Renegade Economists podcast 292
Dr Terry Dwyer (former Treasury economist) continues the investigation into monopoly theory, discussing wasteful competition in what were once natural monopolies. Dwyer hammers home the need for economics to be remembered not as a profit maximising theory but a cost minimising paradigm.
Last week’s show featured the report Electricity and Privatisation – where have the promises gone? Well worth a listen as background to this week’s extensive interview with Dr Dwyer.
KF: Can you get us started with a definition of “monopoly”?
TD: Well, basically, a monopoly is a producer or owner who has an ability to exclude others from the market whether by legislation or natural advantage. But, if you look at it, all monopolies fundamentally come down to some sort of legislative privilege, for example, the parliament may say “You have this patent right. Nobody else can produce something without paying you a rent or they can be sued for infringement.” But the most obvious monopolies are to do with natural resources, for example, land, water or air rights. For example, the carbon credits and the carbon trading scheme are a manufactured legal monopoly to burn oxygen and turn it into carbon dioxide. So parliament can create a monopoly of anything, actually.
However, historically, of course, English law and the common law were hostile to monopolies and Queen Elizabeth I had to apologize to Parliament in her Golden Speech of 1601 for the fact that she had dished out too many monopoly grants to her courtiers and they were busy oppressing the population by mercilessly exploiting their privileges. But the most common examples of monopolies are spatial monopolies, and in a sense, all land by definition of land is a monopoly – no piece of land is reproducible as such. But the ones we see clearly are the network monopolies. For example, it would be utterly inefficient to have five competing railroads all running along the same track or having five telecommunications providers running down the street putting down five lots of fibre optic cable. And that is why we traditionally did have monopoly water boards and monopoly telcos and monopoly railways and so on. The idea was to avoid duplication of costs.
KF: So, in the past we have been through this cycle. Queen Elizabeth I granted too many monopolies and then had to rein them in. You’re saying that perhaps we are going through the same phenomenon at present.
TD: Yes, I think so. There seems to be a cycle where every hundred years or so, people have to re-learn their history. I’ll give you an example of this: in the 1840s in the railway boom in Great Britain, all sorts of promoters were racing to parliament to get privileges and private acts of parliament to build railroads. There were lots of companies rushing into it, and there was a great deal of hostility, actually. Lots of landowners rejected the idea that somebody would turn up at their front door and say “I’ve got a private act of parliament allowing me to run a railroad through your farm.” There was a great deal of controversy, but you also had cut-throat competition, and eventually out of those many private railroad companies, gradually, there were consolidations. One would undercut the others and eventually you ended up with several major companies such as the Great Western and so on. And of course in the end, they were nationalised into British Rail, but in a way a similar thing has happened in Australia. We had private gas companies.
The Australian Gas Light Company got a Royal Charter in about 1837, but there were some private electricity companies that started off. But people quickly realised it was silly to have private little monopolists when it was much more efficient to combine them into one big monopoly. The danger is that if it’s privately owned it can exploit the community, so what happened in Britain and Australia was that from the 1880s and 1890s there was a wave of what was called municipalisation. For example, Glasgow and Edinburgh municipalised their tramways. They paid out the tramway companies and said “We’ll run them as a municipal corporation for the public benefit at cost instead of charging monopoly profits.” And there were debates then about compensating the private owners for being forced to sell their assets into public ownership. So it is quite funny – we have come round full circle.
KF: What side of politics was leading that reform agenda and what was the background to create the movement in this direction?
TD: Actually, funnily enough, I think it was the Tories. From memory – well, I wasn’t there at the time, but I remember reading that Chamberlain, who was the mayor of Birmingham, and other people generally thought it was a good thing – it wasn’t just socialists saying it was more efficient to have one provider providing things in the public interest to achieve the economies of scale. By the way, John D. Rockefeller discovered the importance of economies of scale and the benefits of monopoly and that was why he thought he was a public benefactor in creating the Standard Oil Trust. He thought that he was (and he was) driving out inefficient producers by combining to cut costs and passing them on to consumers, while of course getting a reasonable profit. So, he actually was an intelligent monopolist.
KF: When it comes to the mysteries of economic reform, many people look at economies of scale as the one big issue that is very hard to challenge and you’re saying here that John D. Rockefeller in the second half of the 19th century as oil was being discovered left, right and centre, that he basically led by example and the theory followed that.
