Category: Economics for Business: Ch 20

In the last few years there have been growing concerns (see here for example) that markets in the USA are becoming increasingly dominated by a small number of firms. It is feared that the result of this will be a reduction in competition. Consistent with this, evidence suggests that the profits these firms make have increased. Last month The Economist and the Resolution Foundation published evidence (see references below) suggesting a similar picture may be emerging in Britain.

The Economist divided the British economy into 600 sub-sectors and found that in 58% of these the share of total revenue accruing to the 4 biggest firms had increased since 2008. The Resolution Foundation found a similar picture, especially in manufacturing industries where from 2004-16 the top five firms’ share of total revenue increased by over 10%.

Economic theory would suggest that as markets become more concentrated prices are likely to rise and The Economist cites research showing that mark-ups charged by firms in Britain have indeed risen. In addition to consumers facing higher prices, there is also concern that the lack of competition both in the USA and the UK is leading to lower wages being paid to workers. On the other hand, unlike in the USA, the evidence from the UK does not so far suggest there has also been an increase in corporate profits. Instead, it appears that the more successful firms’ profits have increased at the expense of their rivals.

This evidence on profits is line with a number of arguments that suggest we should perhaps be less concerned when markets are dominated by a small number of firms. Large firms may benefit from economies of scale and, being sufficiently large may be necessary for firms to innovate in new products and processes. Furthermore, high market shares may result from the competitive process as a reward for a firm developing a unique product or being more efficient than its rivals.

The Economist cites the supermarket industry as an example where concentrated is high, but competition is intense. Interestingly, this is a market where the British competition authorities have previously been concerned about the level of competition and spent considerable amounts of time investigating.

Despite these two opposing viewpoints, overall, The Economist argues strongly that we should be concerned about the situation in Britain. Not only are prices too high and wages too low, but growth in productivity is slow, even for the leading firms. Furthermore, they make clear that the situation may worsen following Brexit. It is argued that:

leaving the EU’s single market and customs union would reduce trade, easing competitive pressure from abroad.

This is consistent with evidence that joining the EC in the mid 1970s increased foreign competition in the UK and helped to end the low productivity growth that had plagued the economy since the 1930s.

Furthermore, it is suggested that:

to attract investment the government might look more favourably on proposed mergers—and loosening regulations would be easier outside the EU’s competition regime.

Therefore, it is clear that in the future there will be a vital role for the UK’s competition authority to remain independent of political objectives and aim to promote competition. In particular, they must prevent mergers that raise concentration and harm competition and intervene if they believe firms are abusing their dominant positions. Of course, following Brexit the case load of the competition authority in the UK will increase dramatically as they have to take on cases previously dealt with by the European Commission. One estimate is that it will need to look at around 40% more merger cases. It will certainly be interesting to see how competition in markets in Britain evolves over the next few years and the role competition policy plays in regulating this process.

Articles

Last week was a rough week for Britain. The “Beast from the East” and storm Emma swept through the country, bringing with them unusually heavy snowfall, which resulted in severe disruption across nearly all parts of the country. Some recent estimates put the cost of these extreme weather conditions at up to £1 billion per day. The construction industry suffering the biggest hit as work came to a halt for the best part of the week. Losses for the industry were estimated to be up to £2 billion.

Closed restaurants, empty shops and severely disrupted transport networks were all part of the effect that this extreme weather had on the overall economy. According to Howard Archer, chief economic adviser of the EY ITEM Club (a UK forecasting group):

It is possible that the severe weather [of the last few days] could lead to GDP growth being reduced by 0.1 percentage point in Q1 2018 and possibly 0.2 percentage points if the severe weather persist.

 

Source: Jahn (2015), Figure 2

As the occurrence of freak weather increases across the globe due to climate change, so does the economic cost of these events. The figure above shows the estimated costs of extreme weather events in the USA between 1980 and 2012 and it is reproduced from Jahn (see link below), who also fits a quadratic trend to show that these costs have been increasing over time. He goes on to characterise the impact of different types of extreme weather (including cold waves, heat waves, storms and others) on different sectors of the local economy – ranging from tourism and agriculture, to housing and the insurance sector.

