In this essay, SMF Director James Kirkup reflects on the merits and failures of markets, whilst looking forward towards work we’re doing with Citizens Advice, exploring what we can do when markets don’t deliver the social benefits we expect of them.
When my microwave broke down recently, I bought a basic model to replace it, at a cost of around £80. From next week, the national minimum wage will be £10.42, meaning that microwave would cost less than eight hours of gross income for a low-paid worker. Nothing that costs the equivalent of a day’s labour should be described as cheap, but that microwave is undeniably cheaper.
My interest in microwaves probably betrays my age. I’m 47, meaning I’m old enough to remember when microwaves were new and scarce, rather than the commonplace they are today.
In 1985, a standard microwave would have cost something in the region of £330. There was no minimum wage at the time, but full-time workers in the lowest income decile earned around £2.83 an hour. In other words, a microwave would cost such a worker around 116 hours – almost three weeks – of gross income.
I’m writing about microwaves because this essay is the introduction to a new SMF project that is all about markets and how they work – and what happens when they don’t work.
The tumbling cost of a microwave oven in my lifetime is a simple example of markets working and making things cheaper. The price of microwaves fell because businesses seeking to sell those ovens sought ways to make their ovens cheaper than the ones sold by their competitors. That dynamic, iterative process drove down prices, meaning more people could afford the product: more than 90% of UK homes now have a microwave.
This, ultimately, is why we use markets as the primary mechanism for allocating resources in advanced economies. The efficient allocation of resources – physical, digital and intellectual – means we can get the things we want and need at ever-lower cost, so that more people can have as much of those things.
Markets work because there is wisdom in crowds. Instead of a few people making a small number of big decisions for many people about who gets what and at what price, they mean that many people get to make a large number of small decisions for themselves that, in aggregate, help determine who gets what and at what price.
Those decisions in markets have had hugely positive effects on the world and continue to do so. But they are neither moral nor in, isolation, socially benevolent artefacts. They are, as Adam Smith put it, founded on the self-interest of market participants:
It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.
Markets don’t have any intrinsic aim of helping consumers by lowering prices and boosting living standards. They do so instrumentally, because the things that deliver lower prices and higher living standards are generally things that benefit producers.
I’m drawing this distinction here in order to make very clear that we use markets for a reason that is not found in markets themselves, a benefit to society and its members. That, of course, raises questions about what we do when markets don’t deliver that benefit.
Are markets working?
It doesn’t seem controversial to suggest that quite a lot of people, especially people on lower incomes, aren’t currently feeling that life-changing magic of markets in their standard of life. The Office for Budget Responsibility (OBR) reckons aggregate living standards will won’t be back to their pre-pandemic levels until 2028.
When you look below the aggregate and consider the condition of people on low incomes, the picture looks grimmer still.
Based on Office of National Statistics (ONS) data that only goes up to the very start of the pandemic, my SMF colleague Matthew Oakley calculates that in much of the country, people in the lowest income quintile were having to allocate more than 60% of all their spending to essentials in the period 2017 – 2020.
Figure 1: Percentage of spending on essentials for low-income consumers by region, UK, 2017/18-2019/20
Source: SMF analysis of ONS
What this means for people’s daily lives is captured grimly well in Citizens Advice estimates of “negative budgets”, where essential spending exceeds income. The latest figures suggest that more than half the people who seek help from Citizens Advice with financial troubles now have negative budgets:
Source: Citizens Advice
Here you might be wondering what counts as “essential”. Sadly, the answer is: “It’s complicated”. For those calculations above, we use the ONS definitions, but they raise some questions.
The ONS lists 150 different sorts of purchases and then decides whether they’re “discretionary” or “non-discretionary”. Unsurprisingly, things like heat and water and electricity are considered essential. So are most foods, but not all: “buns, cakes and biscuits” are not essential to life, according to our national statisticians who clearly need to have more fun.
More seriously, the ONS lists as “discretionary” some things that many of us might consider essential: telephone and broadband services; “maintenance and repair of dwelling”; contents insurance. Household appliances like my microwave are out too, which might surprise someone whose oven or fridge or washing machine breaks down.
If you’re really interested in those classifications of essential and non-essential, you can find them here.
Are these classifications the right ones? I’m not sure, so in this project we’re going to be asking people – especially people living in poverty and on low incomes – what they think should be considered essential for a decent life in Britain in 2023.
Definitions of “essential” are, of course, subjective: there’s no absolute physical law here, just a judgement, or set of judgements that some, most or all people share. Those judgements about essential products amount to a society’s expectation of what markets should provide for everyone, one way or another. This is important when we think about whether markets are doing their job, or failing.
How markets can fail society
Generally when society deems something essential, measures are put in place to ensure its universal provision – even when that thing is largely provided through a market. Where a person does not have housing, the state (generally) provides it. Some people do go hungry, but our expectation again is that no one is left to starve. In reality, coverage in these markets is incomplete. Some people are homeless and some people go short of food. But these outcomes are not shrugged off as the inevitable result of market provision. Society accepts that the arrangement relying on market mechanisms to provide housing and food can fail some people and leave them without essentials, even if the market is, in the narrow technical sense, functioning well and efficiently.