TD: Yes, he basically realised that he could get rid of what was described as “wasteful competition”, and it was more efficient to have common terminals and combine, but he realised that if he exploited the monopoly too rapaciously, of course, the Standard Oil Trust would not survive, so in a way what he did was kept on cutting the price of oil to consumers so that meant that competitors were scared off because he wasn’t hanging on to the economies of scale, he was passing a lot of them on to the consumers. A greedy monopoly can cut its throat because if it really exploits its monopoly position, while it can get a lot of fat, if it tries to be too greedy, it eventually may lose money. The classic example here in Canberra is the ACT water monopoly, the government-owned company ACTEW. The price of water in the ACT is now about $4.86 per kilolitre. In 1990 it was 47 cents, and that way outpaces the rate of inflation, but the funny thing is as soon as it rained, demand for water and for gardens and everything in this territory plummeted, so being a greedy rapacious monopolist it actually cut its own throat and made losses, and then it had the hide to go to the regulator and say “Oh, we lost money because demand dropped and because of the wet years, we should get an increase in our regulated prices to make good the loss we’ve inflicted on ourselves by being rapacious.” Well, fortunately the regulator threw that one out but they seriously could have tried it on.
KF: As well-connected monopolies often try to do but can we just spell that out for the listener there, that they pushed their prices up, their marginal revenues above their marginal costs, so they were claiming a nice tidy profit on that, and then when it rained and people caught enough rain in their own rain tanks, demand for the monopolised product fell and their revenues dropped and then they went begging.
TD: That’s right – they cut their own throats through their greed. And it is ridiculous at $4.86 and lots of people no longer bother watering their lawns, they’re just content – well, they’re not content, but they have just given up. It’s not a pretty sight in what was designed to be a garden city.
KF: Well, if only policy would return back to common sense where these natural monopolies recognise the power of economies of scale to deliver the low-cost inputs we need to run business. When it comes to the monopolisation of water, we are seeing some very interesting trends in Australia with the split in water titles away from land and water to separating those titles. Terry, I wonder what your insights are on the fact that you can buy a megalitre of water from one of the tradable water schemes for some $3000 per megalitre, but to buy the same megalitre off one of these monopoly powers selling us water in the suburbs it is maybe $3500-$4000 per megalitre.
TD: Yes, well that’s very interesting because for all of the talk about competition policy and having an efficient market, the truth is that the cities in a way have been screwed, if I can put it politely, or not so politely. The price downstream, for example, from Canberra where water is released is far, far less than what urban consumers are paying, and they’re not allowed to trade. You’re not allowed as a householder to say, “Gee, my usage is around 1000 kilolitres per year, I’ll just buy that on the open market and hand over the certificate to the local water monopoly and say ‘Please deliver at your cost of transport’.” But to be fair to the farmers, there is another problem that they have discovered. Many of them at first thought that tradable water rights would be a good thing, although some of them were hesitant, but some of them said “Oh, well, during the drought, water rights have been a godsend because we could sell our water rights and pay off the banks.” The only trouble is, once having sold them, next time a drought comes along they’ll be driven bankrupt by having to buy back the water rights.
It’s a bit like when somebody came to Australia and said that the carbon credit scheme had been a godsend for the UK and their electricity generators. He was saying that it was a great thing because after the global financial crisis, the electricity generators in the UK were able to sell their monopoly carbon rights which they had had issued to them free of charge, and were able to sell them to make a windfall profit which helped them to survive the global financial crises. But from a social point of view, it means they then have to buy those rights to produce electricity back. And they will pass that cost back on to the consumers. So they got a right to emit carbon dioxide free of charge as part of the transition to the carbon trading scheme; they’ve sold that off and they’ve made a profit; now they have to buy it back, but the cost of what they have bought back, what they got for free is now being passed on to British electricity consumers as part of their costs.
That is one of the big problems of the type of privatised monopoly we’ve got, whether it’s water, electricity or gas. It’s always companies that can revalue their assets or dispose of them, pocket a profit and then buy them back, or mark them up. And the way the system works is called “depreciated optimised replacement cost”.
