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Articles for the ‘Essential Economics for Business: Ch 02’ Category

The oil see-saw

In the blog OPEC deal pushes up oil prices John discussed the agreement made by OPEC members to reduce total oil output from the start of 2017, with Saudi Arabia making the biggest cut in output. The amount of oil being provided is a key determinant of the oil price and this agreement to reduce oil output contributed to rising prices. However, now oil prices have begun to fall (see chart below) with Saudi Arabia in particular recording an increase in output but all OPEC nations noting that global crude stocks had risen.

Supply and demand are key here and over the past few years, it has been a problem of excess supply that has led to low prices. OPEC nations have been aiming to achieve greater stability in global oil markets. Given the excess supply, it has been output of oil that the cartel member have been trying to cut. That was the point of the agreement that came into effect from the start of 2017. However, even with the recent increase in production Saudi Arabia notes that its output is still in line with its output target. The 10 percent fall in crude prices over such a short period of time has led to renewed concerns that pledges to reduce production will not be met. However Saudi Arabia’s energy ministry stated:

“Saudi Arabia assures the market that it is committed and determined to stabilising the global oil market by working closely with all other participating Opec and non-Opec producers.”

There were already concerns about the oil market relating to a potential increase in US shale oil output. Oil producers include OPEC and non-OPEC members and so while the cartel has agreed to cut production, it has little control over production from non-cartel members. This was one of the main factors that contributed to the oil price lows that we previously saw. OPEC’s forecast for oil production from non-OPEC member has been raised for 2017 and overall production from all oil producing nations looks set to increase for the year, despite OPEC curbing output by 1.2 million barrels per day. However, despite the 10% drop, the price of crude oil ($50) still remains well above its low of $28 in January 2016.

Oil prices are one of the key factors that affect inflation and with UK inflation expected to rise, this fall in oil prices may provide a small and temporary pause in the rise in the rate of inflation. There are many inter-related factors that affect oil prices and it really is a supply and demand market. If US shale oil production continues to rise, then total oil output will rise too and this will push down prices. If OPEC members undertake further production curbs, then this will push supply back down. Then we have demand to consider! Watch this space.

Report
OPEC Monthly Oil Market Report OPEC (14/3/17)

Articles
Saudis stand by commitment to oil production cuts Financial Times, Anjli Raval and David Sheppard (15/3/17)
Oil prices fall after Opec stocks rise BBC News (14/3/17)
Crude oil price slumps to new three-month low after OPEC supply warning Independent, Alex Lawler (14/3/17)
Opinion: Saudi Arabis has a big motivating interest in keeping oil prices high MarketWatch, Thomas H Kee Jr. (14/3/17)
Why oil prices may come under even more pressure next month Investor’s Business Daily, Gillian Rich (13/3/17)
Oil price crashes back towards $50 as Opec raises US oil forecasts The Telegraph, Jillian Ambrose (14/3/17)

Data and Information
Brent Crude Prices Daily US Energy Information Administration
OPEC Homepage Organisation of the Petroleum Exporting Countries

Questions

  1. What are the demand and supply-side factors that affect oil prices? Do you think demand and supply are relatively elastic or inelastic? Explain your answer.
  2. Use a demand and supply diagram to illustrate how OPEC production curbs will affect oil prices.
  3. If we now take into account US shale production rising, how will this affect oil prices?
  4. Why have OPEC members agreed to curb oil production? Is it a rational decision?
  5. What are the key points from the oil market report?
  6. How do oil prices affect a country’s rate of inflation?
  7. What, do you think, are oil prices likely to be at the end of the year? What about in ten years? Explain your answer.
  8. Should the USA continue to invest in new shale oil production?
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Christmas Trading

We all know that our spending changes during the Christmas period: namely we spend a lot more than during the rest of the year. This applies across the board – we buy more clothes, food and drink, even though each day, we can generally only wear, eat and drink the same amount as usual! This has some interesting points from a behavioural economics stance, but here I’m going to think about the impact of this on some key retailers.

Marks & Spencer have previously made headlines for the wrong reasons: poor sales on clothes and the need for serious restructuring of its stores, target audience and marketing in order for this long-standing retailer to remain current and competitive. Although sales were expected to rise in the Christmas period, they did significantly better than expected, with sales growth of 2.3%, above the expected 0.5%. More encouragingly, this growth was not just in food, but in clothing and homeware as well.

One of the key reasons given for this above-expected improvement in sales was the conveniently timed Christmas, falling on a Sunday and hence giving extra shopping days. M&S have said that this certainly helped with their Christmas trading. Although this was good for Q4 trading, the timing will not play ball for Easter and they are expecting a negative effective during that trading period. Some analysts have said that despite the growth being boosted by the timing of Christmas, there were still signs of a change in fortunes. Bryan Roberts from TCC Global said:

“It might be the sign of some green shoots in that part of the business.”

This is consistent with the Chief Executive, Steve Rowe’s comments that despite the timing of Christmas adding around 1.5% to clothing and home sales growth, the recovery was also due to “better ranges, better availability and better prices”.

It appears as though many other retailers have experienced positive growth in Christmas sales, with the John Lewis Partnership seeing like-for-like sales growth of 2.7%, with Waitrose at a 2.8% rise.

The other interesting area is supermarkets. Waitrose and M&S are certainly competitors in the food industry, but at the higher end. If we consider the mid-range supermarkets (Asda, Morrisons, Sainsbury’s and Tesco), they have also performed, as a whole, fairly well. The low-cost Aldi and Lidl have been causing havoc for these supermarket chains, but the Christmas period seemed to prove fruitful for them.

