Why demand-side support trumps energy price caps
8 September 2022
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8 September 2022
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20 September 2022
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Imagine you buy 10 cans of beer every week, at a price of £2.50 each.
Due to a shortage of hops, the price of a can of beer now soars to £5 per can. This means that if you carried on drinking 10 cans of beer per week, your total beer budget would have to rise from £25 to £50.
Now, suppose the government decides to compensate you for the beer price hike. They ponder two different policy options to do this:
Both policies would cost the same, and both could lead to identical outcomes. But even in this über-simplified example, they probably would not.
Option 1 simulates a situation in which nothing has changed. To you, it looks as though beer continues to cost £2.50 a can, just as it always has. Unless you read about it in the news, you might never even know that there is a hop crisis going on.
Option 2 takes away the pain of the beer price hike (because it fully compensates you for it), but it still makes you notice that it has happened. You are still faced with very different relative prices. Suppose a can of cider costs £2.50, and a bottle of wine £7.50. This means that the opportunity cost of every can of beer has risen steeply, and no amount of compensation can take that away. Before the price hike, each can of beer meant giving up one can of cider, or one third of a bottle of wine. Now, it means giving up two cans of cider, or two thirds of a bottle of wine. You can carry on buying 10 cans of beer, if that’s what you want. The compensation payment enables you to do that. But it can’t take away that nagging feeling of guilt about what you could have had instead.
So unless you have a religious commitment to your current level of beer consumption, under option 2, you would probably make some adjustments. And that is desirable. Because, remember, the price of beer has not gone up because brewers have suddenly become greedier (although I know which MPs would tweet about how greedy brewers are to blame for the crisis, and how the only solution is to nationalise the lot of them). It is because of a hop shortage, which will sooner or later manifest itself in fewer beer cans on the shelves. If you have already adjusted your consumption, you may not notice that. But if you arrive one day, expecting your 10 cans, and there are only 5 cans on the shelf – you have a problem.
If the price of X goes up, we buy less X. This happens for two reasons, which economists call the “income effect” and the “substitution effect”. A price hike makes us poorer: it is as if we had taken a pay cut. And if we are poorer, we generally buy less stuff, across the board – not specifically less X, but including less X.
But an increase in the price of X also makes it more lucrative to substitute Y and/or Z for X, because we now get more Y and more Z for every unit of X we give up. That is the substitution effect.
In the above example, both policy options eliminate the income effect of the price change. You are not poorer than you were before. But option 1 also eliminates the substitution effect, while option 2 leaves it intact.
Option 2 is therefore clearly the superior strategy, even in this ultra-simple example. The case for option 2 becomes stronger if we look at the effect on an entire population, rather than just a single individual. It is not necessary for everyone to be sensitive to beer price changes. But if we look at a sufficiently large population, someone will be. What matters is the aggregate effect.
More importantly, with option 2, support can be targeted, i.e. focused on those who need it most. Option 1 indiscriminately subsidises everyone’s consumption, whether you are a single mum who works as a cleaner, or whether you are Roman Abramovich.
This can be true under option 2 as well. If that compensation payment is a universal benefit, Roman Abramovich would receive it too. But under option 2, this is a political choice. The government can means-test the payment, and target it in whichever way it wants to (provided it has the administrative capacity). They can choose to limit it to the bottom third of the income distribution, or the bottom quarter, or the bottom quintile, or the bottom decile.
Under option 1, you cannot do that, unless you want the shopkeeper to ask each customer: “Sorry, are you Roman Abramovich, by any chance? Because if so, I need to charge you the uncapped market price. However, if you are a cleaner, I will charge you the capped price, and claim back the difference from the government.”
You have, of course, figured out that this article is not really about beer (or even wine or cider), but energy. Governments all over Europe have responded to the energy price surge with a package of measures. Some of these are a variant of option 1 (suppressing price signals and compensating energy companies), and some are a variant of option 2 (direct financial support to households). But there has been a strong bias towards price suppression-type measures. As the International Monetary Fund explains:
“[M]any European governments have taken measures to delay the pass-through of wholesale to retail energy prices through tax reductions or price controls. […] [T]hese measures are an inefficient tool to protect the economically vulnerable, are fiscally costly, and they mute the demand adjustment to the price shock (including energy-conserving behavior and energy efficiency investments).”