The theory is that consumers should only be charged the efficient cost of delivering the water or electricity or gas that they’re using. But, they have an engineering approach to this – they say that the efficient cost is what you would need to replace the infrastructure in its present condition as efficiently as possible, so that’s why they say it’s depreciated optimized – it’s re-engineered to be as efficient as possible – replacement cost. And the big sting in that is replacement cost because with inflation, a dam that cost, say, a hundred million pounds in 1955 might be worth two billion dollars now.
I’ll give you an example of how this works against consumers – take, for example, Sydney Water. The New South Wales treasury in about the 1880s sold all the water assets of Sydney into a new board that was set up representing local councils around Sydney and thereafter from the 1880s right through to the 1980s, the rate-payers were levied through rates to pay for the dams, the pipes and all the costs of collecting and storing and delivering clean drinking water. And this of course was a public health measure as much as anything else because Sydney, like most cities, had had stinky, dirty, filthy, cholera-ridden water at various times. Typhoid was something they were worried about – after all, Prince Albert died of water-borne diseases. So, from the 1880s to the 1980s the New South Wales treasury did not pay a cent for the water infrastructure of Sydney, and in the 1950s when Sydney looked as though it needed more water, the water board raised loans to build Warragamba Dam and it paid those loans off over many years through rates on the landholders and the householders of Sydney. And that was fair enough, because after all, if you’re a landholder, the availability and the provision of drinking water for you or available to your site obviously adds value to your land. Serviced land, which has water available, is more valuable than land in the sticks that doesn’t. So, that was a fair system because in a sense the site value of the land represented the value of the amenities being provided to it. So, Warragamba Dam was paid for by the rate-payers of Sydney – the State Treasury never paid a cent.
In the 1980s under this wave of reform or corporatisation, the New South Wales government got rid of the Sydney water board, removed the representation of the councils in it and turned it into a corporation owned by the State Treasury. Now, this is interesting, the State Treasury took over control of about $5 billion worth of assets or whatever they were, for which they had never paid tuppence ha’penny. They then said “Oh, look, with this new economic theory of efficient pricing for utilities, we should now go around and revalue all of the assets of the Sydney water board, and here it is, $5 billion, and to be efficient, we should make sure a return is charged on that capital, so the Treasury is entitled to an indexed rate of return on this replacement cost of these assets so we should set prices so as to be able to give us a dividend of $500 million per year”, or whatever it was. So, the water users of Sydney were being charged a rate of return on assets that effectively had been stolen from them.
It’s as though somebody went into your house and said, “Thank you very much Karl, you’ve got a nice house here, you’ve paid off the mortgage, now I’m taking it over – I’ve got the government to transfer the legal title to me. Now, you can still use your house, but it’s efficient that you pay me top market rent on what I could get for the house now, and I’ll keep increasing the rent each year as I revalue the house with inflation, and thank you very much.” That’s basically what happened and effectively it is a form of a disguised, corporatized or privatised tax system because none of the money being paid was really necessary to bring those assets into existence – they had already been brought into existence. It was not necessary to create those assets – they were already created. It’s one thing for a state monopoly or a government monopoly to charge you for creating new assets, but it’s another thing to charge you again for assets you have already paid for.
KF: Last week we had interesting discussions with David Richardson on electricity and privatisation – what happened to those promises? David Richardson was talking to us about how the cost of electricity has increased by 170% since 1995 versus the CPI having just increased by 60% over that time. Productivity across the industry had increased by some 30% but in electricity it had fallen by 30% and that was due to a doubling of administrative workers and a tripling of management numbers – and so what was once an efficient industry was split into what Dr Terry Dwyer has just reminded us is called “wasteful competition”. And from that, one of the big points, Terry, that came through in last week’s interview that sounds very similar to what you have just discussed is that David Richardson from The Australia Institute used a term called “capital asset revaluation”. Now, how similar is that to depreciated optimised replacement costs in terms of accounting trickery?
TD: It’s basically another way of saying the same thing. Replacement cost essentially is revalued, and they keep revaluing upwards.
Now, another thing I should mention is what is included in the asset base. Years ago, when I was first writing about this, I wrote a footnote in a paper for the Business Council. I don’t think they really understood it at the time – I made a comment that easements are theoretically assets. Now, an easement is the right of a utility to run its wires or its pipes through your back yard. Normally if someone comes onto your land or uses your land, you would think that they should pay you a rent, or a license fee, for the privilege of using you land. But it doesn’t work that way with these utilities. They pay nothing for the use of your land. In fact, in some states, you are under an obligation to clear the trees from the power lines at your own expense for their benefit.