Tesco saw UK like-for-like sales up by 1.8%, which showed significant progress in light of previously difficult trading periods with the emergence of the low-cost chains. Q$ was its better quarter of sales growth for over five years. One of the key drivers of this growth is fresh food sales and its Chief Executive, Dave Lewis said “we are very encouraged by the sustained strong progress that we are making across the group.” However, despite these positive numbers, Tesco only really met market expectation, rather than surpassing them as Morrison, Sainsbury’s and Marks & Spencer did.

Perhaps the stand-out performance came from Morrisons, with its best Christmas performance for seven years. Another casualty of the low-cost competitors, it has been making a recovery and Q4 of 2016 demonstrated this beyond doubt. Like-for-like sales for the nine weeks to the start of 2017 were up by 2.9%, with growth in both food and drink and clothing.

Morrisons has been on a long and painful journey, with significant reorganisation of its stores and management. While this has created problems, it does appear to be working.

We also saw a general move up to the more premium own-brands and this again benefited all supermarkets. Morrisons Chief Executive, David Potts said:

“We are delighted to have found our mojo … Every year does bring its challenges, but so far we haven’t seen any change in consumer sentiment. Customers splashed out over Christmas and wanted to trade up … We are becoming more relevant to more people as we turn the company around.”

So it seems to be success all round for traders over the Christmas period and that, in many cases, this has been a reversal of fortunes. The question now is whether or not this will continue with the uncertainty over Brexit and the economy.

Articles
M&S beats Christmas sales forecast in clothing and homeware BBC News (12/1/17)
Marks & Spencer reports long-awaited rise in clothing sales The Telegraph, Ashley Armstrong (12/1/17)
Marks and Spencer reveals signs of growth in clothing business Financial Times, Mark Vandevelde (12/1/17)
Tesco’s festive sales lifted by fresh food The Telegraph, Ashley Armstrong (12/01/17)
Tesco caps year of recovery with solid Christmas Reuters, James Davey and Kate Holton (12/1/17)
Tesco, Marks & Spencer, Debenhams, John Lewis and co cheer strong Christmas trading Independent, Josie Cox and Zlata Rodionova (12/1/17)
Morrisons sees best Christmas performance for seven years BBC News (10/12/17)
Morrisons enjoys some ‘remarkable’ Christmas cheer’ The Guardian, Sarah butler and Angela Monaghan (10/1/17)
Record Christmas as Sainsbury’s ‘shows logic of Argos takeover’ The Guardian, Sarah Butler and Angela Monaghan (11/1/17)

Questions

  1. Why have the big four in the supermarket industry been under pressure over the past 2 years in terms of their sales, profits and market share?
  2. How have the changes that have been made by M&S’ Chief Executive helped to boost sales once more?
  3. Share prices for supermarkets have risen. Illustrate why this is on a demand and supply diagram. Why has Tesco, despite its performance, seen a fall in its share price?
  4. What are the key factors behind Morrison’s success?
  5. What type of market structure is the supermarket industry? Does this help to explain why the big four have faced so many challenges in recent times?
  6. If there has been a general increase in sales across all stores over the Christmas trading period, that goes beyond expectations, can we infer anything about customer tastes and their expectations about the future?
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What’s Next?

The economic climate remains uncertain and, as we enter 2017, we look towards a new President in the USA, challenging negotiations in the EU and continuing troubles for High Street stores. One such example is Next, a High Street retailer that has recently seen a significant fall in share price.

Prices of clothing and footwear increased in December for the first time in two years, according to the British Retail Consortium, and Next is just one company that will suffer from these pressures. This retail chain is well established, with over 500 stores in the UK and Eire. It has embraced the internet, launching its online shopping in 1999 and it trades with customers in over 70 countries. However, despite all of the positive actions, Next has seen its share price fall by nearly 12% and is forecasting profits in 2017 to be hit, with a lack of growth in earnings reducing consumer spending and thus hitting sales.

The sales trends for Next are reminiscent of many other stores, with in-store sales falling and online sales rising. In the days leading up to Christmas, in-store sales fell by 3.5%, while online sales increased by over 5%. However, this is not the only trend that this latest data suggests. It also indicates that consumer spending on clothing and footwear is falling, with consumers instead spending more money on technology and other forms of entertainment. Kirsty McGregor from Drapers magazine said:

“I think what we’re seeing there is an underlying move away from spending so much money on clothing and footwear. People seem to be spending more money on going out and on technology, things like that.”

Furthermore, with price inflation expected to rise in 2017, and possibly above wage inflation, spending power is likely to be hit and it is spending on those more luxury items that will be cut. With Next’s share price falling, the retail sector overall was also hit, with other companies seeing their share prices fall as well, although some, such as B&M, bucked the trend. However, the problems facing Next are similar to those facing other stores.

But for Next there is more bad news. It appears that the retail chain has simply been underperforming for some time. We have seen other stores facing similar issues, such as BHS and Marks & Spencer. Neil Wilson from ETX Capital said:

“The simple problem is that Next is underperforming the market … UK retail sales have held up in the months following the Brexit vote but Next has suffered. It’s been suffering for a while and needs a turnaround plan … The brand is struggling for relevancy, and risks going the way of Marks & Spencer on the clothing front, appealing to an ever-narrower customer base.”

Brand identity and targeting customers are becoming ever more important in a highly competitive High Street that is facing growing competition from online traders. Next is not the first company to suffer from this and will certainly not be the last as we enter what many see as one of the most economically uncertain years since the financial crisis.

