The (supposed) rationale for the National Living Wage

What with Aldi’s recent announcement that they are going to be paying the “Living Wage” to their employees (see here), it seems as good a time as any to re-visit the possible motivations behind the UK government’s introduction of a National Living Wage above the level of the National Minimum Wage recommended by the Low Pay Commission.

It seems as though the standard theoretical argument that imposing a minimum price on a product results in the oversupply of that product (resulting in more people wanting to work than there are jobs available – i.e. higher unemployment) has been put to bed, albeit perhaps for the wrong reasons. For example, the simple argument that unemployment did not increase after the introduction of the Minimum Wage in 1999 is fallacious because it fails to take into account the fact that the economy was growing at the time and, as such, does not use the correct counterfactual (i.e. it does not compare what did happen to what would have happened to unemployment had the minimum wage not been introduced).

Instead, the more relevant results are those that allow one to control for other factors that might have changed over time.  For example, Dube at al. account for this by comparing areas of the US that introduced minimum wages with those that did not do so, and find that the introduction of a minimum wage did not result in an increase in unemployment.Similarly, Leonard et al. conducted a meta-study for the UK and found that the national minimum wage did not affect unemployment. For an interesting discussion regarding why the predictions of standard theory are not borne out by reality, see Schmitt.

These results are, of course, conditional on the minimum wage not being set “too high” – obviously, if the minimum wage was set at some absurd figure, then the aforementioned results would not apply.  However, it is not clear at what level the “absurdity” kicks in. It could well be that anything above the current UK minimum wage could result in unemployment (indeed, the Low Pay Commission takes the impact on unemployment into account when determining the minimum wage).  In other words, it is still entirely possible that the introduction of the National Living Wage could result in an increase in unemployment, albeit perhaps a rather negligible one.

So, given the limited downsides of the Living Wage, what are the (economic) upsides from the government’s perspective? First, and most obviously, is that the population has more disposable income, leading to them being able to spend more, thereby resulting in an increase in GDP.  Moreover, one can expect (almost) the full amount of the difference between the minimum wage and the Living wage to be spent rather than saved, due to lower-income people having a higher propensity to spend rather than save.

Second, and more insidiously, the fact that the Living Wage is higher than the National Minimum wage means that the government can keep its pledge of ensuring that all those who are paid the Minimum wage do not pay income tax (although note that they would still pay National Insurance), while making sure that they still receive income tax from those low earners.  To see this, note that a 25 year old working 30 hours a week at the National Minimum wage of £6.50 per hour would earn about £195 per week, whereas if after the change to being paid the Living Wage they would earn about £216.

Given that the personal income tax allowance amounts to £204 per week, it is clear that someone earning the Minimum wage does not pay any income tax, but someone earning the Living Wage would do so (they would pay about £2.40 income tax per week). While just over £2 per person per week might not seem like a lot for a government that runs a deficit in the billions of pounds, when combined with the number of people affected by the increase, the amount of tax raised is quite substantial.  Indeed, assuming that roughly five million employees are paid less than the Living Wage (see here) and also assuming that all of these would subsequently be paid the Living Wage (i.e. it does not include any of the “grey economy”) the implementation of the Living Wage would benefit the government by about £10 million per week – i.e. £520 million per year.  (Note that this figure may well be an underestimate of the benefit to the government because it does not include the extra National Insurance receipts that would also be obtained.)

Hence, it is possible that, rather than being for the benefit of the working people, the government has introduced the Living Wage as a somewhat roundabout way of increasing tax receipts, making it a very cunning ploy (almost worthy of Baldrick).


Corbynomics and the expropriation of private assets

With Jeremy Corbyn’s victory in the Labour leadership elections, there likely will be a renewed focus on Corbyn’s economic policies.  Indeed, there has already been some interesting analysis of Corbyn’s proposal for “people’s QE” and the ramifications that would have for the (instrument) independence of the Bank of England (see Simon Wren-Lewis’ mainlymacro blog).

However, one area of Corbyn’s stated economic policy that has received less attention is his desire to (re-)nationalise the energy, rail, and banking industries. It is conceivable that there might be a re-hashing of the age-old debate regarding the relative advantages and disadvantages of privatisation vs nationalisation, with the same age-old conclusions.