Linnenluecke et al (linked below) argue that extreme weather caused by climate change could influence the decision of firms on where to locate and could lead to a reshuffle of economic activity across the world and have important policy implications. As the authors explain:

Climate change-related relocation has been given consideration in policy-oriented discussions, but not in management decisions. The effects of climate change and extreme weather events have been considered as peripheral or as a risk factor, but not as a determining factor in firm relocation processes…. This paper therefore [provides] insights for understanding how firms can enhance strategic decision-making in light of understanding and assessing their vulnerability as well as likely impacts that climate change may have on relocation decisions.

The likelihood and associated costs of extreme weather events could therefore become an increasingly important matter for discussion amongst economists and policy makers. Such weather events are likely to have profound economic implications for the world.

Academic papers

Articles

Questions

  1. Explain how extreme weather can affect the decision of firms to locate between regions.
  2. Explain how extreme weather can affect the behaviour of consumers and the level of consumer spending.
  3. “The poorest countries are often the ones that are the most vulnerable to the effects of climatic change”. Discuss.

On 15 January 2018, Carillion went into liquidation. It was a major construction, civil engineering and facilities management company in the UK and was involved in a large number of public- and private-sector projects. Many of these were as a partner in a joint venture with other companies.

It was the second largest supplier of construction and maintenance services to Network Rail, including HS2. It was also involved in the building of hospitals, including the new Royal Liverpool University Hospital and Midland Metropolitan Hospital in Smethwick. It also provided maintenance, cleaning and catering services for many schools, universities, hospitals, prisons, government departments and local authorities. In addition it was involved in many private-sector projects.

Much of the work on the projects awarded to Carillion was then outsourced to other companies, many of which are small construction, maintenance, equipment and service companies. A large number of these may themselves be forced to close as projects cease and many bills remain unpaid.

Many of the public-sector projects in which Carillion was involved were awarded under the Public Finance Initiative (PFI). Under the scheme, the government or local authority decides the service it requires, and then seeks tenders from the private sector for designing, building, financing and running projects to provide these services. The capital costs are borne by the private sector, but then, if the provision of the service is not self-financing, the public sector pays the private firm for providing it. Thus, instead of the public sector being an owner of assets and provider or services, it is merely an enabler, buying services from the private sector. The system is known as a Public Private Partnership.

Clearly, there are immediate benefits to the public finances from using private, rather than public, funds to finance a project. Later, however, there is potentially an extra burden of having to buy the services from the private provider at a price that includes an element for profit. What is hoped is that the costs to the taxpayer of these profits will be more than offset by gains in efficiency.

Critics, however, claim that PFI projects have resulted in poorer quality of provision and that cost control has often been inadequate, resulting in a higher burden for the taxpayer in the long term. What is more, many of the projects have turned out to be highly profitable, suggesting that the terms of the original contracts were too lax.

There was some modification to the PFI process in 2012 with the launching of the government’s modified PFI scheme, dubbed PF2. Most of the changes were relatively minor, but the government would act as a minority public equity co-investor in PF2 projects, with the public sector taking stakes of up to 49 per cent in individual private finance projects and appointing a director to the boards of each project. This, it was hoped, would give the government greater oversight of projects.

With the demise of Carillion, there has been considerable debate over outsourcing by the government to the private sector and of PFI in particular. Is PFI the best model for funding public-sector investment and the running of services in the public sector?

On 18 January 2018, the National Audit Office published an assessment of PFI and PF2. The report stated that there are currently 716 PFI and PF2 projects either under construction or in operation, with a total capital value of £59.4 billion. In recent years, however, ‘the government’s use of the PFI and PF2 models has slowed significantly, reducing from, on average, 55 deals each year in the five years to 2007-08 to only one in 2016-17.’

Should the government have closer oversight of private providers? The government has been criticised for not heeding profit warnings by Carillion and continuing to award it contracts.

Should the whole system of outsourcing and PFI be rethought? Should more construction and services be brought ‘in-house’ and directly provided by the public-sector organisation, or at least managed directly by it with a direct relationship with private-sector providers? The articles below consider these issues.

