Monday, May 19, 2014

Does SM create higher prices?

In a recent posting on Better Farming, another person repeats the often made claims that Supply Management ("SM") doesn't create higher prices for the commodities that they control.  He provides the case of Australia and New Zealand as proof positive.

I assume he is referring to the removal of SM from their dairy industry in New Zealand.

For those interested, the Globe & Mail provides a good, short history on SM in New Zealand, why New Zealand developed the way it did, and then chose to abandoned SM, starting around the 1980.

I agree that doing away with, or modifying SM in Canada will not necessarily lower the price of previously SM commodities in Canada.  The world is complex, many factors interact to create the outcome.  Not all economists agree why there are "sticky prices" (also called nominal rigidity, market inertia, or market friction).

In 1998, Alan Blinder and others surveyed 100 corporations on how and why they made changes to their prices, so as to compare real-world actions against the 12 prominent theories economists have used to describe price stickiness.  Blinder wrote the book on price stickiness, called "Asking About Prices:   A New Approach to Understanding Price Stickiness", 400 pages, ISBN 978-0-87154-121-5, $34.95,

Alan Blinder is Gordon S. Rentschler Memorial Professor of Economics at Princeton University, where he has taught since 1971. He also founded and directs Princeton’s Center for Economic Policy Studies. He has served as vice chairman of the Board of Governors of the U.S. Federal Reserve System and as a member of the US President’s Council of Economic Advisers.  To me, it sounds like he might know what he is talking about.

Why don't companies change prices more frequently than they do?  The #1 reason provided was:

"It would antagonize or cause difficulties for our customers" which was 20.9% of all responses received (41 responses out of 196 total responses, from 151 firms.

Here is the survey answers received (click on graphs & tables for larger version):

Why don't you change your prices more often?, survey results from Blinder et al, for
151 US firms in various industries, 1998.
The top 6 reasons provided represent 81% of all answers received (ie. Pareto's "Vital Few").

Reasons for not changing prices more frequently.  Source:   Blinder et al.

Organizations tend to care about how customer's feel when they realize that angry or disrespected customers tend to get even by voting with their feet and/or wallets, leaving you for your competitors.  With a monopoly, that can't easily happen, so monopolists tend to be less concerned about what customers think or do.  This would mean that the top two reasons don't apply to monopolists, so they are ready to change prices much more easily, in both frequency and magnitude.

Blinder also provides data on the 4 major driving forces on those who change prices, and how long before a price change occurs after that exogenous event (ie. outside forces cause a change, then firm decides to change their prices in response):
How long after an exogenous trigger event does the firm change their prices?
Time lag in months.  As expected, it can be as fast as the same day for a firm
suffering cost increases (Mean - 3 Std. Deviations or zero, whichever is greater),
to as long as 15 months for a firm experiencing a decrease in their costs before
they pass those savings on to their customers (Mean + 3 Std. Deviations).
Source: Table 4.3, Blinder et al.

The firms were asked why they tend to avoid raising prices before their competitors do.  An overwhelming majority said,

"If we raised our prices first, we would lose too much business to low price competitors."

Obviously, not a concern when you're running a monopoly with 99.96% market share.  Guess why Canada's SM Mafia love raising prices on a consistent basis, like clock work?

Canada's Chicken Mafia are obviously not troubled by "Sticky Prices",
they make absolutely sure to raise prices almost continuously, rain or shine,
for the last 17 years and counting, 3.54%/yr price increase on average.
Graph from SFPFC's Blog posting on Feb. 28, 2013
Chicken Price Parity Will It Ever Come?

Flexible pricing is the opposite of sticky prices.  The most flexible pricing occurs when every trading opportunity is priced on a 1-off basis, without regard to any previous trades made.

Sticky prices serve a useful purpose in the marketplace.  In one simple model used to investigate sticky prices,

As I understand it, to get price reductions, there has to be:
  1. a free market,
  2. effective price discovery,
  3. no or minimal collusion by the major players
  4. a competitive marketplace, and
  5. adequate slope on the price-volume supply curve
  6. low or insignificant barriers or thresholds to the entry of new players
  7. natural consequences (ie. bankruptcy, consumer shunning, etc.) for poor suppliers.
Without all of these and more factors, prices tend not to change for the better.
One of the biggest drivers of price changes are competitors.  If a competitor raises or lowers prices, other suppliers tend to follow the lead, or at least, it prompts them to reconsider their current strategy, and decide if they want to join, stand pat, or go in the opposite direction.  Witness the wave of retail gas price changes that often occur once one gas station bites the bullet, and changes their price.

The second biggest factor is the slope of a supplier's price-volume curve.  This means that there must be a significant difference to the total profits of the supplier if they are to go to the work and hassle of optimizing their price vs. volume factors (usually means low overhead cost suppliers are more motivated to change first in a competitive market).

There also must be low thresholds for new people to enter the marketplace.  Without this, the veterans often get sloppy and complacent over time, become less and less efficient over time, and don't take care of their customer's best interests.

When suppliers are saved from the natural consequences of poor service (ie. government grants, favors to "friends", regulatory entrapment and changing the rules in favor of status quo, etc.), the pain in the marketplace is allowed to continue a little longer, and to a greater degree.

Economists have found that price changes can occur second by second (ie. Chicago Board of Trade commodities), to as long as a 4 year cycle, but the median is around 1 year between price changes.  For more info, see Sticky Price Manifesto and Nominal Rigidity

To reach equilibrium, it usually takes between 3 to 7 time constants to get over 90% of the resulting price adjustment effect to have occurred.

We must therefore hold off in jumping to conclusions about price effects until 3 to 7 years have passed.

For example, someone who understands how the world works won't check the status every day on an acorn that they planted by digging it up to check for root development, then giving up in just seven days because nothing seems to have occurred as assumed.

It takes longer, you must have patience.

When SM is removed, either by government changing the laws, or by consumers bypassing the laws and SM's monopoly, we need to ensure that the new system meets the 7 requirements listed above, and we will soon enjoy the more affordable commodities Canadians deserve, and will enjoy more and more.

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