Much more interesting, on the other hand, is the mechanism (and the implications of said mechanism) by which Corbyn proposes to carry out his re-nationalisation policies. Specifically, Corbyn has stated that he “reserves the right to” nationalise a firm “”with either no compensation or with any undervaluation deducted from any compensation for renationalisation.” (as reported by The Independent)

In other words, Corbyn has stated a potential desire to expropriate a privately-owned firm (or multiple firms) while providing a less-than-market return on the assets that a Corbyn government would acquire.This is likely to have a dramatic impact on private incentives to 1) acquire any of the assets that the current Conservative government would privatise over the next five years; 2) invest in the energy and rail industries that Corbyn has said he already wants to re-nationalise; and 3) invest in other industries in the UK.

First, Corbyn thus far seems to have restricted the target of this policy to firms that are privatised by the current Conservative government over the next five years.  Therefore, the heaviest impact is likely to fall on those assets that the current Conservative government was planning to sell off over the next five years. In particular, Corbyn’s expropriation policy is likely to reduce the amount of money any selling-off of assets by the current government is able to raise.

To see this, note that should a Corbyn Labour government win the 2020 election, any asset sold off by the current government between now and then would be taken back by the Corbyn Labour government. This means that any private entity thinking of purchasing any asset the current government sells off would need to factor in the possibility that they lose control of (and, hence, also lose any profits resulting from) that asset in 2020.  As such, a private entity would reduce the amount it was willing to pay for the asset being sold-off – the obvious result of this is that it reduces the amount of money the current government would be able to raise from selling-off any assets (with the associated implications concerning any reduction of the national debt).

It is possible that this makes selling-of the asset not to be worthwhile such that the current government decides to retain control of it after all (perhaps this is Corbyn’s plan all along?). If so, then it would mean that assets that might be put to more efficient use in the private sector instead continue to be run by the public sector (with the resulting potential impact on GDP).

Second, although Corbyn does seem to have restricted his expropriation policy to government assets that are sold off between now and 2020, there remains the possiblity that he extends that policy to his entire re-nationalisation aims.  In other words, Corbyn could conceivably expropriate the assets of energy and rail companies.  This introduces substantial uncertainty regarding the rate-of-return energy and rail companies can expect to obtain on any investments they might make between now and then. As increased uncertainty regarding the rate of return of an investment results in fewer investments being made (see here and here), the impact of Corbyn’s policy (even if Corbyn is not elected in 2020) is to reduce the current levels of investment made by firms in these industries. This comes at a time when both the energy and rail industries are in need of substantial investment in new infrastructure – anything that reduces the incentives of these firms to make these necessary investments cannot be a good thing.

Third (and this is somewhat speculative on my part), to the extent that Corbyn might wish to expand his nationalistion policy to other industries, the same impact would be felt in those industries.  However, the impact in these as-yet-unnamed industries may well be negligible, particularly in comparison to all the other areas of uncertainty that affect firms’ investment decisions (at least until any further nationalisation policies are stated).

It remains to be seen if Corbyn gets a chance to implement his policies, but, regardless those stated policies are already having an effect. Corbyn needs to clarify exactly what his plans regarding nationalisation are very soon lest those effects grow substantially.

Could Tesco’s “Price Promise” be anti-competitive?

For a few years, Tesco has been operating what it calls its “Price Promise”, in which it states that “[w]hen you shop at Tesco, we’ll check your basket against the prices at Asda, Sainsbury’s and Morrisons. If your comparable grocery shopping would have been cheaper there, we’ll give you a voucher for the difference (up to £10)” (see Tesco’s website).

In other words, Tesco is promising to match any lower price charged by a rival. This is precisely what the economic literature refers to as a “price-matching guarantee” (PMG) – one firm promises to match the price of a rival firm should it transpire that the customer could have obtained a lower price at that rival firm.

At first glance, this appears to be uncontroversially beneficial to consumers – they are guaranteed to receive the best possible price wherever they shop, such that they can save on “search costs” (essentially, time and money spent searching for the cheapest price) while at the same time obtaining the cheapest price.

However, this simple assessment fails to take into account the incentive of PMGs on the retailers themselves. If one retailer is considering decreasing its price, it will determine whether or not doing so would be profitable by weighing the decrease in margin per unit sold it would obtain against the increase in sales it would make (via enticing additional customers to purchase the product at the lower price). If its rivals do not have a PMG in place, then the price cut would result in consumers switching from rival retailers such that the price cut might be profitable. On the other hand, if rivals have PMGs in place, then the price cut might not be profitable as consumers have no incentive to switch to the cheaper retailer – they can just tell their current retailer that they have found a cheaper price elsewhere and be refunded the difference. Hence, if rivals have PMGs, then an individual retailer would experience a reduced increase in sales subsequent to a price cut, thereby decreasing that retailer’s incentives to cut prices in the first place. As such, PMGs could harm consumers by maintaining an “artificially” high level of retail prices.