Here, we have to delve into a bit of economic theory, specifically price discrimination. Because I’m 47 and it’s been a long time since I had to study this stuff at university, my younger and cleverer SMF colleague John Asthana Gibson has helped me out with the next bit.
Price discrimination happens when a supplier charges different prices for the same thing to different consumers. Sometimes this leaves people feeling unhappy, but there are actually some benefits to it. It allows firms to increase or even maximise profits, and profits can be a good thing. It can increase consumption and production and drive economies of scale that lower prices for everyone. And it can be more fair: consider a barber’s shop that charges lower prices to students and OAPs with lower incomes than it does to other customers. You might recognise the self-interest of Adam Smith’s butcher, baker and brewer in that pricing decision, a self-interested act that benefits consumers. From an economist’s perspective, price discrimination is generally efficient, in the sense that it matches customers’ willingness to pay with suppliers’ willingness to sell and maximises the amount of stuff that gets bought and sold.
Sometimes, a bit of social pressure also encourages some price discrimination in the favour of certain groups. Think of those firms that offer discounts to NHS workers since the COVID-19 pandemic, for instance. Do they do so for purely self-interested reasons (because it makes them look good, and thus generates more business) or because market actors are driven by factors other than self-interest?
Whatever the reason – and we’ll explore those reasons in this project – the point is that some forms of price discrimination can be socially positive, at the same time as being economically efficient.
But not all forms of price discrimination are acceptable.
The most visible and controversial examples are the premiums that seem to be charged to some groups in some markets. People on low incomes can pay hundreds of pounds more than richer ones for insurance products. And, as Citizens Advice has recently revealed, ethnic minority customers can pay more than White ones. Even if such pricing decisions were wholly explained by those customers’ additional risk of claiming on their policies – and no one has proved that this is the case – society would still judge such narrowly efficient pricing to be unacceptable.
A similar point can be made about markets for our essential goods. A dessicated economic calculating machine might conclude that the markets for, say, broadband are working well enough because broadband is priced such that all the people who want it buy it at a price that they are – self-evidently – willing to pay. But some people can’t afford broadband and the market doesn’t always price discriminate so as to allow them to buy it. And many who can just about afford it are struggling. There is, as we’ve seen with biscuits and buns, more to life than economics. Market provision can fail people even when there is no “market failure.” Does someone who has to devote almost two-thirds of their spending power to pay for “essentials” (and remember, that might not even include things most of us consider essential) consider that the market is working for them? I have my doubts about that, which is why we’re going to ask them, via a big opinion survey and some focus groups.
Switching and the limits to competition
If markets are failing to provide people on low incomes with the stuff they need at a decent price, what’s the remedy? A lot of answers to this question in recent years have boiled down to “shop around more”. Policymakers have put a lot of faith in competition to improve consumer outcomes. The idea is that when people shop around – increasing the elasticity of their demand – they increase the pressure on the butcher, brewer and baker to cut their prices and unleash that life-changing market magic I mentioned earlier.
It’s a good plan in general terms. Competition is almost always good for the wider economy and often good for consumers. But there are limits to the benefits it can deliver, not least because that whole “shopping around” thing depends on people doing what old-fashioned economics textbooks would call the rational thing, allocating their money in the way that maximises their “utility”, the term economists use for happiness. Economists should eat more biscuits too.
But not everyone does this. The awkward fact is that people in poverty and financial stress, often the people with the greatest need of the savings that can come from shopping around, can be the people with the lowest capacity for doing that shopping. A number of non-old-fashioned economists such as Anandi Mani have shown how poverty causes stress that impairs cognitive function, meaning the people who really need to get the best deal in markets can be the people least able to meet the traditional standard of “rationality” needed to get that deal.
Here I need to talk about Martin Lewis, because he’s living proof of the limits to the benefits that competition can bring to people in markets. He has done huge amounts of good for the world by creating a website that allows people to get good information about good deals in markets: users of MoneySavingExpert can find out how to shop around and maximise their utility. MSE is hugely popular and that made it hugely valuable when Lewis sold it.
The great irony of the man who has helped millions of consumers to navigate markets is that he made millions from the failure of consumers or markets to function in the way that those old textbooks suggested they should.
Put another way, if we had more competitive markets, MSE would never have built up the loyal audience that made it so valuable. I don’t, to be clear, say this as any sort of criticism of Lewis – quite the contrary. He’s done a huge amount of public good, and deserves all the acclaim he gets.
My point is that Martin Lewis embodies the challenge encountered by those who would argue that the answer to public policy problems involving markets is for policymakers to leave those markets alone to work their allocative magic. The reality of markets is that imperfect competition, imperfect information and imperfect consumer choices – because humans are all imperfect – all mean that markets left to their own devices are likely to deliver outcomes that we consider suboptimal.
