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Articles for the ‘Essential Economics for Business: Ch 09’ Category

Hurricanes and the social rate of discount

With first Houston, then several Caribbean islands and Florida suffering dreadful flooding and destruction from Hurricanes Harvey and Irma, many are questioning whether more should be spent on flood prevention and reducing greenhouse gas emissions. Economists would normally argue that such questions are answered by conducting a cost–benefit analysis.

However, even if the size of the costs and benefits of such policies could be measured, this would not be enough to give the answer. Whether such spending is justified would depend on the social rate of discount. But what the rate should be in cost-benefit analyses is a highly contested issue, especially when the benefits occur a long time in the future.

I you ask the question today, ‘should more have been spent on flood prevention in Houston and Miami?’, the answer would almost certainly be yes, even if the decision had to have been taken many years ago, given the time it takes to plan and construct such defences. But if you asked people, say, 15 years ago whether such expenditure should be undertaken, many would have said no, given that the protection would be provided quite a long time in the future. Also many people back then would doubt that the defences would be necessary and many would not be planning to live there indefinitely.

This is the familiar problem of people valuing costs and benefits in the future less than costs and benefits occurring today. To account for this, costs and benefits in the future are discounted by an annual rate to reduce them to a present value.

But with costs and benefits occurring a long time in the future, especially from measures to reduce carbon emissions, the present value is very sensitive to the rate of discount chosen. But choosing the rate of discount is fraught with difficulties.

Some argue that a social rate of discount should be similar to long-term market rates. But market rates reflect only the current generation’s private preferences. They do not reflect the costs and benefits to future generations. A social rate of discount that did take their interests into account would be much lower and could even be argued to be zero – or negative with a growing population.

Against this, however, has to be set the possibility that future generations will be richer than the current one and will therefore value a dollar (or any other currency) less than today’s generation.

However, it is also likely, if the trend of recent decades is to continue, that economic growth will be largely confined to the rich and that the poor will be little better off, if at all. And it is the poor who often suffer the most from natural disasters. Just look, for example, at the much higher personal devastation suffered from hurricane Irma by the poor on many Caribbean islands compared with those in comparatively wealthy Florida.

A low or zero discount rate would make many environmental projects socially profitable, even though they would not be with a higher rate. The choice of rate is thus crucial to the welfare of future generations who are likely to bear the brunt of climate change.

But just how should the social rate of discount be chosen? The following two articles explore the issue.

Articles
How Much Is the Future Worth? Slate, Will Oremus (1/9/17)
Climate changes the debate: The impact of demographics on long-term discount rates Vox, Eli P Fenichel, Matthew Kotchen and Ethan T Addicott (20/8/17)

Questions

  1. What is meant by the social rate of discount?
  2. Why does the choice of a lower rate of social discount imply a more aggressive climate policy?
  3. How is the distribution of the benefits and costs of measures to reduce carbon emissions between rich and poor relevant in choosing the social rate of discount of such measures?
  4. How is the distribution of the benefits of such measures between current and future generations relevant in choosing the rate?
  5. How is uncertainty about the magnitude of the costs and benefits relevant in choosing the rate?
  6. What is the difference between Stern’s and Nordhaus’ analyses of the choice of social discount rate?
  7. Explain and discuss the ‘mortality-based approach’ to estimating social discount rates.
  8. What are the arguments ‘for economists analysing climate change through the lens of minimising risk, rather than maximizing utility’?
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Collusion between German car makers

The car industry has featured heavily in the news in recent weeks with the announcement of plans to ban the sale of new petrol and diesel cars in the UK from 2040. Around the same time, news broke that the European Commission had commenced an investigation into potential collusive behaviour between German car makers.

Since the investigation is ongoing, it is not yet clear exactly what the firms are accused of. However, allegations first published in German magazine Der Spiegel claim that since at least the mid 1990s Volkswagen (and subsidiaries Porsche and Audi), Daimler (owner of Mercedes-Benz) and BMW met several times a year. Furthermore, it is alleged the meetings aimed to give the firms an advantage over overseas rivals by:

co-ordinating the development of their vehicles, costs, suppliers and markets for many years, at least since the Nineties, to the present day.

In particular, Der Spiegel claims that the cartel limited the size of the tanks that manufacturers install in cars to hold chemicals that reduce diesel emissions. Smaller tanks then left more room for the car’s sound system.

