The Free Market Works, Until It Doesn’t GLOBAL ECONOMIC UPDATE
▮ Free market and efficiency are the terms often used together, familiar to economists and economics students worldwide. A simple explanation is a theoretical free market, which is a market with little to no government intervention, encourages business competition. Competition promotes efficiency because the winner is usually the one who produces goods with the highest quality and the lowest costs. ▮ Policymakers around the world try to benefit from this concept. The US state of Texas is among them. In the early 2000s, the Texas government deregulated and privatised its electricity market. Ever since, the state has been flooded with modern technology, ranging from natural gas grids to renewable wind turbines, as companies compete to supply power. In fact, citizens in the state love the idea of limited regulation so much it has a standalone grid twice as large as those in several other states. However, the recent power outage in early February revealed a sad truth: the free market works, until it doesn’t. Let’s explore some of the failures of the infamous free market in the real world. ▮ In theory, as mentioned earlier, the free market is expected to increase the efficiency of businesses, ensuring the lowest prices for consumers. However, this is not always the case in the real world. Since Texas introduced a private electricity market in the early 2000s, electricity prices should have significantly fallen. According to the US Energy Information Administration (EIA), electricity prices in Texas rose by 68.9% between 2002 and 2008, before gradually falling thereafter. Moreover, the downward trend in prices does not mean the Texas electricity fee has been reduced. An analysis in the Wall Street Journal shows since 2004, electricity users in Texas have been paying $28 billion more in the privatised electricity market than they would have paid if rates were charged by the state. ▮ Another assumption about the free market is participants’ behaviour can be incentivised. To ensure uninterrupted flow of electricity during freezing weather, the Electricity Reliability Council of Texas set a cap of $9,000 per megawatt-hour for companies supplying electricity in harsh winter conditions. Although the revenue generated during extreme weather could amount to what a firm can make for the entire year, the unlikelihood of such an occurrence discourages companies from making additional investment in weather-protective equipment. The polar vortex in Texas highlighted companies’ reluctance to incur more costs despite the incentive of a skyrocketing electricity price. ▮ The problems mentioned above can partly be explained by another famous economic concept called the “natural monopoly”. According to the OECD, a natural monopoly exists in a market if a single firm can produce goods at a lower cost than it could in the presence of more than one producer. The tremendous fixed costs of electricity grids pave the way for the rise of a natural monopoly because a firm could minimise average costs (cost per production) if it can claim the entire market share. ▮ Texas, as the second most populous state in the US, may tempt policymakers to think its market size is large enough for many entries, but that is not the case. Even though a dozen retail energy providers emerged after the 2002 privatisation, most of them were unable to survive. In fact, the Texas electricity market is becoming more like a monopoly in recent years. In 2019, Vistra Corp and NRG Energy, two of the nation’s largest retail energy providers, owned as much as three-quarters of the retail market in Texas. This could be evidence the market is returning to what it should have been in the first place. ▮ No one denies Texas’s power market needs reform, but the question is whether competition or monopoly provide a better outcome. Perfect policies do not exist in this world, so Texas should try to strike the right balance between regulations and allowing for free market mechanisms. This task is difficult given the distinctive characteristics of different markets and hard-to-measure opportunity costs involved in choosing one decision over another. Knowing fundamental economic theories is good, but knowing how to apply them in the real world is even better.