So back to the question: what do we do when markets don’t deliver the social benefits we expect of them for people in need? Sometimes we put in place a social tariff, and that’s what this new SMF/Citizens Advice project is really about. We’re looking at the case for using social tariffs in some of the markets for essential goods.
Here, a word is needed on the meaning of that term “social tariff”.
Once, “social tariff” had a relatively narrow meaning. It indicated a policy whereby a particular group of consumers were offered the chance to buy goods in a market at a lower per-unit price than other consumers.
SMF research in this area elsewhere – also in partnership with Citizens Advice – has shown us how the term has now expanded and blurred.
“Social tariff” is used to describe a range of different policies intended to deliver a better (generally cheaper) market experience for a designated (generally poorer) group (generally poorer) of consumers.
Rather than get caught up in definitional niceties, a far greater priority here is to think about the conditions under which social tariffs (of whatever sort) are an appropriate response to markets falling short of what society needs of them.
As with many other aspects of British policymaking, we have little in the way of a systematic approach to this question.
This shouldn’t really surprise. British public life has a (partly unconscious) aversion to grand strategy or systematic planning. There are a lot of advantages to polity where policymakers follow a tradition of muddling along and seeking to make the least-bad choices on the day, rather than consulting a textbook, philosophical tract or holy book. But it does often make for inconsistent and patchy policy.
So social tariffs have grown up organically in some markets but failed to germinate in others.
Insurance is a prime example of a market where there is a strong social case for some sort of social tariff (at the SMF we’ve suggested vouchers for low-income consumers to help with insurance prices, among other interventions.) But as yet, no such tariff has appeared.
The most notable examples of where social tariffs have sprung up are in broadband and water.
In the broadband market, lower prices are available to those on a variety of benefits. Prices range from £10 to £20 for superfast broadband packages, and speeds differ between providers. In water, every water company offers a social tariff, but the eligibility and level of support varies between companies.
These are both, to be clear, positive things and better than nothing, since without them more low-income consumers would face even higher prices. But would bigger, smarter social tariffs deliver better outcomes? And are there other markets where such tariffs should be in place? We think those are questions worth asking.
We also think it’s worth learning from other countries and how they do it, which is why John has looked around the world and found lots of intriguing examples of social tariffs deployed in essential markets.
Public transport in Belgium
In Belgium, measures are taken to improve access to train, bus and tram services for people on a low income. People who benefit from enhanced reimbursement status for healthcare (defined by being low-income/ in receipt of benefits) can be granted a pass at a reduced tariff, for use on both trains and buses. Tariffs vary according to the transport and region. For rail travel the reduction is 50% across the country whilst bus discounts depend on region in the country.
Water and sanitation in Portugal
In Portugal there is a social tariff for water, and for waste water collection and treatment, aimed at facilitating access for low-income people to these services. Eligibility is based on being a low-income household and/or being in receipt of a number of social security benefits. Although the legal framework of the measure is defined at the national level, the detailed implementation is decided at the local level.
Australia offers a range of social tariffs on a regional basis, set by individual states. New South Wales, for instance, offers a number of energy rebates based on various criteria, such as being a pensioner or being in receipt of child benefit22.
We might also consider things that are effectively social tariffs but are rarely acknowledged as such. Things such as railcards that deliver discounted travel for young people, albeit in exchange for a fee, or those NHS discounts. Sometimes those come about because of legislation or regulations. Sometimes it’s simple social pressure.
In each case, different criteria have been used and different conditions met before a social tariff was implemented. What were those criteria and conditions? How should we decide which markets need a social tariff? What are the rules here?
Right now, British policymaking doesn’t have answers to those questions.
Social tariffs in the social market
To bring this back to the theory of markets and their role, the lack of systematic thinking about when and how social tariffs are appropriate is a significant problem for anyone who values markets. Because to work best, a market-based economy needs rules.
At the SMF, we firmly believe that there is a role for policymakers and the state to establish those rules.
To quote from John Kay, inter alia a former trustee of the SMF:
“…markets function well only when embedded in strong and supportive social institutions….a successful market economy requires the legal, social, and economic infrastructure that only a strong state can provide.”
And it is very much the role of those state-made rules to ensure that not just economic but social interests are reflected in markets. To quote from Lars P. Feld, Peter Jungen and Ludger Schuknecht, recent German scholars and practitioners of the social market approach:
“The “social” element of the social market economy, then, is not about state ownership or state direction, as under socialism. Instead, it refers to a rules-based economy in which social interests are properly accounted for.”
We think that social tariffs can and should play a role in dynamic economy where markets work their magic wherever possible while the state also ensures support for all those who need it.
But the decision to introduce such tariffs should be made carefully and systematically, on the basis of clear evidence and analysis rather than ad hoc political whim and muddle. That is what this project aims to deliver. We welcome thoughts and contributions from anyone who shares our aims.