8 minute read
LABOR RATE: Facts, Fiction and the
Labor RatE:
Facts, Fiction and the Future - Part 5 ( An Economist’s Perspective )
Editor’s note: For this latest installment in our ongoing series on the Labor Rate, we welcome economist Fred Jennings, Jr. for his third in a series of articles that will feature his research and perspectives on the issue. We thank Fred for his contributions and welcome reader feedback on any of the topics he presents.
This is my third in a series of four articles that take an in-depth view into the Labor Rate issue. The first installment described the current situation and discussed the 1963 Consent Decree and litigation involving the collision repair industry. The second piece examined the real level of Labor Rates in a market not controlled by insurers, using widely accepted methods of economic evaluation to show why Labor Rates in an uncontrolled market would exceed the prevailing free-market level of auto mechanical Labor Rates.
This third part will address two arguments: Auto insurers maintain an “efficiency argument” that their control of the collision repair market benefits policyholders by cutting costs and premiums, while the collision repair industry adopts a “market power interpretation” that auto insurers’ behavior neither benefits policyholders nor protects consumers’ safety.
The fourth part will test these views, based on a statistical analysis of geographical Labor Rate patterns. The analysis will be explained, its method described and the findings reported and interpreted.
Introduction
The auto insurance industry justifies its suppression of Labor Rates with the claim that its referral/program shop system is efficient and also reduces cost to consumers. Some collision repair providers contend that this system is not efficient and involves an abuse of market power against the consumer and the auto body industry. Many complaints brought by collision shops against insurers have been filed based on alleged violations of fair trade and antitrust statutes. But the general issues surrounding these conflicting claims of efficiency versus market power need further attention.
First, I will look at market power: What it means, why it matters and how we might think about its effects. Second, I will consider the question of how we might determine whether auto insurers’ control of collision repair is efficient or not. Third, I will address some factual information that might help to resolve this question. Fourth, I will anticipate what my final article in this series might show about this controversy.
Market Power
Economics is about choice; the more options you have, the better. The antitrust laws are intended to protect our range of options from attempts to narrow or restrict them. After all, if a seller can limit buyers’ options, they are more likely to buy from that seller. The same principle applies to buyers trying to limit suppliers’ options. The argument goes like this:
Monopoly Power: When you have a single seller (or just a few sellers with oligopoly, so they can collude much like a monopoly), that seller can raise prices and restrict output to consumers if such behavior enhances monopoly profits, at least in the short run. In normal markets, such high profits attract competitive entry, which brings those profits down to “normal” levels. Competitive entry does not occur for some reason, so consumers are not served more efficiently at competitive prices. The monopolist is somehow protected from these market forces.1 Monopolies involve an abuse of market power by sellers against final buying consumers in the form of higher product prices that consumers have to pay.
Monopsony Power: Monopsony power is a bit different, because instead of facing downstream (being used against consumers), it is used by buyers against suppliers, squeezing their prices and profits. In a manufacturing context, a monopsonistic price squeeze against suppliers pushes them back down an upwardsloped supply curve (under normal assumptions), thus reducing costs
along with the amount and/or quality of the inputs sold by those suppliers.
This situation can “look like” efficiency with its lower costs, except for one important issue: Those “cost savings” cannot be passed to consumers by a monopsonistic buyer! Why? Because that buyer’s final product demand curve slopes downward, meaning that passing on those savings in cost will increase sales of final products. But the price-profit squeeze against suppliers has decreased the amount and/or quality of the inputs supplied, and you cannot increase output with fewer inputs!
The whole point and purpose of monopsony power abuse is to drive a wedge between final product prices (which rise with reduced output) and the costs – and amounts – of inputs supplied (which have fallen). Final product prices are rising (just like with monopoly), while input costs and final output are both reduced as a means to increase monopsony profit. So, in both cases – of monopoly and monopsony – output is reduced, final product prices rise and consumers have to pay more. The main difference is that, with monopsony, suppliers are squeezed as well.
