Ananish Chaudhuri: Electricity backlash will come - sooner or later

Power companies' practices are not illegal, but customers see them as inequitable. Photo / Simon Baker

The recent hue and cry about price gouging by our electricity companies has me somewhat bemused.

After all, the companies have done exactly what we teach students in our economics principles courses - charge high prices when demand is high, a policy commensurate with profit maximising, which is at the core of market-based economies.

No one is actually accusing these firms of doing anything illegal. In cases like this, there is always the possibility of implicit collusion among the companies involved, but at this point there seems to be no evidence to support this conjecture.

In fact, the National Government's outrage in the matter appears rather disingenuous, given its decision to fire Paula Rebstock, who, by all accounts, was doing an excellent job of combating such practices during her tenure at the Commerce Commission.

On the face of it, what the electricity companies were doing was no different from the pricing practices of others. Try buying tickets on Air New Zealand during the school holidays, or check out the fare differences in flights at peak and off-peak times and you will know what I am talking about. No one, as far as I can make out, is making similar accusations against Air New Zealand.

Obviously, one could argue that price gouging in electricity markets is of greater concern, given that heat and electricity are necessities. Airline travel is more of a luxury.

But what the outrage over electricity prices shows is that beyond profit maximisation and market economics, people care deeply about fundamental fairness and companies that contravene those fairness norms do so at their own peril.

Firms that have some degree of monopoly power often exploit it to increase profits by charging different customers different prices depending on their willingness to pay a higher price. What the seller is trying to achieve in such cases is to get from each customer the most that the latter is willing to pay for the goods or service.

A group of American researchers, including the 2002 Nobel economics laureate Daniel Kahnemann, have used extensive questionnaires to understand people's predispositions towards a multitude of pricing strategies adopted by businesses.

A relevant example is of a hardware store that had been selling snow shovels for $15, until the morning after a large snowstorm when the store raised the price to $20. Respondents were asked to rate this move as completely fair, acceptable, unfair or very unfair. Out of 107 respondents, 82 per cent considered this unfair or very unfair.

Many forms of price discrimination were considered outrageous by the survey respondents. How about a landlord who rented out a small house, but just before the lease was due for renewal, found out that the tenant had taken a job very close to the house and was therefore unlikely to want to move. The landlord then raised the rent $40 a month more than he was planning to do.

It is interesting that out of 157 respondents, only 9 per cent thought this was acceptable, while 91 per cent considered it unfair. On a different question, a majority of respondents thought it unfair for a popular restaurant to impose a $5 surcharge for Saturday night reservations.

The near unanimity of these responses suggests that pricing strategies which deliberately exploit the vulnerability of a particular individual are considered offensive by most. These findings illustrate the role that norms of fairness play in day-to-day pricing decisions, and how these norms can and do serve as a constraint on unfettered profit-making.

The above suggests that many actions - both profitable in the short run and not obviously dishonest - are likely to be perceived as unfair exploitations of market power. You could be tempted to discount some of these conclusions by arguing that these are, after all, responses to hypothetical questions.

A particular respondent might say that he will not patronise a firm that is engaging in price gouging by jacking up the price of an essential commodity in an emergency ... but when push comes to shove, the buyer might easily give in.

The problem here is that it is very hard to show that people are not buying something in protest, since it is impossible to prove a negative.

But economists have recently used economic decision-making experiments, with relatively large amounts of money at stake, to show that "demand withholding" by buyers - where they essentially refuse to buy at prices considered unfair and discriminatory - can indeed be a significant factor in market interactions.

Such demand withholding is especially pronounced when the sellers are significantly better off at the expense of the buyers, and especially when the buyers are aware of this inequitable benefit distribution by knowing the seller's profits.

In the backdrop of the recession, where households are feeling the pinch, what the electricity companies have done may not be illegal, but by exploiting vulnerability they have contravened fundamental notions of fairness that many of us hold dear.

And for that, I expect, they will pay a price. We will just have to wait and see what it is.

* Ananish Chaudhuri is an associate professor of economics at the University of Auckland, and the author of Experiments in Economics: Playing Fair with Money.