after a long series of rejections. Anne Frank’s diary received several rejections; one comment stating it was “a dull dreary record of typical family bickering, petty annoyances and adolescent emotion. Even if the book had come to light five years ago, when the subject was timely, I don’t think there was a chance for it”.  J.K Rowling received nine rejections before she was signed and Dr Sues, twenty seven rejections. John Kennedy Tole received so many rejections he gave up all hope of ever being a successful writer; he became so depressed he committed suicide.  Eleven years later he won Pulitzer Prize for Fiction and his book, A Confederacy of Dunces, sold over 2 million copies.

Success

This blog has looked at the two aspects of success, hard work and chance. But some conclusions can be made; whilst chance plays a key aspect to success and many of us are not given head starts in life, it doesn’t mean we have to give up on our dreams. We cannot give up and become a John Tole. As much as John Grisham owes much of his success to chance, he didn’t give up, even after twenty six rejections. At times John Grisham must have felt as low as John Tole, but he kept going, he kept writing and he kept on improving himself.

For most of us our careers are already established, our lives seem fixed and unchangeable. Success seems to be for those who are fortunate to have the right parents and the right settings.

But the truth is, if we try hard, dedicate our spare time to our own goals then maybe, just maybe, we’ll get lucky and succeed.

Success (Part 1): The myth of talent

This two part blog entry will look into the fundamentals of success and the economic policy implications that result.

Too often we look at a high achiever and say “isn’t he talented” or “isn’t she clever”. But is this just an excuse we give ourselves for not fulfilling our potential? Is talent real?

The Myth of Talent

Two psychologists grouped a range of violinist’s into three groups based on their assessed ability level. The top group were soloists; many of them having had success with their own albums. The middle group were individuals who played in orchestras and were either professional or semi-professional and the last group were amateurs who played in local music groups and free concerts.

The psychologists were interested to find out what differences in their backgrounds may have affected their success. Was it their schooling, their social economic background or something else? To their surprise there was only one thing separating them, they all came from fairly well off backgrounds and they all had decent schooling. The only difference was the amount of time they had practised. The lower group had practiced just a few thousand hours over their lifetime, the middle group had practiced over 5,000 hours but the top group had spent over 10,000 hours practicing.

To an outsider, watching the violists perform, it would seem as if they had some natural ability. As they effortlessly play Vivaldi’s four seasons it appears as if they just have a gift. However they don’t, because talent is just a myth.

People are not born with innate abilities; they do not process knowledge or have a hereditary setup that gives them an advantage. It is hour and hours of practice that we don’t see, that makes someone appear talented.

Matthew Syed, a British champion at table tennis, wondered why it was, that three other people on his street were also champions of table tennis in some form or another. If talent really exists, shouldn’t its geographical location follow some form of random distribution? Matthew explored what it was that made him a champion and found that there were several things that contributed to his success. Crucially, at his local school the P.E. teacher was a keen table tennis coach and ran classes after school every day. Also, there was a 24hr table tennis club nearby. These factors ultimately gave him and the other champions on his street a massive advantage over other players his age.  At a young age he had already accumulated thousands of hours more practice than other players. He believed that this early start gave him the advantage and lead to a sequence of events that eventually saw him crowned champion.

Fortunate Training

So if you have two individuals that have trained the exact same length of time how could there be a winner and why would the other person win? Isn’t their some fundamental talent that makes someone that bit better?

The type of training you do is not going to be homogenous, even in tennis if you play against the same person all the time, there will be random development of strengths and weaknesses. For example you might have a slightly stronger forehand than your opponent, but he might have a slightly stronger backhand. At the crucial moment when a shot will determine the outcome of the game, a stronger forehand might just make the difference between winning and losing. This would not be talent, you just happen to play more forehands in training than your opponent.

Matthew Syed experienced this training fortune firsthand when a group of table tennis players had their reflexes tested. Amongst the group was Desmond Douglas, the greatest ever UK table tennis player. He was renowned worldwide for his speed and reflexes, so when he stepped up to have them tested there was a quiet a bit of excitement in the room. Surely his reflexes must be off the scale! They were not; in fact they were the slowest in the room.

Confused by this result the other players probed his training history. One particular training method stood out; instead of playing against other people Desmond would often lift up the other side of the table and just play against the upside. By doing this he had began to learn how to return the ball at an incredibly quick speed. Even though his reflexes were naturally slow, his brain had learnt to cope and pre-empt the way the ball would travel. He practiced so much that it soon became second nature to him; he didn’t even have to think about it.  Desmond was not talented; he just practiced for tens-of-thousands of hours in a way that gave him an advantage over his competitors.