The Auto Insurance Case: The primary difference between monopsony power abuse in manufacturing (as described herein) and that by auto insurers – if the market power interpretation of their behavior is correct – is that the “demand” for collision repair services is not very sensitive to prices and costs. It is more closely dependent upon the frequency of auto collisions. Some minor repairs may respond to price by being foregone, but the overall volume of such repairs is not very price-sensitive.
Consequently, a price-profit squeeze against suppliers does not reduce the level of demand for collision repairs very much. Its primary impact is to drive a wedge between higher final product prices (namely, auto insurance premiums) and lower payments for collision repair services. Since the demand for collision repair services is not responsive to price, the primary impact of a price squeeze on suppliers may be on the quality of the repairs performed (although that possible loss of consumers’ safety is hard to quantify).
There is another wrinkle to this argument, however, when auto insurance premium rate hikes must be justified by a rise in the “costs of fulfilling claims.” This means that if higher premiums for auto insurance are to be cost-justified through monopsony power abuse, the lower payments must be internally padded in some manner so accounting costs are raised.
In the realm of utilities such as electricity, economists have identified a phenomenon called the “Averch-Johnson Effect,” associated with rate-of-return regulation, where capital costs are inflated to increase absolute profits for a fixed rate of return. Utilities would – in effect – place the equivalent of lead-coated gold statues on their lawns to raise their capital costs in order to increase profits under a fixed rate of return. The auto insurance situation differs slightly, in the absence of rate-of-return restrictions, though an incentive for inflating costs still remains strong as a means to raise insurance premiums. In order to work, such a padding of costs has to be internal and disguised, implemented through means such as “marketing” rebates back to an insurer from high-cost referral/ program shops or in the form of excessive administrative processing costs (which operate like gold statues).
The point is that auto insurers’ squeeze on the costs of collision repair must coincide (somehow) with an increase in the “costs of fulfilling claims” in order to justify higher premiums. The padding of cost must be well disguised as a means to profit from monopsony power abuse. An indirect test of these costs is suggestive, however, based on a comparative history of auto insurance premiums and collision repair prices.
Auto Insurance Premiums vs. Collision Repair Costs
The auto insurers’ “efficiency argument” means that prices align with costs so profits are being constrained by a competitive process. If so, then their inflation rates should coincide. The auto collision repair industry’s “market power interpretation” implies that profits are not so contained and that costs are suppressed while premiums are not. This means that auto insurance premiums will rise faster than the costs of auto collision repair. A quick look at the history of prices for collision repair versus auto insurance premium rates (relative to other price indices such as the consumer price index [CPI]) is informative in this regard. Please see the chart below. The base years for all these comparisons are 1982-84.
The average prices of motor vehicle (MV) parts and equipment have risen relatively slowly at 1.07 percent per year, while the price of MV body work has risen at 3.23 percent per year, with an average rate of increase for both combined being somewhere between those two figures (perhaps close to the CPI for all items of 2.6 percent per year). The price of MV insurance has risen by 4.69 percent per year, which exceeds even the rising costs for medical care of 4.55 percent per year.
The difference between the inflation rates for motor vehicle insurance and for body work plus parts over the 37 years since 1983 (if labor and parts charges are assumed to be approximately equal) implies that premiums have risen more than twice as fast as the costs of body work plus parts (with comparable CPIs through 2020 of 544.6 versus 236.4, which shows insurance premiums rising 2.3 times as fast as the costs of collision repair).2
The apparent fact that premiums have risen much faster than collision repair costs, especially when parts are included, supports a market power interpretation of this situation, as it shows an increasing wedge between price and cost that might result from monopsony power abuse. The evidence is not definitive, but it does
continued on pg. 30
Description
CPI – All Items CPI – Medical Care
CPI – MV Maint & Repr CPI – MV Body Work CPI – MV Parts & Eqpt CPI – MV Insurance
Base Year 2020 Index Average Growth Rate
1982-84 306.0 3.07% per year 1982-84 324.7 3.23% per year 1982-84 148.1 1.07% per year 1982-84 544.6 4.69% per year