Limiting the size of these tanks should be seen in the context of the 2015 emissions scandal where it became clear that Volkswagen had programmed its cars to limit the use of these chemicals and cheated in emissions tests. This meant that 11 million cars worldwide produced excess emissions. Whilst other manufacturers have suggested that the cars they produced may also produce excess emissions, Volkswagen has so far been the only firm to admit to breaking the rules so explicitly. However, if the allegations in Der Spiegel turn out to be true, there will be clear evidence that the harm caused was widespread and that illegal communication between firms played a key role in facilitating this. If found guilty, substantial fines will be imposed by the European Commission and several of the firms have already announced plans to put in place measures to reduce emissions.

It is not clear how the competition authorities discovered the cartel. However, it has been suggested that incriminating documents were uncovered during a raid of Volkswagen’s offices as part of an investigation into a separate steel cartel. It seems that Volkswagen and Daimler are now cooperating with the investigation, presumably hoping to reduce the penalties they could face. It has also been reported that Daimler’s role in the investigation will have serious implications for future cooperation with BMW, including a project to develop charging sites for electric cars. It will be extremely interesting to see what the investigation uncovers and what the future ramifications for the car industry are.

Articles
European officials probe claims of huge German car cartel CNN Money, Mark Thompson (23/7/17)
Automotive corruption: German manufacturer collusion could spell bankruptcy Shout out UK, Christopher Sharp (4/8/17)
Germany’s auto industry is built on collusion Bloomberg, Leonid Bershidsky (31/7/17)
BMW reassured top staff about cartel allegations: sources Reuters, Edward Taylor (4/8/17)

Questions

  1. What are the consequences of the coordination between German car makers likely to have been for consumers? What about for rival car manufacturers?
  2. Are there circumstances in which coordination between car makers might be beneficial for society?
  3. How do you think the German car industry will be affected by these allegations going forward?
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An energy price cap – a sensible response to a market imperfection?

Following concerns about the market power of the Big Six energy suppliers in the UK and high prices for gas and electricity, the industry regulator, Ofgem, referred the industry to the Competition and Markets Authority (CMA) in June 2014. The CMA published its final report in June 2016. This argued that while there was sufficient potential for competition, consumers nevertheless needed further encouragement to switch suppliers. This would strengthen competition in the market.

To encourage switching, the CMA proposed the creation of a database that would include the details of customers who have been on a supplier’s standard variable tariff (SVT) for three or more years. Competitor energy suppliers would have access to this database to offer better deals for these customers.

There had already been calls for price caps to be imposed on suppliers. For example, in the run-up to the 2015 general election, the then Labour leader, Ed Miliband, proposed imposing a price freeze. This was criticised by the Conservatives for being too anti-market, that it would encourage energy companies to raise prices prior to the freeze and that it would be of no benefit in times of falling wholesale energy prices (which was the position in 2015).

Indeed, in its 2016 report, the CMA recommended price caps only for the 16% of people on prepayment meters and these would be variable caps not freezes. This was followed in February 2017, by Ofgem’s announcement that a temporary price cap for such customers would come into effect in April 2017. The level of the cap would vary by meter type and region. It would also be reviewed every six months to reflect changes in costs and remain in place until 2020. There would be no cap on other customers.

But in the run-up to the 2017 election, the Conservatives announced that they would, after all, introduce a price cap on SVTs – 66% of customers are on such tariffs. Before the details were announced, there was much speculation as to what form such a cap would take? It would not be a simple freeze. But there was debate as to whether caps would vary with wholesale costs or whether they would be relative to the company’s lowest tariffs or to those of its rivals.

As it turned out, the proposal was for a cap on standard variable tariffs. It would be set by Ofgem and reviewed every six months. The cap would be based on the cheapest standard variable tariffs in each part of the UK, taking into account the variable costs for transporting energy there. Ofgem will adjust the cap every six months to reflect changes in the wholesale cost of energy.

