Sunday, 8 October 2017

Theresa May Shows Economic Ignorance Of The Worst Kind

"The UK’s Big Six gas and electricity suppliers saw billions wiped off their stockmarket valuations after Theresa May outlined plans to go ahead with a cap on energy prices."

This is on the back of Theresa May's foolish announcement of a draft bill to impose an energy price cap for consumers in order to “bring an end to rip-off energy prices once and for all”.

Alas, because Theresa May is unapprised of basic economics, she seems to have it in her head that the nefarious energy firms are enjoying excessive profits at the expense of their customers. Here's where she is going wrong (any Corbynites who have the same idea about rent controls should grab a pen and paper too).

The word ‘excessive’ is a strange one when talking about profits, because excessive is a term that is relative to a perceived value or number. If the average height for a woman is 5ft 5in, and your sister is 6ft 2in, her height is excessive compared to the average. But ‘excessive’ profits in the market simply mean higher than expected, where expected means marginal revenues equal marginal costs of the standard textbook order we are more used to (most firms make a lot less profit than you probably imagine).

If an entrepreneur is making higher than expected profits, it indicates that he or she evaluated future projections better than competitors did - or if there’s a lack of competition, it indicates that he or she innovated ahead of others in the market. To do this you need to find a gap in the market that isn’t being filled, or identify better than others scarcity of supply or abundance of demand that are not being matched in equilibrium. Such entrepreneurs are the ones most likely to bid up the prices of goods that are not priced high enough, or not in sufficient supply, and push down the price of excessive outputs.

That’s short term. In the long run, though, we don’t want businesses to make excessive profits above the average cost of capital, because it means there aren’t enough competing forces for price efficiency. Competitors are the ones pushing the boundaries of innovation in order that they obtain their share of the profits, and in doing so they are contributing to increased value, better technology, more efficiency, and greater well-being and prosperity.

And that scenario is pretty much always what you see in a competitive market, because in the short term when profits are higher than expected due to some niche being found, or innovation-based success being enjoyed, there is room for others to enter that part of the market and add more value to society (you can click on my Energy part of the side bar to read why there are quite naturally only a few big players in the energy industry, and how they are not charging 'rip-off energy prices' as our dearly confused politicians seem to think). 

I wish our politicians would bear in mind this next important thing too. Most people don't know what it's like to be a large employer, so they hardly ever put themselves in the position of the corporation. They foolishly think that corporations have plenty of spare capital knocking around that can be confiscated and used to ramp up wages and pay people what politicians and their supporters have avowed that they 'deserve' (price caps are merely an indirect form of confiscation).

But even if it were not the case that corporate profits aren't that high, there is an even bigger picture that has to be factored in. Investors in large capital projects are not just the ones making the biggest risk of no return, they are the ones that stand to lose the most if the venture fails.

Good large scale investment is much harder than it sounds - you not only need a good assessment of the current market landscape, you need a solid eye for future landscapes and the concomitant probabilities that accompany that evaluation. This is even more of a compelling point when you remember that average profits hover around the 5%-7% mark. Time you factor in the large amounts of planning, building, and other capital investment to get the project off the ground, many entrepreneurs face a risk of a huge loss for a relatively small gain.

Given the foregoing, it's also easy to see how government policy designed to cap prices or extract high levels of tax from these companies makes the reckless assumption that the company's income will carry on at the same level - often failing to realise that some way down the line, price fixing and heavy regulatory protocols do a lot of invisible harm to businesses - harm that is off the radar - because, like the butterfly effect, the long chain of events that precede it are not tracked by the naked eye, and engender lots of tangible costs down the line that make prospective investment more precarious that it needs to be.

I wish politicians of all party colours would learn the very basic economic principle that you cannot impose these burdening interferences on the signals of supply and demand without changing a lot of behaviour and creating a lot of market disincentives that will have the knock on effect of harming the consumers they think they are helping. and make the marketplace more unstable for prospective investors.