Next’s gloomy 2017 forecast drags down fashion retail shares The Guardian, Sarah Butler and Julia Kollewe (4/1/17)
Next shares plummet after ‘difficult’ Christmas trading The Telegraph, Sam Dean (4/1/17)
Next warns 2017 profits could fall up to 14% as costs grow Sky News, James Sillars (4/1/17)
Next warns on outlook as sales fall BBC News (4/1/17)
Next chills clothing sector with cut to profit forecast Reuters, James Davey (4/1/17)
Next shares drop after warning of difficult winter Financial Times, Mark Vandevelde (22/10/15)

Questions

  1. With Next’s warning of a difficult winter, its share price fell. Using a diagram, explain why this happened.
  2. Why have shares in other retail companies also been affected following Next’s report on its profit forecast for 2017?
  3. Which factors have adversely affected Next’s performance over the past year? Are they the same as the factors that have affected Marks & Spencer?
  4. Next has seen a fall in profits. What is likely to have caused this?
  5. How competitive is the UK High Street? What type of market structure would you say that it fits into?
  6. With rising inflation expected, what will this mean for consumer spending? How might this affect economic growth?
  7. One of the factors affecting Next is higher import prices. Why have import prices increased and what will this mean for consumer spending and sales?
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OPEC deal pushes up oil prices

OPEC members agreed on 30 November 2016 to reduce their total oil output by 1.2m barrels per day (b/d) from January 2017 – the first OPEC cut since 2008. The biggest cut (0.49m b/d) is to be made by Saudi Arabia.

Russia has indicated that it too might cut output – by 0.3m b/d. If it carries through with this, it will be the first deal for 15 years to include Russia. OPEC members hope that non-OPEC countries will also cut output by 0.3m b/d. There will be a meeting between OPEC and non-OPEC members on 9 December in Doha to hammer out a deal. If all this goes ahead, the total cut would represent nearly 2% of world output.

The OPEC agreement took many commentators by surprise, who had expected that Iran’s unwillingness to cut its output would prevent any deal being reached. As it turned out, Iran agreed to freeze its output at current levels.

Although some doubted that the overall deal would stick, there was general confidence that it would do so. Markets responded with a huge surge in oil prices. The price of Brent crude rose from $46.48 per barrel on 29 November to $54.25 on 2 December, a rise of nearly 17% (click here for a PowerPoint of the chart)..

The deal represented a U-turn by Saudi Arabia, which had previously pursued the policy of not cutting output, so as to keep oil prices down and drive many shale oil producers out of business (see the blog, Will there be an oil price rebound?)

But if oil prices persist above $54 for some time, many shale oil fields in the USA will become profitable again and some offshore oil fields too. At prices above $50, the supply of oil becomes relatively elastic, preventing prices from rising significantly. As The Observer article states:

It is more likely that a $60 cap will emerge as the Americans, who stand outside the 13-member OPEC grouping, unplug the spigots that have kept their shale oil fields from producing in the last year or two.

… The return to action of once-idle derricks on the Texas and Dakota plains is the result of efficiency savings that have seen large jobs losses and a more streamlined approach to drilling from the US industry, after the post-2014 price tumble rendered many operators unprofitable. Only a few years ago, many firms struggled to make a profit at $70 a barrel. Now they can be competitive at much lower prices, with many expecting $50 for West Texas Intermediate – a lighter crude that typically earns $5 a barrel less than Brent.

OPEC as a cartel is much weaker than it used to be. It produces only around 40% of global oil output. Cheating from its members and increased production from non-OPEC countries, let alone huge oil stocks after two years when production has massively exceeded consumption, are likely to combine to keep prices below $60 for the foreseeable future.

Webcasts
OPEC Cuts Daily Production by 1.2 Million Barrels MarketWatch, Sarah Kent (30/11/16)
How Putin, Khamenei and Saudi prince got OPEC deal done Reuters, Rania El Gamal, Parisa Hafezi and Dmitry Zhdannikov (2/12/16)
Fuel price fears as OPEC agrees to cut supply Sky News, Colin Smith (30/11/16)
OPEC Confounds Skeptics, Agrees to First Oil Cuts in 8 Years Bloomberg, Jamie Webster (30/11/16)
Game of oil: Behind the OPEC deal Aljazeera, Giacomo Luciani (3/12/16) (first 10½ minutes)
Russia won’t stick with its side of the OPEC cut bargain CNBC, Silvia Amaro (1/12/16)

Articles
Oil soars, Brent hits 16-month high after OPEC output deal Reuters, Devika Krishna Kumar (1/12/16)
OPEC reaches a deal to cut production The Economist (3/12/16)
Opec doesn’t hold all the cards, even after its oil price agreement The Observer, Phillip Inman (4/12/16)
Saudi Arabia discussed oil output cut with traders ahead of Opec Financial Times, David Sheppard and Anjli Raval (4/12/16)
The return of OPEC Reuters, Jason Bordoff (2/12/16)
‘Unfortunately, We Tend To Cheat,’ Ex-Saudi Oil Chief Says Of OPEC Forbes, Tim Daiss (4/12/16)
After OPEC – What’s Next For Oil Prices? OilPrice.com (2/12/16)
The OPEC Oil Deal Sells Fake News for Real Money Bloomberg, Leonid Bershidsky (1/12/16)

Data and information
Brent crude prices, daily US Energy Information Administration
OPEC home page Organization of the Petroleum Exporting Countries
OPEC 171st Meeting concludes OPEC Press Release (30/11/16)

Questions

  1. What determines the price elasticity of supply of oil at different prices?
  2. Why is the long-term demand for oil more elastic than the short-term demand?
  3. What determines the likelihood that the OPEC agreement will be honoured by its members?
  4. Is it in Russia’s interests to cut its production as part of the agreement?
  5. Are higher oil prices ‘good news’ for the global economy and a boost to economic growth – a claim made by Saudi Arabia?
  6. What role does oil storage play in determining the effect on the oil price of a cut in output?
  7. What are oil prices likely to be in five years’ time? Explain your reasoning.
  8. Is it in US producers’ interests to invest in new shale oil production? Explain.
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When owning your own home becomes more of a distant dream

Young people are increasingly finding it impossible to buy their own home. The reasons are easy to find: income rises of young people have failed to match rises in house prices, and access to loans has become more restrictive since the financial crisis. In 2002, 58.6% of 25-34 year-olds owned their own home; today, the figure is just 36.7%.