Articles before details were anniunced
U.K. Energy Industry Faults May’s Election Pledge to Cap Prices Bloomberg, Rakteem Katakey (23/4/17)
Conservatives promise to cap prices in UK energy market Financial Times, Jim Pickard and Nathalie Thomas (23/4/17)
How might an energy price cap work? BBC News, Brian Milligan (24/4/17)
UK government vows strong action to rein in energy companies The Guardian, Adam Vaughan (19/4/17)
Energy bills: what’s the difference between Tory cap and Miliband freeze? The Guardian, Adam Vaughan (23/4/17)
Capping energy prices? Still a bad idea Adam Smith Institute blogs, Sam Dumitriu (25/4/17)
Bulb becomes ‘first’ provider to cut energy prices this year Moneywise (24/4/17)
Experts slam Conservative plans to cap energy bills as ‘clumsy and counterproductive’ The Telegraph, Lauren Davidson (23/4/17)
Capping energy tariffs isn’t a one-way ticket to Venezuelan-style economic ruin Independent, Ben Chu (25/4/17)

Articles after details were anniunced
Conservatives defend plans to cap UK energy bills Financial Times, Jim Pickard and Nathalie Thomas (9/5/17)
What is the energy price cap – and what does it mean for bills? The Telegraph, Jillian Ambrose (9/5/17)
The new energy price cap con? The Telegraph, Jillian Ambrose (9/5/17)
May defends plan to cap ‘rip-off energy bills’ BBC News (9/5/17)
Q&A: The Tory plan to cap energy prices BBC News, Brian Milligan (9/5/17)
Energy prices could still go up under Theresa May’s price cap plans, admits Business Secretary Greg Clark Independent, Rob Merrick (9/5/17)
Tory claims over energy price cap are just hot air The Guardian, Nils Pratley (9/5/17)

Video and audio
UK government energy price cap ‘sheer politics’: Bernstein CNBC, Deepa Venkateswaran and Andrew Sentance (25/4/17)
Energy UK: price cap could backfire Sky News, Lawrence Slade (24/4/17)
Scottish Power: Capping prices ‘damages customers’ BBC News, Keith Anderson (24/4/17)
Tories to pledge energy bill cap BBC News, Michael Fallon (24/4/17)
Tories: Energy cap will protect vulnerable people BBC Today Programme, Business Secretary Greg Clark (9/5/17)
Energy cap: good or bad for consumers? Sky News, Stephen Fitzpatrick and James Kirkup (9/5/17)

Questions

  1. What scope is there for tacit collusion between the Big Six energy suppliers?
  2. What is meant by the RPI–X price cap? How does it differ from proposals being considered by the government?
  3. Why are people often reluctant to switch energy supplier?
  4. How could people be encouraged to switch supplier?
  5. What are the advantages and disadvantages of imposing a price cap for SVTs (a) relative to costs; (b) relative to lower-priced tariffs?
  6. Comment on Centrica’s chief executive officer Iain Conn’s statement that “price regulation will result in reduced competition and choice, and potentially impact customer service”.
  7. Comment on the statement by Lawrence Slade, chief executive officer of Energy UK, that intervention would create “huge uncertainty around government intentions, potentially putting at risk the billions in investment and jobs needed to renew our energy system”.
  8. Would an announcement of the introduction of a price cap in the near future necessarily encourage energy companies to raise their price now?
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New tools to enhance cartel detection

Price fixing agreements between firms are one of the most serious breaches of competition law. Therefore, if detected, the firms involved face substantial fines (see here for an example), plus there is also the potential for jail sentences and director disqualification for participants. However, due to their secretive nature and the need for hard evidence of communication between firms, it is difficult for competition authorities to detect cartel activity.

In order to assist detection, competition authorities offer leniency programmes that guarantee full immunity from fines to the first participant to come forward and blow the whistle on the cartel. This has become a key way in which competition authorities detect cartels. Recently, competition authorities have introduced a number of new tools to try to enhance cartel detection.

First, the European Commission launched an online tool to make it easier for cartels to be reported to them. This tool allows anonymous two-way communication in the form of text messages between a whistle blower and the Commission. The Commissioner in charge of competition policy, Margrethe Vestager, stated that:

If people are concerned by business practices that they think are wrong, they can help put things right. Inside knowledge can be a powerful tool to help the Commission uncover cartels and other anti-competitive practices. With our new tool it is possible to provide information, while maintaining anonymity. Information can contribute to the success of our investigations quickly and more efficiently to the benefit of consumers and the EU’s economy as a whole.

Second, the UK Competition and Markets Authority (CMA) has launched an online and social media campaign to raise awareness of what is illegal under competition law and to encourage illegal activity to be reported to them. The CMA stated that:

Cartels are both harmful and illegal, and the consequences of breaking the law are extremely serious. That is why we are launching this campaign – to help people understand what cartel activity looks like and how to report it so we can take action.

This campaign is on the back of the CMA’s own research which found that less that 25% of the businesses they surveyed believed that they knew competition law well. Furthermore, the CMA is now offering a reward of up to £100,000 and guaranteed anonymity to individuals who provide them with information.

