…. And Businesses Must Now Operate at “Real Market Price.”
The market economy is often criticized as much for generating competition as it is for engendering monopolies. When, for example, fierce competition leads to volatility and starkly different prices for the same product or service, legislators call that an “anarchic market.” If companies work together to tackle that problem and maintain price stability, legislators do not accept that either. Government, in either case, favors regulation. Companies, as a rule, never let people know whether the state imperatively impose prices on them.
“I do not threaten anyone, nor do I intimidate someone. But you yourselves must reconsider your activity and decrease prices yourselves to real market prices,” businessmen were told by Georgian Dream leader and future Prime Minister Bidzina Ivanishvili at a special meeting convened for them. After that meeting, the price of gasoline dropped by almost eight tetri.
As part of its liberal reform agenda, the Georgia government six years ago established the Agency for Free Trade and Competition. The new entity was not given power to impose sanctions and regulatory bodies were retained only in the energy, communications and financial sectors. That reform initiative was guided by the principle that every company seeks profit and only strong competition provides impetus to protect customers from artificial price increases. In those years, economic growth rose from five percent to double digits. The key stimulus was the dramatic decrease in corruption brought about by downsizing government functions.
The new government is taking a different stance – it intends to enhance the size of government again. Its purported aim is to end cartel agreements as well as monopolies. That supposedly will result in the decrease of “very high prices” and lower tariffs for the population.
But what exactly does “very high price” mean?
Prices on the free market are established by supply and demand. The only fair free market price is the price on which a seller and a buyer agree. In reality, a “very high price” means an undesirable price. From a buyer’s standpoint, the most desirable price is zero. Nevertheless, a buyer does not realistically expect to receive any product or service for zero price. From the point of view of the seller, a desirable price is the one which is indeterminately high. But a seller does not reasonably expect either to sell a product or service at just any price. Price is not determined by production costs alone; the cost of production is only the lowest margin.
Gasoline has to travel a long way before it is pumped into the tank of a buyer’s car and the company selling it has to incur various costs to get it there.
First, that company must have a gas station which meets a host of safety rules. A decree of the Georgian Minister of Economic Development sets out those rules and all related aspects – the required engineering design, construction, technological equipment and technical service, repair and management of fire safety measures.
After a gas station and its technical service facilities have been equipped with expensive fuel tanks, treating facilities, water supply system, drainage system, special cisterns, etcetera, it must then pass a test for commissioning the fuel facility systems. That involves examining fuel pipes for proper pressure and leak resistance. Meeting those requirements incurs additional costs. Moreover, given the multitude of regulations, the period of testing can become protracted, thereby causing the company financial damage.
Let’s assume that the company has met all the safety requirements for filling stations; it has passed the commissioning test and is ready to supply gasoline to the Georgian market. One must agree here that the price of crude oil is linked to the international market price and that changes in that price necessarily affect local product. The higher the market demand, the higher the price and vice versa.
Crude oil must first go to a refinery to be converted into gasoline. Refining has its cost. That cost is calculated by a specific formula which is tied to geographical oil zones. In the case of Georgia, the Platts price assessment is topped off with a tariff established for the Mediterranean oil zone.
Because Georgia does not have its own refineries, its market players must import gasoline. The transportation costs further raises the price. After the oil tanker has pulled into port, gasoline must be unloaded and stored in a terminal. All of that costs money too.
From the terminal, the gasoline is then shipped by railway. The railway sets tariffs based on the number of rail-tank cars and the distance they must travel. As the Georgian Railways is a public entity, that money goes directly into the state budget.
When the railcars reach their destination, they must be unloaded. The fee for that service is calculated by tonnage. At that point, all of the different transportation costs have to be tallied and an eighteen-percent VAT rate levied on the total amount.
The next step is gasoline quality control, which involves the inspection of quality, volume, specific share, etcetera. Quality control must be carried out by state-certified companies. That service costs money as well.
The company then has to store the product again until it can be delivered to affiliate companies for further distribution to filling stations. Operation and maintenance of the oil supplier and the entire gas station network requires the payment of salaries, utility fees, rent, insurance, profit taxes.
At the end of the day, it costs a company tens of millions USD on average to open filling stations to pump gasoline into the tanks of cars. The highest cost is rail transportation. As it turns out, that market is virtually closed for smaller companies; it is cost-prohibitive to enter for a company with small start-up capital.
Any incentive which smaller players may have to enter the market is also diminished by the fact that the large oil importers have their own suppliers which own their own oil refineries. A new player seeking to enter the market has two choices: (1) team up with a supplier or (2) enter the market independently.
If the company decides to team up with a supplier, it will need a facility where the product can be stored until it is ready for distribution to the network of filling stations. Construction of such a storage unit and building a distribution network on the scale of Tbilisi would require several million USD. Initially, the company would have to operate at a lower price than its competitors in order to attract customers and to secure a competitive place in the market.