Conventional wisdom is that the source of the problem is on the supply side: a lack of house building. But according to the Redfern Review, led by the chief executive of Taylor Wimpey, Pete Redfern, the source of the problem lies mainly on the demand side. Overall demand for housing has been rapidly rising, stoked by low interest rates and the Help to Buy scheme, which is available to existing home owners as well as first-time buyers. However, purchases by first-time buyers have fallen as their incomes have declined relative to those of older people.

Of course, increasing supply, especially of cheaper starter homes, would help young people, but, according to the Redfern Review, such schemes take a long time to make much of a difference (although building modular homes could be much quicker). In the meantime, help could be provided on the demand side by making the Help to Buy scheme available only to first-time buyers and by increasing the help to them provided under the scheme, and also by encouraging lenders to make access to mortgages easier.

But a problem for most young people is high levels of debt, including student loans. Such debt and a lack of savings makes it difficult to raise a deposit, let alone afford mortgage repayments. And on the rental side, accommodation is becoming less and less affordable as rents rise faster than incomes, further exacerbating the difficulty of clawing down debt and saving for a deposit.

A long-term solution must involve increased supply – as the Redfern Review recognises. But in the short-term, providing more help to first-time buyers and those paying high rents could make a significant difference.

Webcast
Tackling UK housing crisis ‘will take generations’ ITV News, Joel Hills (16/11/16)

Articles
Review of home ownership in UK shows severe decline in young buyers PropertyWire (16/11/16)
Housing crisis: Lack of new building not to blame for soaring house prices finds Labour-commissioned report Independent, Ben Chu and Ashley Cowburn (16/11/16)
Redfern Review: Focus on First Time Buyers and Launch Housing Commission Money Expert, Danny Lord (16/11/16)
First-time buyers need more help, review finds BBC News (16/11/16)
Redfern Review echoes Homes for Scotland’s call for joined-up approach to housing Scottish Housing News, Nicola Barclay (17/11/16)
Redfern review into housing: worth building on? The Guardian, Nils Pratley (15/11/16)
UK housing review downplays developers’ role in crisis, critics say The Guardian, Graham Ruddick (16/11/16)

Report
The Redfern Review into the decline of homeownership (16/11/16)

Data
Economic Data freely available online: UK house prices The Economics Network
UK House Price to income ratio and affordability Economics Help blog (21/9/15)
House Price Index Nationwide
UK House Price Index: reports ONS/Land Registry
House Price Index: Statistical Bulletin ONS (Sept. 2016)

Questions

  1. Do a data search to find out what has happened since 1990 to (a) average UK house prices; (b) average incomes; (c) the distribution of income since 1990; (d) first-time buyer affordability of houses.
  2. Use a supply and demand diagram to illustrate current average house prices compared with house prices in 2000.
  3. How does the price elasticity of supply of houses affect the impact of a rise in demand on house prices? Illustrate your answer with a diagram.
  4. What determines the price elasticity of supply of houses?
  5. What particular problems do young people face in being able to afford to buy a house or flat?
  6. How would making it easier for young people to be able to raise finance to purchase their first home affect the price of starter homes?
  7. What policies could be adopted by the government to make rents more affordable? Discuss the advantages and disadvantages of such policies.
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The housing market: an Australian case study of demand and supply

Many countries have experienced soaring house prices in recent years. To find out why, you need to look at demand and supply.

Low mortgage interest rates and more relaxed lending rules in the last couple of years have stimulated demand. In some countries, such as the UK, demand has been further boosted by governments providing increased help to buyers. In others, various tax breaks are given to house purchasers.

Typically the rise in demand has not been matched by an equivalent rise in supply. Social house building has slowed in many countries and building for private purchase has often be hampered by difficulties in obtaining appropriate land or getting planning permission.

The articles linked below look at the situation in Australia. Here too house prices have been soaring. Over the past 30 years they have grown by 7.25% per year – way above the growth in incomes. As the second article below states:

So expensive are homes becoming that the share of median household income devoted to mortgage payments for Australians aged 35 to 44 has more than doubled in 30 years. Incredibly, it’s happened at a time when mortgage rates have slid to their lowest on record.

But why? Again, to understand this it is necessary to look at demand and supply.

Strong population growth combined with easy availability of mortgage loans, low interest rates and tax breaks for both owner occupiers and property investors have stoked demand, while new building has lagged behind. As far as investors are concerned, any shortfall of rental income over mortgage payments (known as negative gearing) can be offset against tax – and then there is still the capital gain to be made from any increase in the property’s price.

But in some Australian towns and cities, price rises have started to slow down or even fall. This may be due to a fall in demand. For example, in Perth, the ending of the commodity boom has led to a fall in demand for labour in the mining areas; mine workers often live in Perth and fly up to the mining areas for shifts of a week or more. The fall in demand for labour has led to a fall in demand for housing.