Switching to option-2-type measures would be vastly more cost-effective:
“Policy responses to the surge in energy costs should aim to preserve the price signal while providing targeted support. For households, lump-sum cash transfers, vouchers, or fixed discounts on utility bills are appropriate means of providing income support without distorting marginal energy prices, thus conserving the incentive to reduce energy consumption. As an example, fiscal measures to fully offset the consumption losses of the bottom 20 (40) percent of households would have an average annual estimated cost of 0.4 (0.9) percent of GDP in European economies. Non-targeted measures typically have a larger fiscal cost […]
In some countries, the fiscal costs of measures introduced since the summer of 2021 are estimated to exceed 1.5 percent of GDP by end-2022. Most of these costs come from non-targeted relief measures such as cuts in VAT/excise taxes or price caps”
Unfortunately, the UK government’s strategy is also heavily biased towards option-1-type measures. The exact cost is, as yet, unknown, but as my colleague Andy Mayer shows, even if you take a conservative estimate, it would have been more than enough to pay for an extremely generous package of direct support for households and businesses.
This would have offered more bang for the buck, and much stronger incentives to economise on energy.
_______
Recommended reading:
Due to a shortage of hops, the price of a can of beer now soars to £5 per can. This means that if you carried on drinking 10 cans of beer per week, your total beer budget would have to rise from £25 to £50.
Now, suppose the government decides to compensate you for the beer price hike. They ponder two different policy options to do this:
- Cap the price of beer at the old price of £2.50 per can, and pay a subsidy of £2.50 per can – the difference between the market price and the capped price – to the brewery, to compensate the brewery for the increased price of hops. If you carry on buying 10 cans, this policy would cost the government £25 per week.
- Allow the price to rise to £5, and pay you a lump sum compensation of £25.
Both policies would cost the same, and both could lead to identical outcomes. But even in this über-simplified example, they probably would not.
Option 1 simulates a situation in which nothing has changed. To you, it looks as though beer continues to cost £2.50 a can, just as it always has. Unless you read about it in the news, you might never even know that there is a hop crisis going on.
Option 2 takes away the pain of the beer price hike (because it fully compensates you for it), but it still makes you notice that it has happened. You are still faced with very different relative prices. Suppose a can of cider costs £2.50, and a bottle of wine £7.50. This means that the opportunity cost of every can of beer has risen steeply, and no amount of compensation can take that away. Before the price hike, each can of beer meant giving up one can of cider, or one third of a bottle of wine. Now, it means giving up two cans of cider, or two thirds of a bottle of wine. You can carry on buying 10 cans of beer, if that’s what you want. The compensation payment enables you to do that. But it can’t take away that nagging feeling of guilt about what you could have had instead.
So unless you have a religious commitment to your current level of beer consumption, under option 2, you would probably make some adjustments. And that is desirable. Because, remember, the price of beer has not gone up because brewers have suddenly become greedier (although I know which MPs would tweet about how greedy brewers are to blame for the crisis, and how the only solution is to nationalise the lot of them). It is because of a hop shortage, which will sooner or later manifest itself in fewer beer cans on the shelves. If you have already adjusted your consumption, you may not notice that. But if you arrive one day, expecting your 10 cans, and there are only 5 cans on the shelf – you have a problem.
If the price of X goes up, we buy less X. This happens for two reasons, which economists call the “income effect” and the “substitution effect”. A price hike makes us poorer: it is as if we had taken a pay cut. And if we are poorer, we generally buy less stuff, across the board – not specifically less X, but including less X.
But an increase in the price of X also makes it more lucrative to substitute Y and/or Z for X, because we now get more Y and more Z for every unit of X we give up. That is the substitution effect.