It will be fascinating to see the extent to which these new tools are used and whether they aid the competition authorities in detecting and prosecuting cartel behaviour.

Articles
CMA launches crackdown on cartels as illegal activity rises The Telegraph, Bradley Gerrard (20/03/17)
European Commission launches new anonymous whistleblower tool, but who would use it? Competition Policy Blog, Andreas Stephan (21/03/17)
CMA launches campaign to crackdown on cartels Insider Media Limited, Karishma Patel (21/03/17)

Questions

  1. Why do you think leniency programmes are a key way in which competition authorities detect cartels?
  2. Who do you think is most likely to blow the whistle on a cartel (see the article above by A.Stephan)?
  3. Why is it worrying that so few businesses appear to know competition law well?
  4. Which of the two tools do you think is most likely to enhance cartel detection? Explain why.
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Secondary ticket markets: legitimate, a rip-off or downright illegal?

The UK Parliament’s Culture Media and Sport Select Committee has been examining the secondary ticketing market. The secondary market for events is dominated by four agencies – viagogo, eBay-owned StubHub and Ticket-master’s Get Me In! and Seatwave. These buy tickets to events in the primary market (i.e. from the events or their agents) and then resell them, normally at considerably inflated prices to people unable to get tickets in the primary market.

One example has grabbed the headlines recently. This is where viagogo was advertising tickets for an Ed Sheeran charity concert for £5000. The original tickets were sold for between £40 and £110, with the money going to the Teenage Cancer Trust. None of viagogo’s profits would go to the charity. The tickets were marked ‘not for resale’; so there was doubt that anyone buying a ticket from viagogo would even be able to get into the concert!

There are four major issues.

The first is that the tickets are often sold, as in the case of the Ed Sheeran concert, at many times their face value. We examined this issue back in September 2016 in the blog What the market will bear? Secondary markets and ticket touts).

The second is that the secondary sites use ‘bots’ to buy tickets in bulk when they first come on sale. This makes it much harder for customers to buy tickets on the primary site. Often all the tickets are sold within seconds of coming on sale.

The third is whether the tickets sold on the secondary market are legitimate. Some, like the Ed Sheeran tickets, are marked ‘not for resale’; some are paperless and yet the secondary ticket agencies are accused of selling paper versions, which are worthless.

The fourth is that multiple seats that are listed together are not always located together and so people attending with friends or partners may be forced to sit separately.

These are the issues that were addressed by the Culture Media and Sport committee at its meeting on 21 March. It was due to take evidence from various people, including viagogo, the agency which has come in for the most criticism. Viagogo, however, decided not to attend. This has drawn withering criticism from the press and on social media. One of the other witnesses at the meeting, Keith Kenny, sales and ticketing director for the West End musical Hamilton, described viagogo as ‘a blot on the landscape’. He said, ‘Ultimately, our terms and conditions say ticket reselling is forbidden. If you look at the way that glossy, sneaky site is constructed, they’ve gone an awful long way not to be compliant in the way they’ve built their site.’

The Competition and Markets Authority launched an enforcement investigation last December into suspected breaches of consumer protection law in the online secondary tickets market. This follows on from an earlier report for the government by an independent review chaired by Professor Waterson.

The government itself is considering amending the Digital Economy Bill to make it illegal to use bots to buy tickets in excess of the limit set by the event. Online touts who break this new law would face unlimited fines.

Articles
Touts to face unlimited fines for bulk-buying tickets online Independent, Roisin O’Connor (13/3/17)
Unlimited fines for bulk buying ticket touts BBC News (11/3/17)
Ticket touts face unlimited fines for using ‘bots’ to buy in bulk The Guardian, Rob Davies (10/3/17)
Ticket touts face unlimited fines in government crackdown on bots Music Week, James Hanley (11/3/17)
Government confirms bots ban and better enforcement in response to secondary ticketing review CMU, Chris Cooke (13/3/17)
The ‘Viagogo Glitch’: Why Fans Must Be Put First In The Secondary Ticketing Market Huffington Post, Sharon Hodgson (14/3/17)
Angry MPs accuse no-show Viagogo of ‘fraudulent mis-selling’ of Ed Sheeran tickets i News, Adam Sherwin (21/3/17)
Ed Sheeran’s manager Stuart Camp on secondary ticketing BBC News, Stuart Camp (21/3/17)
Fury at Viagogo no-show as MPs probe tickets on sale for thousands Coventry Telegraph, James Rodger (22/3/17)
Music fans given 10-step guide on how to tackle ticket touts Daily Record, Mark McGivern (20/3/17)
Viagogo snubs MPs’ inquiry into online ticket reselling The Guardian, Rob Davies (21/3/17)
Viagogo a No-Show at U.K. Hearing Into Secondary Ticketing: ‘Huge Lack of Respect’ Billboard, Richard Smirke (21/3/17)
Daily Record campaign against ticket touts reaches Parliament but Viagogo don’t show up to answer claims Daily Record, Torcuil Crichton and Keith McLeod (22/3/17)
Ticketmaster is using its software — and your data — to take on ticket-buying bots recode, Peter Kafka (14/3/17)