House price changes are amplified by speculation. People rush to buy houses when they think house prices will rise, further pushing up prices. Landlords do the same. This speculation fuels the price rises. Speculation also amplifies price falls, with people with houses to sell keen to sell them quickly before prices fall further. Potential purchasers, including property investors, hold back, waiting for prices to fall.

Articles
House prices are surging because of low supply – it’s Economics 101 The Guardian, Stephen Koukoulas (27/10/16)
Who’s to blame for rising house prices? We are, actually. Sydney Morning Herald, Peter Martin (27/10/16)
The Price of Australia’s Real Estate Boom The New York Times, A. Odysseus Patrick (17/10/16)
Solutions beyond supply to the housing affordability problem The Conversation, Nicole Gurran (24/10/16)

Data
Residential Property Price Indexes: Eight Capital Cities Australian Bureau of Statistics (20/9/16)

Questions

  1. Identify the specific demand factors that have driven house price rises in Australia.
  2. How are the price elasticities of demand and supply relevant to explaining house price rises? Use a diagram to illustrate your analysis.
  3. What determines the rate of increase in house prices?
  4. Explain what is meant by ‘negative gearing’. How is the tax treatment of negative gearing relevant to the property market?
  5. What are the arguments for and against giving tax breaks for house purchase?
  6. Why are rising prices seen as politically desirable by politicians?
  7. What practical steps could a government (central or local) take to increase the supply of housing? Would such steps always be desirable?
  8. Does speculation always amplify house price changes? Explain.
  9. How are house prices related to inequality?
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Ramifications from the recent dispute between Tesco and Unilever

An earlier post on this site described a recent row between Tesco and Unilever that erupted when Unilever attempted to raise the prices it charges Tesco for its products. Unilever justified this because its costs have increased as a result of the UK currency depreciation following the Brexit decision.

It also appears that more general concerns that the fall in the value of sterling would lead to higher retail prices were prevalent around the time that the Tesco Unilever dispute came to light. Former Sainsbury’s boss, Justin King, made clear that British shoppers should be prepared for higher prices. He also said that:

Retailers’ margins are already squeezed. So there is no room to absorb input price pressures and costs will need to be passed on. But no one wants to be the first to break cover. No business wants to be the first to blame Brexit for a rise in prices. But once someone does, there will be a flood of companies because they will all be suffering.

It is interesting to consider further why the Tesco and Unilever case was the first to make the headlines and why their dispute was resolved so quickly. In addition, what are the more general implications for the retail prices consumers will have to pay?

Arguably, Unilever saw itself as having a strong hand in negotiations with Tesco because its product portfolio includes a wide variety of must-stock brands, including Pot Noodles, Marmite and Persil, that are found in 98% of UK households..

Unilever has been criticised for using the currency devaluation as an excuse to justify charging Tesco more, since most of its products are made in the UK. However, Unilever was quick to point outthat commodities it uses in the manufacture of products are priced in US dollars, so the currency devaluation can still affect the cost of products that it manufactures in the UK. In addition, Unilever’s chief financial officer, Graeme Pitkethly, insisted that price increases due to rising costs were a normal part of doing business:

We are taking price increases in the UK. That is a normal devaluation-led cycle.

On the other hand, even if the cost increases faced by Unilever are genuine, it is interesting to speculate whether it would have been so quick to adjust its prices downwards in response to a currency appreciation. After all, a commonly observed phenomenon across a range of markets is ‘rockets and feathers’ pricing behaviour i.e. prices going up from a cost increase more quickly than they go down following an equivalent cost decrease.

Compared to Unilever, some other suppliers are likely to have less bargaining power – in particular, those competing in highly fragmented markets and those producing less branded products. In such markets the suppliers may be forced to accept cost increases. For example, almost 50% of butter and cheese consumed in the UK comes from milk sourced from EU markets. Protecting such suppliers is one of the key roles of the Grocery code of conduct that the UK competition agency has put in place.

From Tesco’s point of view it will have benefited from good publicity by doing its best to protect consumers from price hikes. Helen Dickinson, chief executive of the British Retail Consortium, said:

Retailers are firmly on the side of consumers in negotiating with suppliers and improving efficiencies in the supply chain to control the inflationary pressure that is building through the devaluation of the pound.

However, it is also clear that Tesco had its own motives for resisting increased costs for Unilever’s products. In such situations both supplier and retailer should be keen to avoid a situation where they both impose their own substantial mark-ups at each stage of the supply chain. It is well established that this creates a double mark-up and not only harms consumers, but also the supplier and retailer themselves. Instead, the firms have an incentive to use more complex contractual arrangements to solve the problem. For example, suppliers may pay slotting allowances to get a place on the retailers’ shelves in exchange for lower retail mark-ups.

It has also been claimed that cutthroat competition in the supermarket industry, especially from discounter retailers Aldi and Lidl, made Tesco particularly keen to prevent price rises. Some arguments suggest that these discounters will be best placed to benefit from the currency devaluation as they sell more own brands, have a limited range, the leanest supply chains and benefit from substantial economies of scale. On the other hand, they source more of their products from abroad and it has been suggested that:

A fall in sterling will push prices up for everyone who sources products from Europe, but Aldi and Lidl will be affected more than most.

One prediction suggests that the overall impact of the currency depreciation on food prices will be an increase of around 3%. This may be particularly worrisome given concerns that the impact will fall most heavily on benefit claimants and other low-income households.

Outside of the food industry, Mike Rake, the chairman of BT, has highlighted the fact that:

Imported mobile phones and broadband home hubs were already 10% more expensive and the cost would have to be passed on to consumers in the near future.