In the above example, both policy options eliminate the income effect of the price change. You are not poorer than you were before. But option 1 also eliminates the substitution effect, while option 2 leaves it intact.
Option 2 is therefore clearly the superior strategy, even in this ultra-simple example. The case for option 2 becomes stronger if we look at the effect on an entire population, rather than just a single individual. It is not necessary for everyone to be sensitive to beer price changes. But if we look at a sufficiently large population, someone will be. What matters is the aggregate effect.
More importantly, with option 2, support can be targeted, i.e. focused on those who need it most. Option 1 indiscriminately subsidises everyone’s consumption, whether you are a single mum who works as a cleaner, or whether you are Roman Abramovich.
This can be true under option 2 as well. If that compensation payment is a universal benefit, Roman Abramovich would receive it too. But under option 2, this is a political choice. The government can means-test the payment, and target it in whichever way it wants to (provided it has the administrative capacity). They can choose to limit it to the bottom third of the income distribution, or the bottom quarter, or the bottom quintile, or the bottom decile.
Under option 1, you cannot do that, unless you want the shopkeeper to ask each customer: “Sorry, are you Roman Abramovich, by any chance? Because if so, I need to charge you the uncapped market price. However, if you are a cleaner, I will charge you the capped price, and claim back the difference from the government.”
You have, of course, figured out that this article is not really about beer (or even wine or cider), but energy. Governments all over Europe have responded to the energy price surge with a package of measures. Some of these are a variant of option 1 (suppressing price signals and compensating energy companies), and some are a variant of option 2 (direct financial support to households). But there has been a strong bias towards price suppression-type measures. As the International Monetary Fund explains:
“[M]any European governments have taken measures to delay the pass-through of wholesale to retail energy prices through tax reductions or price controls. […] [T]hese measures are an inefficient tool to protect the economically vulnerable, are fiscally costly, and they mute the demand adjustment to the price shock (including energy-conserving behavior and energy efficiency investments).”
Switching to option-2-type measures would be vastly more cost-effective:
“Policy responses to the surge in energy costs should aim to preserve the price signal while providing targeted support. For households, lump-sum cash transfers, vouchers, or fixed discounts on utility bills are appropriate means of providing income support without distorting marginal energy prices, thus conserving the incentive to reduce energy consumption. As an example, fiscal measures to fully offset the consumption losses of the bottom 20 (40) percent of households would have an average annual estimated cost of 0.4 (0.9) percent of GDP in European economies. Non-targeted measures typically have a larger fiscal cost […]
In some countries, the fiscal costs of measures introduced since the summer of 2021 are estimated to exceed 1.5 percent of GDP by end-2022. Most of these costs come from non-targeted relief measures such as cuts in VAT/excise taxes or price caps”
Unfortunately, the UK government’s strategy is also heavily biased towards option-1-type measures. The exact cost is, as yet, unknown, but as my colleague Andy Mayer shows, even if you take a conservative estimate, it would have been more than enough to pay for an extremely generous package of direct support for households and businesses.
This would have offered more bang for the buck, and much stronger incentives to economise on energy.
_______
Recommended reading:
- “Scrap the energy price freeze plan in favour of targeted welfare and tax cuts“, IEA press release
7 thoughts on “Why demand-side support trumps energy price caps”
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What conditions this analysis is whether or not the good or service is a fungible one – by which we mean whether or not that good or service is easily replaceable in competition. The trouble with energy is that it is not a fungible good in the same way that beer, food, clothes or cars are. If you need to heat your home, you can’t suddenly decide to substitute the narrow range of options and the relatively small range of providers able to produce the infrastructure to enable you to heat your home. Whereas, if you’re thirsty, and you find that beer is too expensive, you can buy some other drinks instead. Similarly, if the price or BMWs or leather jackets became undesirable, there are plenty of other alternatives you can seek, like Fords, Vauxhalls, wool or denim.
With energy, things are not quite the same. The only competition for your energy is from a very small range of big firms offering other tariffs. A small range of big firms that provides a service (like energy to millions of people) is very hard to break, as competition for such a service is hard to generate. It’s very costly to start up a rival firm to energy to millions of people.