If this is true, and talent really doesn’t exist then it has profound implications on what we think we are capable of. No mater what card we are dealt in life, if we work hard and practice hard, we can become seemingly brilliant at whatever we apply ourselves to. We really are the champions of our own destinies.

Or are we?….Part 2 to follow next week.

Adam Smith: The man behind your £20 note

Look on the back of a twenty pound note; you will see a 2 dimensional rendering of a man and a line of text which says, “The Division of labour in pin manufacturing (and the great increase in quantity of work that results).”  It doesn’t sound particularly inspiring; you might be questioning whether such a discovery has a worthy place on the back of our currency. After all, pin manufacturing is not the most important of industries. But what he found has had a profound affect on the way we work, live and the role of government.

 

Why don’t we make our own things?

Why don’t we build our own houses, grow our own crops, farm our cattle, educate our own kids, design and make our own clothes? Well if we did, most of us would be living in wooden shacks, practically starving and have a fashion sense of a prehistoric man.  The reason we don’t is because it is more efficient for someone else to do it, who is specialised in a particular skill.

Adam Smith noticed in a pin factory, a group of workers who produce their own pins from start to finish were significantly less productive than a group specialising in one aspect of pin manufacturing. He estimated that by dividing labour up in a factory there would be between a 240 and 4,800 fold increase in productivity. By focusing the skill of the workers on one task, the worker was able to learn some efficiency tricks, what to do and what not to do in his specific role.

This same principle can be applied to the economy as a whole. Why do we have electricians, doctors, hairdressers etc? – it’s because specialisation increases the total amount of goods and services that we can have.

Consider this quote from Milton Friedman.

“Not one person in the world knows how to make this pencil.”

What he means is the lead (graphite) in the pencil comes from a mine in China. In that mine hundreds of miners are specialised in its extraction. The miners use tracks and tools, tools which are produced by other specialised people. The wood comes from Northern Europe, where lumberjacks work with saws made by blacksmiths. The rubber is grown from trees in Malaysia. Literally thousands of people, all specialised in their own tasks, have been required in order to produce the pencil for you in exchange for 20p.  

Such is the power of the division of labour.

The Invisible Hand

Another aspect of Adam Smiths work was the famous ‘invisible hand’.

Adam Smith was amazed by smugglers. During the 1770s, when the Wealth of Nations was written, there were heavy taxes on certain imported goods; smugglers would avoid importing these goods through the major ports to avoid this tax. It was during this observation that Adam Smith realised that although these smugglers were acting in their own interest, they were also acting in the interest of their customers. By avoiding the tax they were able to provide the goods for a lower cost. It was as if they were guided by an invisible hand.

If somebody wants an income, then they need to produce something that somebody else wants to buy. In order to promote ones own interests, they are serving the interests of his customers.

Gorden Gekko’s famous speech in the film Wall Street, said “greed is good”. And in according with Adam Smiths invisible hand, he’s right. So long as there is effective competition and the markets are working efficiently, the greedier someone is, the more they will have to produce to get it. In other words…“In competition, individual ambition, serves the common good.”

Some Clever Marketing Tricks

In traditional economics marketing was simple a means of informing potential customers about your product. An advert would state what the product does, what it can be used for and how much it costs. It might also say why it’s better than it competitors, but nowadays it has taken on a whole new entity. It has become a means of manipulating customers rather than informing them.

If you’re a private company you are going to use every trick in the book to try and boost your profits. Here are a couple of them.   

Conditioning

Ivan Pavlov, the famous Russian physiologist, found that if you feed a dog and ring a bell at the same time, the dog will begin to expect to be feed every time the bell is rang regardless of whether the food is there or not. Not only will the dog expect to be feed but it will also start salivate. Crucially, salivation is not a cognitive thought, but it is an involuntary response that has been hard coded into the dog. The process of gaining an involuntary response through repeated stimulus is known as ‘Conditioning’, and it doesn’t just apply to dogs.

If I’m a trying to sell something wouldn’t it be great to cause an involuntary response of people to buy my product. All I need to do pair the product or brand I’m selling with an involuntary feeling or response. For example if I was thirsty, what brand or product might you associated with the word ‘thirst’?

Why is Sprite saying “Obey your thirst!” in their advert? It is not informing you about how it tastes, what the price is or how it is better than its competitors. They are trying to condition you so that when you are thirsty you will think of Sprite.

If you regularly watch advertising on the telly you will bombarded by these messages. It’s quite possible that many of your purchasing decisions are not based on rational thought but involuntary responses to marketing stimuli.