It is therefore clear that the currency devaluation has the potential to create substantial tensions in the supply-chain agreements across a range of markets. The impact on the firms involved and on consumers will depend upon a wide range of factors, including the competitiveness of the markets, the nature of the firms involved and their bargaining power. Furthermore, evidence from an earlier currency depreciation in Latin America makes clear that the price elasticity of demand will be another factor that determines the impact price rises have.

Finally, it is also worth noting that a potential flip side of the currency depreciation is a boost for UK exports. However, it has been suggested that the manufacturing potential to take advantage of this in the UK is limited. In addition, even the manufacturing that does take place, for example in the car industry, often relies on components imported from abroad.

Articles
The Brexiteers’ Marmite conspiracy theories exposed their utter ignorance of how markets really work Independent, Ben Chu (16/10/16)
Tesco price dispute sends Unilever brand perceptions tumbling Marketing Week, Leonie Roderick (17/10/16)
Unilever and Tesco both benefit from their price row, but Brexit will bring more pain Marketing Week, Mark Ritson (19/10/16)
Why the Tesco v Unilever feud was good for British business campaign, Helen Edwards (20/10/16)

Questions

  1. What are some of the factors that affect a supplier’s bargaining power?
  2. How might the discount retailers respond to the currency devaluation?
  3. Use the figures from Latin America in the article cited above to calculate the price elasticity of demand.
  4. Explain why the price elasticity of demand is an important determinant of the effect of a price rise.
  5. Can you think of other examples of markets that may be particularly prone to price rises following a currency depreciation?
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Countervailing power: irresistible force meets immovable object as Tesco and Unilever battle it out

A row erupted in mid-October between Tesco, the UK’s biggest supermarket, and Unilever, the Anglo-Dutch company. Unilever is the world’s largest consumer goods manufacturer with many well-known brands, including home care products, personal care products and food and drink. Unilever, which manufactures many of its products abroad and uses many ingredients from abroad in those manufactured in the UK, wanted to charge supermarkets 10% more for its products. It blamed the 16% fall in the value of sterling since the referendum in June (see the blog Sterling’s slide).

Tesco refused to pay the increase and so Unilever halted deliveries of over 200 items. As a result, several major brands became unavailable on the Tesco website. The dispute was dubbed ‘Marmitegate’, after one of Unilever’s products.

This is a classic case of power on both sides of the market: a powerful oligopolist, Unilever, facing a powerful oligopsonist, Tesco. With rising costs for Unilever resulting from the falling pound, either Unilever had to absorb the costs, or Tesco had to be prepared to pay the higher prices demanded by Unilever, passing some or all of them onto customers, or there had to be a compromise, with the prices Tesco pays to Unilever rising, but by less than 10%. A compromise was indeed reached on 13 October, with different price increases for each of Unilever’s products depending on how much of the costs are in foreign currencies. Precise details of the deal remained secret.

An interesting dynamic in the dispute was that Tesco and Unilever were acting as ‘champions’ for retailers and suppliers respectively. Other supermarkets were also facing price rises by Unilever. Their reactions were likely to depend on what Tesco did. Similarly, other suppliers were facing rising costs because of the falling pound. Their reactions might depend on how successful Unilever was in passing on its cost increases to retailers.

This example of ‘countervailing power’, or ‘bilateral oligopoly’, helps to illustrate just how much the consumer can gain when a powerful seller is confronted by a powerful buyer. The battle was been likened to that between two ‘gorillas’ of the industry. Its ramifications throughout industry will be interesting.

Podcasts and Webcasts
Tesco-Unilever row: Can unique shop explain ‘Marmitegate’? BBC News, Dougal Shaw (13/10/16)
Tesco, Unilever in Brexit price clash Reuters, David Pollard (13/10/16)
Brexit price-rise warning to shoppers BBC News, Simon Jack (10/10/16)
Tesco in Brexit Pricing Spat With Unilever Wall Street Journal (13/10/16)
Tesco battles Unilever over prices Financial Times on YouTube (14/10/16)
Tesco vs Unilever: Who won? ITV News, Joel Hills (14/10/16)

Articles
Tesco removes Marmite and other Unilever brands in price row BBC News (13/10/16)
Marmite Brexit Shortage ‘Just The Beginning’ Of ‘Gorilla’ Grocery Battle As Pound Slumps Huffington Post, Louise Ridley (13/10/16)
Unilever sales increase despite dozens of its brands being removed from Tesco shelves Independent, Ben Chapman (13/10/16)
Tesco-Unilever price row: Why pound value slump has caused Marmite to disappear from shelves Independent, Zlata Rodionova (13/10/16)
Tesco pulls Marmite from online store amid Brexit price row with Unilever The Telegraph, Peter Dominiczak, Steven Swinford and Ashley Armstrong (13/10/16)
Tesco runs short on Marmite and household brands in price row with Unilever The Guardian, Sarah Butler (13/10/16)
Tesco pulls products over plunging pound Financial Times, Mark Vandevelde, Scheherazade Daneshkhu and Paul McClean (13/10/16)
Brexit means…higher prices The Economist, Buttonwood’s notebook (13/10/16)
Tesco, Unilever settle prices row after pound’s Brexit dive Reuters, James Davey and Martinne Geller (14/10/16)