Articles

Carillion collapse: How can one of the Government’s biggest contractors go bust? Independent, Ben Chu (15/1/18)
The main unanswered questions raised by Carillion’s collapse The Telegraph, Jon Yeomans (15/1/18)
Carillion taskforce to help small firms hit by outsourcer’s collapse The Telegraph, Rhiannon Curry (18/1/18)
Carillion Q&A: The consequences of collapse and what the government should do next The Conversation, John Colley (17/1/18)
UK finance watchdog exposes lost PFI billions Financial Times, Henry Mance and George Parker (17/1/18)
PFI not ‘fit for purpose’, says UK provider Financial Times, Gill Plimmer and Jonathan Ford (6/11/17)
Revealed: The £200bn Cost Of ‘Wasteful’ PFI Contracts Huffington Post, George Bowden (18/1/18)
U.K. Spends $14 Billion Per Year on Carillion-Style Projects Bloomberg, Alex Morales (18/1/18)
Carillion may have gone bust, but outsourcing is a powerful public good The Guardian, John McTernan (17/1/18)
PFI deals ‘costing taxpayers billions’ BBC News (18/1/18)
Taxpayers will need to pay £200bn PFI bill, says Watchdog ITV News (18/1/18)
The PFI bosses fleeced us all. Now watch them walk away The Guardian, George Monbiot (16/1/18)
Carillion’s collapse shows that we need an urgent review of outsourcing The Guardian, David Walker (16/1/18)
Carillion collapse: What next for public services? LocalGov, Jos Creese (16/1/18)
Taxpayers to foot £200bn bill for PFI contracts – audit office The Guardian, Rajeev Syal (18/1/18)

Official publications
A new approach to public private partnerships HM Treasury (December 2012)
Private Finance Initiative and Private Finance 2 projects: 2016 summary data GOV.UK
PFI and PF2 National Audit Office (18/1/18)

Questions

  1. Why did Carillion go into liquidation? Could this have been foreseen?
  2. Identify the projects in which Carillion has been involved.
  3. What has the government proposed to deal with the problems created by Carillion’s liquidation?
  4. What are the advantages and disadvantages of the Public Finance Initiative?
  5. Why have the number and value of new PFI projects declined significantly in recent years?
  6. How might PFI projects be tightened up so as to retain the benefits and minimise the disadvantages of the system?
  7. Why have PFI cost reductions proved difficult to achieve? (See paragraphs 2.7 to 2.17 in the National Audit Office report.)
  8. How would you assess whether PFI deals represent value for money?
  9. What are the arguments for and against public-sector organisations providing services, such as cleaning and catering, directly themselves rather than outsourcing them to private-sector companies?
  10. Does outsourcing reduce risks for the public-sector organisation involved?

The linked articles below look at the state of the railways in Britain and whether renationalisation would be the best way of securing more investment, better services and lower fares.

Rail travel and rail freight involve significant positive externalities, as people and goods transported by rail reduce road congestion, accidents and traffic pollution. In a purely private rail system with no government support, these externalities would not be taken into account and there would be a socially sub-optimal use of the railways. If all government support for the railways were withdrawn, this would almost certainly result in rail closures, as was the case in the 1960s, following the publication of the Beeching Report in 1963.

Also the returns on rail investment are generally long term. Such investment may not, therefore, be attractive to private rail operators seeking shorter-term returns.

These are strong arguments for government intervention to support the railways. But there is considerable disagreement over the best means of doing so.

One option is full nationalisation. This would include both the infrastructure (track, signalling, stations, bridges, tunnels and marshalling yards) and the trains (the trains themselves – both passenger and freight – and their operation).

At present, the infrastructure (except for most stations) is owned, operated, developed and maintained by Network Rail, which is a non-departmental public company (NDPB) or ‘Quango’ (Quasi-autonomous non-governmental organisation, such as NHS trusts, the Forestry Commission or the Office for Students. It has no shareholders and reinvests its profits in the rail infrastructure. Like other NDPBs, it has an arm’s-length relationship with the government. Network Rail is answerable to the government via the Department for Transport. This part of the system, therefore, is nationalised – if the term ‘nationalised organisations’ includes NDPBs and not just full public corporations such as the BBC, the Bank of England and Post Office Ltd.