Official sites and documents
The Culture, Media and Sport Committee holds a further evidence session on ticket abuse. Culture, Media and Sport Commons Select Committee (20/3/17)
CMA launches enforcement investigation into online secondary ticketing Competition and Markets Authority, Press Release (19/12/16)
Independent Review of Consumer Protection Measures concerning Online Secondary Ticketing Facilities Department for Business, Innovation and Skills, Professor Michael Waterson (May 2016)
Ticket abuse: ban digital ‘harvesting’ software says Committee Culture, Media and Sport Commons Select Committee (24/11/16)

Questions

  1. Use a demand and supply diagram to demonstrate how secondary ticket agencies are able to sell tickets for popular events at prices several times the tickets’ face value.
  2. If secondary ticket sites and ticket touts are able to sell tickets at well above box office prices, isn’t this simply a reflection of people’s willingness to pay (i.e. their marginal utility)? In which case, aren’t these sellers providing a useful service?
  3. How do secondary ticket agencies reduce consumer surplus? Could they reduce it to zero?
  4. See Tickets, the primary market ticket agency, has set up a secondary site, whereby fans can trade tickets with one another at a mark-up capped at just 5%. Will this help to reduce abuses on the secondary market, or is it a totally separate part of the market?
  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 secondary ticket agencies can make? Illustrate this on a diagram similar to the one in question 1.
  7. What measures would you advocate to make tickets more available to the public at reasonable prices? Explain their benefits and any drawbacks.
  8. What would be the effect on prices if the use of bots could be successfully banned?
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Populism and economics

Economists were generally in favour of the UK remaining in the EU and highly critical of the policy proposals of Donald Trump. And yet the UK voted to leave the EU and Donald Trump was elected.

People rejected the advice of most economists. Many blamed the failure of most economists to predict the 2007/8 financial crisis and to find solutions to the growing gulf between rich and poor, with the majority stuck on low incomes.

So to what extent are economists to blame for the rise in populism – a wave that could lead to electoral upsets in various European countries? The podcast below brings together economists and politicians from across the political spectrum. It is over an hour long and provides an in-depth discussion of many of the issues and the extent to which economists can provide answers.

Podcast
Should economists share the blame for populism? Guardian Politics Weekly podcast, Heather Stewart, joined by Andrew Lilico, Ann Pettifor, Jonathan Portes, Rachel Reeves and Vince Cable (23/2/17)

Questions

  1. Why has globalisation become a dirty word?
  2. Assess the arguments for and against an open policy towards immigration?
  3. In what positive ways may economists contribute to populism?
  4. Do economists concentrate too much on growth in GDP rather than on its distribution?
  5. Give some examples of ways in which various popular interpretations of economic phenomena may confuse correlation with causality.
  6. Why did the proportions of people who voted for and against Brexit differ considerably from one part of the country to another, from one age group to another and from one social group to another?
  7. In what ways have economists and the subject of economics contributed towards a growth in human welfare?
  8. What are the advantages and disadvantages of the trend for undergraduate economics curricula to become more mathematical (at least until relatively recently)?
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The UK productivity puzzle

UK productivity growth remains well below levels recorded before the financial crisis, as Chart 1 illustrates. In fact, output per hour worked in 2016 Q3 was virtually the same as in 2007 Q4. What is more, as can be seen from Chart 2, UK productivity lags well behind its major competitors (except for Japan).

But why does UK productivity lag behind other countries and why has it grown so slowly since the financial crisis? In its July 2015 analysis, the ONS addressed this ‘productivity puzzle’.

Among the many reasons suggested are low levels of investment, the impact of the financial crisis on bank’s willingness to lend to new businesses, higher numbers of people working beyond normal retirement age as a result of population and pensions changes, and firms’ ability to retain staff because of low pay growth. While these and other factors may be relevant, they do not provide a complete explanation for the weakness in productivity.