Questions

  1. To what extent can Tesco and Unilever be seen a price leaders of their respective market segments?
  2. What would you advise other supermarkets to do over their pricing decisions when faced with increased prices from suppliers, and why?
  3. What would you advise manufacturers of other consumer goods sold in supermarkets to do in the light of the Tesco/Unilever dispute, and why?
  4. What determines the price elasticity of demand for branded products, such as Marmite, Persil, Dove soap, Hellmann’s mayonnaise, PG Tips tea and Wall’s ice cream?
  5. What factors will determine in the end just how much extra the consumer pays when supermarkets are faced with demands for higher prices from major suppliers?
  6. Give some other examples of firms in industries where there is a high degree of countervailing power.
  7. What are the macroeconomic implications of a depreciating exchange rate?
  8. If, over the long term, the pound remained 16% below its level in June 2016, would you expect the consumer prices index in the long term to be approximately 16% higher than it would have been if the pound had not depreciated? Explain why or why not.
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Sterling’s slide

The pound has fallen to its lowest rate against the euro since July 2013 and the lowest rate against the US dollar since 1985. Since August 2015, the pound has depreciated by 23.4% against the euro and 22.2% against the dollar. And since the referendum of 23 June, it has depreciated by 15.6% against the euro and 17.6% against the dollar.

On Sunday 2 October, at the start of the Conservative Party conference, the Prime Minister announced that Article 50, which triggers the Brexit process, would be invoked by the end of March 2017. Worries about what the terms of Brexit would look like put further pressure on the pound: the next day it fell by around 1% and the next day by a further 0.5%.

Then, on 6 October, it was reported that President Hollande was demanding tough Brexit negotiations and the pound dropped significantly further. By 7 October, it was trading at around €1.10 and $1.22. At airports, currency exchange agencies were offering less than €1 per £ (see picture).

With the government implying that Brexit might involve leaving the Single Market, the pound continued falling. On 12 October, the trade-weighted index reached its lowest level since the index was introduced in 1980: below its trough in the depth of the 2008 financial crisis and below the 1993 trough following Britain’s ejection from the European Exchange Rate Mechanism in September 1992.

So just why has the pound fallen so much, both before and after the Brexit vote? (Click here for a PowerPoint of the chart.) And what are the implications for the economy?

The articles explore the reasons for the depreciation. Central to these are the effects on the balance of payments from a possible decline in inward investment, lower interest rates leading to a net outflow of currency on the financial account, and stimulus measures, both fiscal and monetary, leading to higher imports.

Worries about the economy were occurring before the Brexit vote and this helped to push sterling down in late 2015 and early 2016, as you can see in the chart. This article from The Telegraph of 14 June 2016 explains why.

Despite the short-run effects on the UK economy of the Brexit vote not being as bad as some had predicted, worries remain about the longer-term effects. And these worries are compounded by uncertainty over the Brexit terms.

A lower sterling exchange rate reduces the foreign currency price of UK exports and increases the sterling price of imports. Depending on price elasticities of demand, this should improve the current account of the balance of payments.

These trade effects will help to boost the economy and go some way to countering the fall in investment as businesses, uncertain over the terms of Brexit, hold back on investment in the UK.

Articles
Pound Nears Three-Decade Low as May Sets Date for Brexit Trigger Bloomberg, Netty Idayu Ismail and Charlotte Ryan (3/10/16)
Sterling near 31-year low against dollar as May sets Brexit start dat Financial Times, Michael Hunter and Roger Blitz (3/10/16)
Sterling hits three-year low against the euro over Brexit worries The Guardian, Katie Allen (3/10/16)
Pound sterling value drops as Theresa May signals ‘hard Brexit’ at Tory conference Independent, Zlata Rodionova (3/10/16)
Pound falls as Theresa May indicates Brexit date BBC News (3/10/16)
The pound bombs and stocks explode over fears of a ‘hard Brexit’ Business Insider UK, Oscar Williams-Grut (3/10/16)
Pound Will Feel Pain as Brexit Clock Ticks Faster Wall Street Journal, Richard Barley (3/10/16)
British Pound to Euro Exchange Rate’s Brexit Breakdown Slows After Positive Manufacturing PMI Halts Decline Currency Watch, Joaquin Monfort (3/10/16)
7 ways the fall in the value of the pound affects us all Independent (4/10/16)
The pound and the fury: Brexit is making Britons poorer, and meaner The Economist, ‘Timekeeper’ (11/10/16)
Is the pound headed for parity v US dollar and euro? Sydney Morning Herald, Jessica Sier (5/10/16)
Flash crash sees the pound gyrate in Asian trading BBC News (7/10/16)
Flash crash hits pound after Hollande remarks Deutsche Welle (7/10/16)
Sterling mayhem gives glimpse into future Reuters, Swaha Pattanaik (7/10/16)
Sterling takes a pounding The Economist, Buttonwood (7/10/16)
Government must commit to fundamental reform The Telegraph, Andrew Sentance (7/10/16)

Data
Interest & exchange rates data – Statistical Interactive Database Bank of England

Questions

  1. Why has sterling depreciated? Use a demand and supply diagram to illustrate your argument.
  2. What has determined the size of this depreciation?
  3. What is meant by the risk premium of holding sterling?
  4. To what extent has the weaker pound contributed to the better economic performance than was expected immediately after the Brexit vote?
  5. What factors will determine the value of sterling over the coming months?
  6. Who gain and who lose from a lower exchange rate?
  7. What is likely to happen to inflation over the coming months? Explain and consider the implications for monetary and fiscal policy.
  8. What is a ‘flash crash’. Why was there a flash crash in sterling on Asian markets on 7 October 2016? Is such a flash crash in sterling likely to occur again?
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What the market will bear? Secondary markets and ticket touts

If you want a ticket for an event, such as a match or a concert, but the tickets are sold out, what do you do? Many will go to an agency operating in the ‘secondary market’. A secondary market is where items originally purchased new, such as tickets, company shares, cars or antiques, are put up for sale at a price that the market will bear.