Train operating companies, however, except in Northern Ireland, are privately owned under a franchise system, with each franchise covering specific routes. Each of the 17 passenger franchises is awarded under a competitive tendering system for a specific period of time, typically seven years, but with some for longer. Some companies operate more than one franchise.

Companies awarded a profitable franchise are required to pay the government for operating it. Companies awarded a loss-making franchise are given subsidies by the government to operate it. In awarding franchises, the government looks at the level of payments the bidders are offering or the subsidies they are requiring.

But this system has come in for increasing criticism, with rising real fares, overcrowding on many trains and poor service quality. The Labour Party is committed to taking franchises into public ownership as they come up for renewal. Indeed, there is considerable public support for nationalising the train operating companies.

The main issue is which system would best address the issues of externalities, efficiency, quality of service, fares and investment. Ultimately it depends on the will of the government. Under either system the government plays a major part in determining the level of financial support, operating criteria and the level of investment. For this reason, many argue that the system of ownership is less important than the level and type of support given by the government and how it requires the railways to be run.

Articles

The case for re-nationalising Britain’s railways The Conversation, Nicole Badstuber (27/8/15)
Lessons from the Beeching cuts in reviving Britain’s railwa The Conversataion, Andrew Edwards (7/12/17)
Britain’s railways were nationalised 70 years ago – let’s not do it again The Conversation, Jonathan Cowie (1/1/18)
FactCheck Q&A: Should we nationalise the railways? Channel 4 News, Martin Williiams (18/5/17)
Britain’s railways need careful expansion, not nationalisation Financial Times, Julian Glover (5/1/18)
Right or wrong, Labour is offering a solution to the legitimacy crisis of our privatised railways Independent. Ben Chu (2/1/18)
Whether or not nationalisation is the answer, there are serious questions about the health of Britain’s railways Independent. Editorial (2/1/18)
Why Nationalising The Railways Is The Biggest Misdirect In Politics Huffington Post, Chris Whiting (5/1/18)

Questions

  1. What categories of market failure would exist in a purely private rail system with no government intervention?
  2. What types of savings could be made by nationalising train operating companies?
  3. The franchise system is one of contestable monopolies. In what ways are they contestable and what benefits does the system bring? Are there any costs from the contestable nature of the system?
  4. Is it feasible to have franchises that allow more than one train operator to run on most routes, thereby providing some degree of continuing competition?
  5. How are rail fares determined in Britain?
  6. Would nationalising the train operating companies be costly to the taxpayer? Explain.
  7. What determines the optimal length of a franchise under the current system?
  8. What role does leasing play in investment in rolling stock?
  9. What are the arguments for and against the government’s decision in November 2017 to allow the Virgin/Stagecoach partnership to pull out of the East Coast franchise three years early because it found the agreed payments to the government too onerous?
  10. Could the current system be amended in any way to meet the criticisms that it does not adequately take into account the positive externalities of rail transport and the need for substantial investment, while also encouraging excessive risk taking by bidding companies at the tendering stage?

Do you want to get drunk this festive season in the most tax efficient way: i.e. minimise the amount of tax you pay for the volume of alcohol that you drink? Do tax rates vary or are all alcoholic drinks taxed in the same or similar way?

The UK government imposes two different types of tax on alcohol. One is a specific or fixed tax per unit, referred to as excise duty or excise tax. This varies depending on the type of alcohol and is the focus of this blog. The other is VAT, which is 20% of the price for all alcoholic drinks. The price on which VAT is based includes the impact of the excise tax.

How does the implementation of excise tax differ between alcoholic drinks? Both the tax rate itself and the unit of output on which it is based vary: i.e. the volume of liquid vs the volume of pure alcohol within the liquid.