The lack of investment in technology and lack of infrastructure investment have been key reasons for the sluggish growth in productivity. Many companies are prepared to continue using relatively labour-intensive techniques because wage growth has been so low and this reduces the incentive to invest in labour-saving technology.

Another factor has been long hours and, for many office workers, being constantly connected to their work, checking and responding to emails and messages away from the office. The Telegraph article below reports Ann Francke, chief executive of the Chartered Management Institute, as saying:

“This is having a deleterious effect on the health of managers, which has a direct impact on productivity. UK workers already have the longest hours in Europe and yet we’re less productive.”

Another problem has been ultra low interest rates, which have reduced the burden of debt for poor performing companies and has allowed them to survive. It may also have prevented finance from being reallocated to more dynamic companies which would like to develop new products and processes.

Another feature of UK productivity is the large differences between regions. This is illustrated in Chart 3. Productivity in London in 2015 (the latest full year for data) was 31.5% above the UK average, while that in Wales was 19.4% below.

This again reflects investment patterns and also the concentration of industries in particular locations. Thus London’s financial sector, a major part of London’s economy, has experienced relatively large increases in productivity and this has helped to push productivity growth in the capital well above other parts of the country.

Another factor, which again has a regional dimension, is the poor productivity performance of family-owned businesses, where ownership and management is passed down the generations within the family without bringing in external managerial expertise.

The government is very aware of the UK’s weak productivity performance. Its recently launched industrial policy is designed to address the problem. We look at that in a separate post.

Articles
UK productivity edges up but growth still flounders below pre-crisis levels The Telegraph, Julia Bradshaw (6/1/17)
Weak UK productivity spurs warnings of living standards squeeze The Guardian, Katie Allen (6/1/17)
Productivity gap yawns across the UK BBC News, Jonty Bloom (6/1/17)
The UK productivity puzzle Fund Strategy. John Redwood (26/1/17)
Productivity puzzle remains for economists despite UK growth in third quarter of 2016 City A.M., Jasper Jolly (6/1/17)

Portal site
Solve the Productivity Puzzle Unipart

Report
Productivity: no puzzle about it TUC (Feb 2015)

Data
Labour Productivity: Tables 1 to 10 and R1 ONS (6/1/17)
International comparisons of UK productivity (ICP) ONS (6/10/16)
Gross capital formation (% of GDP) The World Bank

Questions

  1. In measuring productivity, the ONS uses three indicators: output per worker, output per hour and output per job. Compare the relative usefulness of these three measures of productivity.
  2. How would you explain the marked difference in productivity between regions and cities within the UK?
  3. How do flexible labour markets impact on productivity?
  4. Why is investment as a percentage of GDP so low in the UK compared to that in most other developed countries (see)?
  5. Give some examples of industrial policy measures that could be adopted to increase productivity growth.
  6. Examine the extent to which very low interest rates and quantitative easing encourage productivity-enhancing investment.
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A bridge to somewhere

Many politicians throughout the world,
not just on the centre and left, are arguing for increased spending on infrastructure. This was one of the key proposals of Donald Trump during his election campaign. In his election manifesto he pledged to “Transform America’s crumbling infrastructure into a golden opportunity for accelerated economic growth and more rapid productivity gains”.

Increased spending on inffrastructure has both demand- and supply-side effects.

Unless matched by cuts elsewhere, such spending will increase aggregate demand and could have a high multiplier effect if most of the inputs are domestic. Also there could be accelerator effects as the projects may stimulate private investment.

On the supply side, well-targeted infrastructure spending can directly increase productivity and cut costs of logistics and communications.

The combination of the demand- and supply-side effects could increase both potential and actual output and reduce unemployment.

So, if infrastructure projects can have such beneficial effects, why are politicians often so reluctant to give them the go-ahead?

Part of the problem is one of timing. The costs occur in the short run. These include demolition, construction and disruption. The direct benefits occur in the longer term, once the project is complete. And for complex projects this may be many years hence. It is true that demand-side benefits start to occur once construction has begun, but these benefits are widely dispersed and not easy to identify directly with the project.

Then there is the problem of externalities. The external costs of projects may include environmental costs and costs to local residents. This can lead to protests, public hearings and the need for detailed cost–benefit analysis. This can delay or even prevent projects from occurring.