The equilibrium price in a secondary market is where supply equals demand and the actual price will approximate to this equilibrium. In the case of tickets, this equilibrium price can be much higher than the original price sold by the venue or its agents. The reason is that the original price is below the equilibrium.

This is illustrated in the figure (click here for a PowerPoint). Assume that the total supply of tickets is Qs. Assume also that the official box office price is Pbo and that demand is given by the demand curve D. At the box office price demand exceeds supply by QdQs. There is thus a shortage, with many fans unable to obtain a ticket at the official price. Many of you will be familiar with having to be as quick as possible to get hold of tickets where demand considerably outstrips supply. Events such as Glastonbury sell out within seconds of coming on sale.

If you buy a ticket and then find out you cannot go to the event, you can sell the ticket on the secondary market through an online site or agency. Such agencies could be seen as providing a useful service as it means that otherwise empty seats will be filled. But if the equilibrium price is well above the original ticket price, there is the potential for huge gain by the agencies, who may pay the seller considerably less than the agency then sells the ticket to someone else.

What is more, the difference between the original price and the equilibrium price in the secondary market makes ticket touting, or ticket ‘scalping’, highly profitable. This is where people buy tickets with no intention of using them themselves but in order to sell them at much higher prices on the secondary market. Such ticket touting has been illegal for football matches since 1994 and was illegal for the 2012 London Olympics, but it is legal for plays, concerts, festivals and other events.

Ticket touts are often highly organised in obtaining tickets at official prices by buying early and using multiple credit cards and multiple identities to avoid systems that restrict the number of tickets issued to a card. They often use internet bots to mass purchase tickets the moment they go on sale.

Those in favour of ticket touting argue that the high price in the secondary market is just a reflection of demand and supply (see the IEA article below). Ticket touting allows tickets to be directed to people who value them most and will get the greatest benefit from it. What is more, banning ticket touting, so the argument goes, would simply drive it underground.

Those against argue on grounds of equity. Ticket prices set below the equilibrium are designed to give greater equality of access to fans. Rationing on a first-come first-served system, either on the internet or by a queue, is seen to be fairer than one by ability/willingness to pay. A poor person may be just as keen to go to an event as a rich person and gain just as much enjoyment from it, but cannot afford the high equilibrium price. What is more, non of the profit from the higher prices reaches the event organisers or the artists or players. Yet the mark-up and hence profit made by ticket touts can be massive, as the first Observer article below shows.

Various measures are being tried to prevent ticket touting. One is the use of paperless tickets, with the number of tickets limited per person and with people having to show their ticket on their phones along with ID at the door or gate. If a person cannot attend, then the solution is a system where they can give the ticket back to the box office (perhaps electronically) which will re-sell it for them at the official price.

A government-backed investigation, the Waterson review reported in May 2016 and recommended that touts should be licensed and that there should be harsher penalties for firms that flout consumer rights law as applying to ticket sales. Whether this would be sufficient to bring secondary market prices down significantly, remains to be seen. In the meantime, organisers do seem to be trying to find ways of beating the touts through smarter means of selling.

Articles
MP Nigel Adams calls for secondary ticket marketing to be reformed Music Week, James Hanley (14/9/16)
Iron Maiden go to war with ticket touts BBC News, Mark Savage (22/9/16)
The new age of the ticket tout BBC World Tonight, Andrew Hosken (25/5/16)
Government urged to help music industry tackle ticket touts The Guardian, Rob Davies (13/9/16)
Ticket touts face licensing threat The Guardian, Rupert Jones (26/5/16)
How the ticket touts get away with bleeding fans dry The Observer, Rob Davies and Rupert Jones (15/5/16)
What sorcery is this? A £140 ticket for new Harry Potter play now costs £8,327 The Observer, Rob Davies and Laurie Chen (14/8/16)
Ticket touts made $3m from the last Mumford & Sons tour. $0 went back to the music industry. Music Business Woldwide, Adam Tudhope (6/9/16)
This is tout of order – join the Daily Mirror campaign to beat rip-off ticket resales Daily Mirror, Nada Farhoud (19/9/16)
Ticket touts: A muggle’s game The Economist (20/8/16)
Can We Fight Back Against The Robot Touts Ruining Live Music? Huffington Post, Andy Webb (6/9/16)
In defence of ticket touts Institute of Economic Affairs, Steve Davies (25/2/15)

Report
Consumer protection measures applying to ticket resale: Waterson review Department for Business, Innovation & Skills and Department for Culture, Media & Sport 26/5/16)

Guide
#Toutsout MMF & FanFair Alliance September 2016

Questions

  1. Why can ticket touts sell tickets above the equilibrium price shown in the diagram?
  2. In what ways could ticket touts be said to be distorting the market?
  3. How do ticket touts reduce consumer surplus? Could they reduce it to zero?
  4. Why may allowing ticket touting to take place result in empty seats at concerts or other events?
  5. Would it be a good idea for event organisers to charge higher prices for popular events than they do at present, but still below the equilibrium
  6. How does the price elasticity of demand influence the mark-up that ticket touts can make? Illustrate this on a diagram similar to the one above.
  7. Is it in ticket touts’ interests to adjust prices as an event draws closer, just as budget airlines adjust seat prices as the plane fills up? Could organisers sell tickets in the primary market in this way with prices rising as the event fills up?
  8. Discuss the various ways in which the secondary ticket market could be reformed? To what extent do these involve reforms in the primary ticket market?
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