But, what was interesting, as I was involved in a case in the Australian Competition Tribunal called Electronet vs. The Australian Competition and Consumer Commission and Electronet in South Australia said “We have these assets on our balance sheet we inherited from the old Electricity Trust of South Australia – they’re called easements.” And they said “Well, we have looked at these easements, the right to run our wires across our public and private spaces, and we think it would cost us, say, $50 million to do all the work to survey and register all these easements,” (which they had got given to them for free). “Therefore, we should be charging the consumers enough to get a rate of return on the value of these easements. And that’s about $50 million – well, we should be getting maybe $6 or 7 million per year on them.”
And basically, what it amounts to is electricity consumers are being charged in their electricity prices for the privilege of having someone else use their land. They’re not being paid for the use of their land, they are being charged for the use of their land. And what was interesting in this was I went back in preparing for it to the history of municipalisation in the UK. And a case on easements had gone to the House of Lords in about 1905 or 1910 where a municipal tramway company was saying “Oh, look, we should be compensated for our rights of way over public roads when the city council takes over our rolling stock and our tracks.” And the House of Lords threw it out, quite rightly. They said “This is absurd; these easements are not a private asset. They are a grant given by the public for the benefit of the public.” In other words, it’s much more efficient for all of us to let electricity wires go over all of our land so we can all get an efficient, cheap supply of electricity instead of running generators on every little block of land. So we all basically give it freely on the understanding that we’ll get common use of it. So, the House of Lords threw that out, but unfortunately the Australian Competition Tribunal I don’t think quite understood the matter, and the House of Lords decision was basically ignored.
So the electricity authorities and other utilities in this country can bring in as part of their asset base, on which they are entitled to charge you, rights freely given to them, for which they have paid nothing and which were given by an Act of Parliament.
KF: So, in order for some common sense utility-based reform in terms of these monopoly rents and monopoly prices being charged, do you think we should be approaching this from a cost input advantage for business and society in reducing costs? I mean, we have been convinced that economies of scale don’t work anymore and competition is superior to economies of scale. How do we undo this flawed economic thinking?
TD: Well, you have hit the nail on the head. I think the trouble is a lot of economists are poorly educated these days. They don’t actually understand the history of economic thought or the history of economic theory. And I think what people need to be told is that economics is not about profit maximisation. Profit maximisation is valuable only in a competitive market, and the only reason it is valuable is because it leads to a reduction in social cost. The real object in economics is not the maximisation of profit but the elimination of cost.
If you think about economic progress, all economic progress is reflected in the reduction of cost. For example, think of how much a computer costs now compared to 1980 and what it can do. Prosperity is reflected in the cheapness and abundance of goods and services and falling prices and falling costs. And what is absurd is that governments in this country think that rising profits for the water or electricity monopolies reflects efficiency and reflects good economics. It’s quite the reverse. The rising profits of state-owned electricity companies or state-owned water companies really reflect disastrous indirect taxes on the community. It’s really quite strange that we were supposed to get rid of sales tax because indirect taxes in the sales tax were an inefficient tax on exports, and yet state governments have gone around creating this vast system of indirect taxation, with the connivance of the Commonwealth Treasury, which should have known better, which has damaged the productivity of Australian producers.
This country should have some of the cheapest electricity prices in the world, and it doesn’t. Its water prices should be much cheaper in the cities because although this is a dry continent, large parts of it are actually reasonably well watered. There is no reason for the prices that are being charged to producers.
So what we have done is create a system of profit maximisation for these public utilities so governments can pretend that they are not taxing people and say these are just profits from commercial government business enterprises, but really they are monopoly profits way in excess of the cost of producing water or electricity and are disastrously feeding into the input costs of producers like Mitsubishi and Ford in South Australia and leading lots manufacturers to think twice about whether they stay in this country.
If you drive away manufacturing, you drive away that sector of the industry which is responsible in the long run for cheapening the cost of goods and services and raising standards of living. Gains in productivity really come from making things, and those gains in productivity then flow into service industries. But you’re not going to be a rich country if the only industries you have left are changing the sheets for tourists.
Read Dr Terry Dwyer’s submission to the Henry Tax Review