Indeed, the findings in economic literature are generally inconclusive (An excellent non-technical summary of the literature is available here). Some results (see here) suggest that PMGs can act as a credible commitment by a retailer to keep prices low – a retailer making a price guarantee is effectively signalling to consumers that they will do everything they can to keep prices low because they know that if they do not, then consumers will be able to claim money back from them. In this way, PMGs could help competition by making consumers aware of alternatives that charge a lower price than their current provider.

However, other findings (see here) suggest that the incentive effect described above outweighs all other factors, such that the presence of PMGs leads to higher retail prices. In this way, PMGs could hinder competition because they reduce the potential profitability of a price cut by any one retailer (since, if a single retailer were to decrease price, it knows that its rival with a PMG will automatically match it anyway, so the retailer contemplating a price cut would gain fewer customers than it would if its rival did not match its price).

As such, there is a potential that Tesco’s Price Promise is anti-competitive, but it is difficult to reach a definitive conclusion.

Milk prices in the UK: Subsidies and their impact

There has been more than a little recent commotion regarding the prices that supermarkets and milk processing firms pay dairy farmers for supplying their milk. Indeed, the BBC has reported that some farmers have paraded cows through aisles in certain supermarkets, block-bought all the milk no a supermarket’s shelves, or simply blockaded a supermarket (see here, here, and here).

The motivation underlying these protests appears to stem from small dairy farms (such as those operated by “family farmers”) being unable to make a profit at the prices that supermarkets and milk processing firms are willing to pay for their milk. The Guardian mentions farmers’ claims that their break-even level (i.e. the level above which they start to make a profit) is 30p per litre, but that farmers are only paid about 24p per litre, resulting in a loss of 6p per litre (see here).

This has lead to protests that farmers should be paid more for their milk. However, these protests do not appear to have considered the impact of this price increase on the overall efficiency of milk production. Presumably, the larger milk farms (i.e. those run on a large scale, rather than by individual households) are able to make a reasonable profit at the prevailing price – this profit can be considered a “reward” for those farms making the best use of their resources to produce at as low a cost as possible.

On the other hand, if small dairy farms cannot produce at a cost lower than the price they receive, ordinarily they would go out of business because they are too inefficient to compete with their rivals. This is a standard economic process of obtaining “productive efficiency” – i.e. that all goods are produced at the lowest possible price.

If small dairy farms are (effectively) subsidised via the supermarkets paying a higher price, that would keep them in business, but at what cost? First, the production of milk would not be using the most efficient resources available to it. Instead, inefficient farms would be encouraged to remain in business producing milk when those resources (the people working on the farm, the equipment used, and the land itself) could be put to a more productive use. Moreover, farms that would be able to become more efficient if they had the incentive to do so (i.e. were receiving a lower price) would no longer need to make the necessary investments that would make them more efficient. In other words, subsidising small dairy farmers has the potential to harm the overall efficiency and productivity of the economy, both in the short-term and in the long-run. In other words, the reduction in efficiency and productivity would result in the UK’s GDP being lower than otherwise had the resources tied-up in the inefficient milk farms been put to other, more productive use.

Second, the fact that supermarkets are paying a higher price for their milk means that their costs have increased – it is plausible that these costs could be passed on to consumers in the form of higher milk prices. As milk is a staple product, any increase in the price of milk is likely to affect a large number of consumers, so the effective subsidising of small dairy farms has the potential to cause wide-ranging effects across the whole economy. In particular, if consumers need to pay more for their milk, they would have less disposable income to spend on other products, resulting in a decrease in demand. However, given that any increase in the price of milk is likely to be small, the magnitude of this effect may well be negligible.

Third, any increase in the price of milk paid to farms (to the extent that the price of milk is not negotiated on a bilateral basis) means that those farms that are already efficient merely serves to increase the profits of these farms. It is somewhat surprising that this aspect of an increase in milk prices has not received more attention, particularly if one has ethical qualms regarding policies that increase the profits of international firms.

Obviously, weighed against these points are any potential benefits that arise from the continued existence of small dairy farms. Perhaps benefits are derived from their impact on the countryside and/or the local communities in which they operate. I am not in a position to elucidate on these potential benefits, but the “cons” of any increase in the price of milk via an effective subsidy certainly need to be taken into account.

A nice, non-controversial topic to start off!