Anchoring

Human beings have evolved several odd traits that were required to stay alive hundreds of thousands of years ago, but today they can cause suboptimal decision making. One of these traits is Anchoring.

In order to make quick decisions man needed to use reference points. “Is this a good cave to live in?”, “is she a good mate (in the reproductive sense)?” To answer these sorts of questions humans need reference points. They need to compare to previous caves to know if the current one is a good one (and the same is true with girlfriends).

;-p

But when it comes to making purchasing decisions, clever marketing companies can use anchoring to their advantage. Consider this advert for a subscription to the Economist.

1. Internet only subscription $59
2. Print-only subscription $125
3. Print and internet subscription $125

You might think ‘why would anyone want to buy 'Print only subscription' and that ‘the Economist must have either made a mistake or be a bit stupid?’ But actually they are using anchoring to their advantage. By placing the ‘Print only subscriptions’ at the same price as 'Print and Internet' they have forced you to anchor to number 2 and therefore make number 3 appear an excellent deal.

In the above example 84% of sales went to number 3, 0% to number 2 and 16% to number one, but when number 2 was removed sales to number 3 fell to just 32%. Buy using the decoy anchor the economist were able to increase their revenue.

Here’s another example:

1)      When Ghandi died, was he younger or older than 140?

2)      How old do you think Ghandi was when he died?   

With this line of questioning the average response to question 2 was 67 but if I change question one to: ‘When Ghandi died, was he younger or older than 9?’ the average response to question 2 was 50.

Question 1 was another decoy anchor, it was designed so that your brain took that age as the bench mark and the adjusted it.  

However once you are aware of these sales tactics you are less likely to fall for them and more likely to appreciate them. Next time your in Tunisia and a man selling a water pipe says “500 Dinar, no?... Okay for you 100” you can compliment him on his good anchoring.

Why do we tip?

You’re in a restaurant with friends, you’ve just finished your meal, it was ok, nothing spectacular, but when it comes to pay for the bill, for some reason you pay more than it cost. Why did you do this?

For economists, tipping is an odd thing. It is often assumed that people are rational and that they will try to maximise their happiness given their limited budget. But for someone to choose to give away some of that budget unnecessarily is a confusing issue indeed.

Consumer Surplus

Whenever anybody buys something they do so because it adds more value than its price. For example if I buy an apple for 25p, I do so because I was prepared to pay up to 50p. The benefit of the apple to me is 50p. In other words I have converted 25p of currency into 50p worth of appley delight. The 25p worth of additional benefit is known in economics as Consumer Surplus.

But you wouldn’t give away Consumer Surplus to the seller of the apple voluntarily, so why do you do it in a restaurant? To answer this we need to turn to a field of economics called Institutions Economics

Institutions

Institution is a word often floated about the press but its meaning is often misunderstood. An institution is a socially accepted normal behaviour.

The Royal Family is an institution, a hand shake, a tie, queuing, a wedding and saying ‘hello’ when you greet someone are all institutions.  It is the things you do to demonstrate that you are normal person and that your behaviour is predictable.

Without institutions humans would be no different from animals, our behaviour would be erratic and civilised society would not exist.

If you think about it, shaking someone’s hand when you meet them is an odd thing indeed. We do it to demonstrate to the person you are meeting that our behaviour is predictable, that we will obey the socially accepted normal behaviour and in doing so reduce uncertainty or increase trust. If you meet someone who did not shake your hand and just stood there, you might feel uneasy and a bit awkward.

Tipping is no different, by tipping in a restaurant with you friends or girlfriend; you are demonstrating that your behaviour is normal, that you are not ‘tight’.  See the extract from Reservoir Dogs for a convincing argument.

http://www.youtube.com/watch?v=Z-qV9wVGb38

Misallocation

Tipping does cause theoretical problems however. Tipping, particularly in the US where the institution is strongest, can cause a glut in supply or a shortage in demand. If the institution is a 10% tip of the cost of the bill then price is effectively 10% higher, this means reduced demand for and increase in the amount of people who want to become a waiter (since the tip goes exclusively to the waiter). Normally the market would correct for this by reducing the wage of the waiters, but if there is a minimum wage preventing this correction then we are left with people who want to be waiters but are unable to find a job.

The people who want to be waiters are usually young, unskilled and inexperienced. Waiting is often their chance at finding employment and gaining experience for a chance at future higher paid job.

So when you tip you are upholding an unnecessary institution, you are benefiting the waiter by reducing your own consumer surplus. But you are also indirectly hurting potential waiters by reducing their employment chances.

So next time when it comes to paying your bill, perhaps you should take a page out of Mr Pink’s book and not give one just because society tells you to.