The external benefits are to non-users of the project, such as a new bridge or bypass reducing congestion for users of existing routes. These make the private construction of many projects unprofitable, except with public subsidies or with public–private partnerships. So there does need to be a macroeconomic policy that favours publicly-funded infrastructure projects.

One type of investment that is less disruptive and can have shorter-term benefits is maintenance investment. Maintenance expenditure can avoid much more costly rebuilding expenditure later on. But this is often the first type of expenditure to be cut when public-sector budgets as squeezed, whether at the local or national level.

The problem of lack of infrastructure investment is very much a political problem. The politicians who give the go-ahead to such projects, such as high-speed rail, come in for criticisms from those bearing the short-run costs but they are gone from office once the benefits start to occur. They get the criticism but not the praise.

Articles
Are big infrastructure projects castles in the air or bridges to nowhere? The Economist, Buttonwood’s notebook (16/1/17)
Trump’s plans to rebuild America are misguided and harmful. This is how we should do it. The Washington Post, Lawrence H. Summers (17/1/17)

Questions

  1. Identify the types of externality from (a) a new high-speed rail line, (b) new hospitals.
  2. How is discounting relevant to decisions about public-sector projects?
  3. Why are governments often unwilling to undertake (a) new infrastructure projects, (b) maintenance projects?
  4. Is a programme of infrastructure investment necessarily a Keynesian policy?
  5. What accelerator effects would you expect from infrastructure investment?
  6. Explain the difference between the ‘spill-out’ and ‘pull-in’ effects of different types of public investments in a specific location. Is it possible for a project to have both effects?
  7. What answer would you give to the teacher who asked the following question of US Treasury Secretary, Larry Summers? “The paint is chipping off the walls of this school, not off the walls at McDonald’s or the movie theatre. So why should the kids believe this society thinks their education is the most important thing?”
  8. What is the ‘bridge to nowhere’ problem? Why does it occur and what are the solutions to it?
  9. Why is the ‘castles in the air’ element of private projects during a boom an example of the fallacy of composition?
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Might changes to the format of the football World Cup facilitate tacit collusion?

Earlier this week FIFA, the world governing body of football, announced plans to expand the World Cup from 32 to 48 teams starting in 2026. It is fair to say that this has been met with mixed reactions, in part due to the politics and money involved. However, for an economist one particularly interesting question is how the change will affect the incentives of the teams taking part in the competition.

As a result of the change in the first stage of the competition, teams will be play the two other teams in their group. The best two teams in the group will then progress to the next round with the worst team going home. This is in contrast to the current format where the best two teams from a group of four go through to the next round.

Currently, in the final round of group matches all four of the teams in the group play simultaneously. However, an immediate implication of the new format is that this will no longer be the case. Instead, one of the teams will have finished their group matches before the other two teams play each other. This could have important implications for the incentives of the teams involved. To see this we can recall a very famous match played under similar circumstances between West Germany and Austria at the 1982 World Cup.

The results of the earlier group games meant that if West Germany beat Austria by one or two goals to nil both teams would progress to the next round. Any other result would mean that Algeria progressed at the expense of one of these two teams. The way in which the match played out was that West Germany scored early on and much of the rest of the game descended into farce. Both teams refused to attack or tackle their opponents, as they had no incentive to so (see here for some clips of the action, or lack of!).

There is no evidence to suggest that West Germany and Austria had come to a formal agreement to do this. Instead, the two teams appear to have simply had a mutual understanding that refraining from competing would be beneficial for both of them.

This is exactly what economists refer to as tacit collusion – a mutual understanding that refraining from competition and keeping prices high benefits all firms in the market. Much like the fans who had to sit through the farce of a game (you can hear the frustration of the crowd in the video clip linked to above), the end result is harm to consumers who have to pay the higher prices or go without the product.

For this reason governments use competition policy to try to stop situations arising in markets that make the possibility of tacit collusion more likely. One way in which this is done is by preventing mergers in markets where tacit collusion appears possible and would be facilitated by the reduction in the number of firms as a result of the merger. The equivalent for the World Cup would be preventing a change in the format of the competition.

An alternative approach is to tinker with the rules of the game in order to make collusion harder. FIFA seems to have some awareness of the possibility of doing this as it is suggesting that it may require all tied games to extra-time and then a penalty shoot-out in order to determine a winner. Clearly, this would go at least some way to alleviating concerns about tacit collusion in the final group matches because coordinating on a draw would no longer be possible. In a similar fashion, competition authorities can also intervene in markets to change the rules of the game (see for example the recent intervention in the UK cement industry).