If a smaller-size company decides to enter the market as an independent supplier, it would have to buy gasoline from one of its rivals. That virtually ensures that the company’s sales price would always be higher that its rival. That, of course, would make it very difficult, if not impossible, for the smaller independent company to remain in the market.
As the cost breakdown shows, the supply price is inflexible; most costs are fixed and the company has no control over them. It is worth noting that gasoline importing companies do not have a wide choice of suppliers – the largest supplier is Socar, the Azerbaijani state company which supplies almost half of all gasoline imported into Georgia.
Pascal Salin, the French free market economist and professor emeritus of economics at Université Paris-Dauphine, notes that competition is conditioned on a single aspect – free entry into the market. It is not only entirely possible, but is often the case that only one supplier holds a monopoly on a product for a certain period of time after that product is first introduced into the market. If and when that activity proves profitable, then other producers will enter the market too.
A monopoly is not in and of itself a violation of international law. According to Professor Salin, the only monopoly which can be regarded as an international law violation is a state’s privileged treatment of one enterprise and its obstruction of others in the market. When that happens, innovation disappears and the population is left with lower quality products and higher prices.
Most of the discussion concerning “real market price,” cartels and monopolies is almost never focused on why possibilities for cartel agreements and monopolies even exist – whether because entry to the market is free or because it is restricted.
If we look at this issue from the perspective of a private owner, everything will become clear. A private owner has the right to enter into a contract with whomever he/she pleases and on whatever terms the parties fairly negotiate. Consent to the offered terms cannot be coerced; using force or deceit to execute a contract invalidates the agreement.
Following that example, an oil company has a right to establish a price which it considers expedient and to do that either independently or with the agreement of other oil companies. On the other hand, customers have the right to refuse to buy gasoline.
If world prices on oil plummet but market conditions enable companies to maintain and sell the product at the same price, then that is how it must be. Customers are ready to pay the same price.
Does that play into hands of oil companies? No, it does not.
Meta-analysis of various studies conducted by American researchers shows that, under free market conditions, a 10-percent increase in the price of gasoline reduces demand by 2.6 percent on average in the short term and by 5.8 percent on average in the longer term.
If the real price of fuel rises by 10 percent and remains at that price, trade decreases on average by 1 percent within a year and by 3 percent on average within almost five years. Moreover, the amount of gasoline consumed decreases by 2.5 percent on average during that year and by 6 percent in the longer term. On the other hand, the efficiency of gasoline consumption increases by 1.5 percent during the year and by approximately 4 percent during the longer period. The total number of cars decreases by 1 percent in the shorter period and by 2.5 percent in the longer period.
Alternative ways of supplying product almost always exist in a free market. If new players were able to enter the market freely, that would increase demand for alternative products – for example, for ethanol and biodiesel, which are popular and less costly.
Chicago University Economics Professor Sam Peltzman believes that competition does not seem to be a major headache for the Georgian economy. In his opinion, the most important goal for Georgia today is to achieve high economic growth. Demand generated under such conditions will lead to greater competition which, in turn, will facilitate the entry of new players into the market. Pascal Salin contends that the regulation of competition is like a sharp knife which, when applied in the name of encouraging competition, may in some cases actually restrict competition.
The main criticism voiced against competition law is that it does not regulate competition sufficiently. The great majority of laws aimed at regulating competition are, as a rule, vague. The main reason for that is that it is very difficult to come up with precise definitions of “cartel” and “monopoly.” Criteria established to identify a monopoly and a cartel are, as a rule, unsupported. That has not stopped governments from adding criteria to criteria in an attempt to make imprecise definitions seem somehow more credible and accurate.
The size of a company, its number of affiliates, its establishment of “very high” or “very low” pricing as compared to its competitors, or even equal pricing which “undermines competitiveness,” etcetera , are all examples of ambiguous criteria which governments use.
Nothing is truly anti-competitive under any one of those criteria. For instance, it is impossible conceptually to separate a cartel, association or the formation of corporation from one another. The key characteristic of each of those forms is that companies voluntarily distribute assets among themselves in order to serve customers more efficiently.
“We will not tolerate cartel agreements. Prices must be market prices,” Bidzina Ivanishvili repeated several times during his meeting with businessmen. If the businesses represented there react to Ivanishvili’s call by automatically decreasing prices, it would extract too high a price: it would either worsen the quality of their services and/or cut down on the number of people they employ and/or influence them to refrain from social projects.
If the country’s new government does not simplify existing legislation and further open the market, the market would not be saturated. Prices might drop temporarily, but they would soon increase again. By turning competition into a punishing course without implementing systemic reform, the state would fight not the causes but the results of high prices. At the same time, it would jeopardize the key achievement of previous years – combated corruption.
In any case, state interference in the market would damage the country’s economy far more than higher gasoline prices.
This article first appeared in Tabula Georgian Issue # 118, published 15 October 2012.