For example, with lager, beer and spirits the excise tax depends on the units of alcohol in the drink rather than the number of litres. The tax works in the following way. It is based on the alcohol by volume or ABV of the lager, beer or spirit. This is often displayed on the bottle or can. ABV is the percentage of the drink that is pure alcohol. Therefore, if a one-litre bottle of lager has an ABV of 1%, then 10ml of the bottle contains pure alcohol. Ten millilitres of pure alcohol is one unit of alcohol. If a one litre bottle of lager had an ABV of 5% it contains 5 units of alcohol.

Excise duties on spirits are the simplest of all the alcohol taxes. The rate for 2017/18 is 28.74p for each percentage of ABV or unit of alcohol in a one-litre bottle. Most spirits have an ABV of 40%. This means that there are 40 units of alcohol in a litre bottle and the excise tax payable on that bottle is £11.50 (40 × 28.74p). If a litre bottle had an ABV of 57%, such as Woods Navy Rum, then the excise tax would be or £16.38 (57 × 28.74p). Although the volume of liquid is the same in each case, the excise tax has increased by £4.88 because the alcohol content has increased.

For cider and wine the system is quite different. Within certain bands of alcoholic strength, the excise duty is based on the volume of the drink rather than by its ABV. For example, the excise tax on a litre of cider with an ABV of between 1.2% and 7.5% is 40.38p. This has the effect of reducing the tax rate per unit of alcohol as the alcoholic content of the cider increases (up to a limit of 7.5%). For example, the rate of excise tax per unit of alcohol for a litre bottle of cider with an ABV of 2% is 20.19p (40.38/2) whereas for a litre bottle of cider with an ABV of 7.5% it is just 5.39p (40.38/7.5). Wine is taxed in a similar way. A litre of wine with an ABV of between 5.5% and 15% is taxed at 288.65p per litre.

The excise tax rates per unit of alcohol for different drinks are illustrated below.

Drink
ABV  
Excise tax per
unit of alcohol
Beer/lager
5%
19.08p     
Beer/lager
8%
24.77p     
Spirits
1-100%
28.74p     
Wine
12.5%
21.90p     
Wine
15%
19.24p     
Cider
5%
8.08p     
Cider
7.5%
5.39p     

The table clearly shows that cider with an ABV of 7.5 per cent is by far the most tax effective way of consuming alcohol.

Although this blog is a rather light-hearted look at excise tax, it does help to illustrate the strange anomalies of the system used in the UK. Research by the Institute for Fiscal Studies (IFS) has indicated that heavier drinkers are more likely to switch between different alcoholic products in response to price changes. They also tend to drink products with more units of alcohol in them: i.e. spirits such as whisky and gin. For these reasons, the IFS has suggested that the excise tax rates on cider and spirits should be increased.

In the November budget, the Chancellor announced plans to introduce a new excise tax rate on still cider with an ABV of between 6.9% and 7.5%.

The excise taxes on cider and wine are based on the volume of liquid because of the European Community Directive 92/84/EEC. It will be interesting to see if the government changes this system to one based on alcohol content once the UK had left the European Union.

Articles

Budget 2017 – Why is white cider being taxed more? BBC News (22/11/17)
Is it time for a flat tax on alcohol – health campaigners can drink to that The Telegraph, Christopher Snowdon (15/2/17)
Traditional cider makers say tax on strong brands will hurt their business The Guardian, Rob Davies (22/11/17)
Minimum price would increase cost of 70% of alcohol BBC News (15/12/17)
Designing alcohol taxes IFS, Kate Smith (24/4/17) .

Questions

  1. Explain the difference between an ad valorem tax and a specific tax.
  2. Illustrate the impact of an ad valorem tax and a specific tax on a demand and supply diagram.
  3. What is the excise tax rate per unit of alcohol on a litre bottle of cider with an ABV of 6%?
  4. What is the economic rationale for imposing excise tax on alcohol?
  5. How will the external costs of consuming alcohol differ from those of smoking cigarettes? Draw a marginal external cost of consumption curve for both products to illustrate the difference.
  6. Compare the impact of increasing excise tax rates on cider and spirits with introducing a minimum unit price for alcohol.
  7. In April 2012 the government in England and Wales imposed a ban on ‘below cost’ pricing of alcohol. Explain how this policy works and what impact you think it has had.