Therefore, more generally, the World Cup example highlights the fact that variations in the structure of markets and the rules of the game can have significant effects on firms’ incentives and this can have important consequences for market outcomes. It will certainly be fascinating to see what rules are imposed for the 2026 World Cup and how the teams taking part respond.

Articles
World Cup: Fifa to expand competition to 48 teams after vote BBC News (10/1/17)
How will a 48-team World Cup work? Fifa’s plan for 2026 explained The Guardian, Paul MacInnes (10/1/17)
The Disgrace of Gijón and the 48-team FIFA World Cup Mike or the Don (12/1/17)

Questions

  1. What is the difference between tacit collusion and a cartel?
  2. Why does a reduction in the number of firms in a market make collusion easier?
  3. What other factors make collusion more likely?
  4. How does competition policy try to prevent the different forms of collusion?
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CMA imposes record fine

The Competition and Markets Authority (CMA) has imposed a record fine of £84m on the American pharmaceutical manufacturing company Pfizer and of £5.2m on its UK distributor, Flynn Pharma. The CMA found that the companies charged unfair prices to the NHS for phenytoin sodium capsules, the anti-epilepsy drug.

The price was previously regulated, but Pfizer deliberately de-branded the drug in September 2012 and immediately raised the price to Flynn Pharma by between 780% and 1600%, which, in turn, raised the price to the NHS by nearly 2600%. This made the drug many times more expensive than in any other European country.

The cost to the NHS rose from around £2m per year to around £50m in 2013. Although other generic drugs are available, there would be serious health risks to patients forced to switch drugs. The NHS thus had no alternative to paying the higher price.

Pfizer claimed that the drug was loss-making before it was de-branded. However, the CMA calculated that this did not justify the size of the price increase; that the higher price enabled Pfizer to recover all these claimed losses within just two months.

The usual practice is for pharmaceutical companies to charge high prices for new drugs for a period of time to enable them to recover high research and development costs. Later, the drugs become available as generic drugs that other manufacturers can produce. The price then normally falls dramatically.

Phenytoin sodium was invented many years ago and there has been no recent innovation and no significant investment. But, unlike with many other drugs, there has been no switching by the NHS because of possible dangers to patients. This has given Pfizer and its distributor considerable market power. As the CMA states in its press release:

Epilepsy patients who are already taking phenytoin sodium capsules should not usually be switched to other products, including another manufacturer’s version of the product, due to the risk of loss of seizure control which can have serious health consequences. As a result, the NHS had no alternative to paying the increased prices for the drug.

In conclusion, the CMA found that “both companies have held a dominant position in their respective markets for the manufacture and supply of phenytoin sodium capsules and each has abused that dominant position by charging excessive and unfair prices”.

Articles
Pfizer fined record £84.2m for overcharging NHS 2600% Independent, Zlata Rodionova (7/12/16)
Pfizer fined record £84.2m over NHS overcharging The Guardian, Angela Monaghan (7/12/16)
CMA fines drug firms £90m for over-charging NHS nhe (7/12/16)
Pfizer hit with record fine after hiking price of NHS epilepsy drug by 2,600pc – costing taxpayer millions The Telegraph (7/12/16)
Pfizer, Flynn Get Record Fine on 2,600% Drug Price Increase Bloomberg, Patrick Gower (7/12/16)

CMA publications
Phenytoin sodium capsules: suspected unfair pricing Competition and Markets Authority: Case reference: CE/9742-13, Competition and Markets Authority cases (updated 7/12/16)
CMA fines Pfizer and Flynn £90 million for drug price hike to NHS CMA Press Release (7/12/16)

Questions

  1. What are the arguments for drug companies being allowed to charge high prices for new drugs?
  2. How long should these high prices persist?
  3. Sketch a diagram to illustrate Pfizer’s price for its anti-epilepsy drug before and after it was de-branded. Illustrate the effect on Pfizer’s profits from the drug.
  4. What determines the price elasticity of demand for (a) a drug which is branded and unique; (b) a drug produced by a specific producer but which is generic and can be produced by a number of producers; (c) a generic drug produced by many producers?
  5. How should a regulator like the CMA decide what price a firm with market power should be allowed to charge?
  6. Under what legislation did the CMA fine Pfizer and Flynn Pharma? What is the upper limit to the fine it is able to impose? Did it impose the maximum fine on Pfizer?
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