21 November 2012

Price Discrimination and the Cameron Rule

Gas is a commodity. Electricity is a commodity. If a commodity market is efficient there should only be one price: one price for gas and one price for electricity. Either there is a competitive market or there are several energy tariffs.

The energy bill announced yesterday will allow each supplier to offer households four different core prices.With six suppliers that could mean up to 24 different prices for the same basic commodity. There could be even more if discounts can be offered on the core prices.

The energy bill will not create a competitive market leading to lower prices. The oligopoly of six firms will be allowed to compete by appearing to offer different products to their customers. They are in effect pretending to offer a choice between an "Armani" kilo-Watt-hour or a "Top Shop" kilo-Watt-hour.

Is some social purpose served by allowing different prices? Lets say, cheaper tariffs for customers who pay in advance using pre-pay meters? Lower prices for poorer customers who do not have bank accounts? In fact, the outcome is the opposite; it is better-off customers who are able to use the cheaper tariffs.

Price discrimination is the trick used in this kind of market to extract above normal profits from customers.

Price discrimination
The diagram shows how it works. The dotted line represents the cost of supply and the solid blue line is the demand curve. When the price is set at T1 the company makes a small profit above its cost. Some consumers are willing to pay more, and so if they can be induced to pay T2 the firm will make additional profits (equal to the light shaded area). Some consumers are still able to pay a higher price, T3, which would yield even more rent to the lucky firm (the darker shaded area). Imagine how the diagram would look with 24 prices.

A Cameron Rule would help - all customers must be given the most favourable tariff offered to any customer. The rule should apply to core tariffs and discounts. A special offer to one customer should be applied to all energy bills. Effectively each firm would sell at one price, and the greater price transparency would enable competition between the big six to focus on price.

Of course, it will still be an oligopoly and there is no guarantee that the price will fall to the lowest level compatible with an ordinary level of profit. The regulator would still be need inter alia to ensure no tacit collusion on price and to act against barriers to new entrants.

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