James – I think you are wrong.
I could use the money to buy solar panels or a new Air source heat pump (the government are already offering me £5000 towards that – another £2500 and I’d only have to pay for 1/4 of its cost. Unless of course everyone did that – and then the demand might make them a bit more pricey… ) Both of these options would permanently reduce the amount of costly energy needed to heat my house.
Of course – I could also use wood from a nearby forest to heat my house – and pay my neighbour’s son to collect that for me. He’s only £5 an hour (don’t tell the revenue) and could probably collect enough to heat most of my house for two days in that time. (although – apparently I’m only legally allowed to collect a faggot a day – and I don’t know what the conversion rate from sticks to faggots is – so I’d have to guess…)
Or – I could be prudent, reduce the heating at night, turn it off during the day – and just keep the extra cash (maybe put towards the increased cost of my mortgage?)… Why on earth should the government decide to give (my) cash to very rich energy companies – rather than back to me? Its absurd.
Kris is correct and I have put this argument to several people.
However, he doesn’t mention that a price cap has one – short term -political advantage. It lowers the rate of inflation temporarily. Of course, after 12 months, this effect will fall out of the system and inflation will be commensurately higher than it would otherwise have been, but perhaps the advantage lies in controlling the public perception of inflation.
You’ve forgotten to include the immense cost and the sheer impracticality of administration in option 2. Your assumption of guilt implied in option 2 is as false as the rest of your rambling and false logic.
Option 2 is clearly the best option and need not be complicated – just give a fixed amount back to every household: it’s fairer, simple, progressive, and crucially encourages users to take action to save energy. Cutting energy bills by subsidising unit cost directly lowers the incentive for individuals to take action themselves. High energy prices could help save the planet by massively increasing the value to consumers of insulating, installing PV etc etc.
I am having trouble with the lack of precision of “immense cost” and “impracticality” of administration. The govt knows who currently receives what benefits, which would surely be their target recipients for enhanced support over the worst (winter) period for energy use initially. Blanket changes to other, untargeted, blunt areas of taxation, just don’t feel like a fiscally responsible approach to take. Uprating benefits to the most needy (which would also benefit those working people most in need of it) feels like the right approach to me.
The issue with either option is that they indiscriminately support a crises induced peak in net profit. To continue your analogy, the 100% increase in price (from £2.50 to £5) is what the consumer sees, the rise in COGS due to the market value of hops that the producer sees was however only £0.50. (From £0.50 to £1) . Whilst this is a 100% increase, the cost of labour, aluminium, plant maintenance etc grew modestly and even if we factor in the rise in energy cost, we may enthusiasts add a total of £1 to the cost of a can of beer.
That most pricing models are formulaic and demands % based margin return based upon a key ingredient i.e. the can of beer is priced at 5x the cost of Hops.
Before | £0.50 *5 = £2.50 per can and ≈ £1 profit
After | £1 *5 = £5 per can and ≈ £2.50 profit (if we increase COGS enthusiastically from £1.50 to £2.50)
That 150% increase in profit at a population scale is the real conversation point. Whilst I am in no way in favour of government intervention in a free market dynamic, as James Knight has already pointed out, the consumer simply doesn’t have the ability to act upon the feeling of ‘guilt’ by changing retail provider.
If this scenario were based upon a commodity instead of a utility, the pricing model would have to dynamically recognise that that demand for 5x margin on the cost of hops would simply eviscerate a large part of their customer base given a temporary market fluctuation. For this period is would be more prudent to project a mean profit target or say £1.10-25ish and launch a PR campaign to reassure the consumer base that they are foregoing Billions of £ in order to safeguard the livelihood of the population at large.
Instead, the unfair advantage of the knowledge that the consumer has nowhere to go and that government will step in seems to be the strategy. This is undesirable unless you are a bonus paid employee or shareholder. In which case it’s fantastic as in the short term profits are supported by a government payout, longer term more of the customer base will be forced onto a PAYG system of consumption which attracts a higher price per unit.