Category: Economics 10e: Ch 06

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?

The articles below examine the rise of the sharing economy and how technology might allow it to develop. A sharing economy is where owners of property, equipment, vehicles, tools, etc. rent them out for periods of time, perhaps very short periods. The point about such a system is that the renter deals directly with the property owner – although sometimes initially through an agency. Airbnb and Uber are two examples.

So far the sharing economy has not developed very far. But the development of smart technology will soon make a whole range of short-term renting contracts possible. It will allow the contracts to be enforced without the need for administrators, lawyers, accountants, bankers or the police. Payments will be made electronically and automatically, and penalties, too, could be applied automatically for not abiding by the contract.

One development that will aid this process is a secure electronic way of keeping records and processing payments without the need for a central authority, such as a government, a bank or a company. It involves the use of ‘blockchains‘ (see also). The technology, used in Bitcoin, involves storing data widely across networks, which allows the data to be shared. The data are secure and access is via individuals having a ‘private key’ to parts of the database relevant to them. The database builds in blocks, where each block records a set of transactions. The blocks build over time and are linked to each other in a logical order (i.e. in ‘chains’) to allow tracking back to previous blocks.

Blockchain technology could help the sharing economy to grow substantially. It could significantly cut down the cost of sharing information about possible rental opportunities and demands, and allow minimal-cost secure transactions between owner and renter. As the IBM developerWorks article states:

Rather than use Uber, Airbnb or eBay to connect with other people, blockchain services allow individuals to connect, share, and transact directly, ushering in the real sharing economy. Blockchain is the platform that enables real peer-to-peer transactions and a true ‘sharing economy’.

Article

New technology may soon resurrect the sharing economy in a very radical form The Guardian, Ben Tarnoff (17/10/16)
Blockchain and the sharing economy 2.0 IBM developerWorks, Lawrence Lundy (12/5/16)
2016 is set to become the most interesting year yet in the life story of the sharing economy Nesta, Helen Goulden (Dec 2015)
Blockchain Explained Business Insider, Tina Wadhwa and Dan Bobkoff (16/10/16)
A parliament without a parliamentarian Interfluidity, Steve Randy Waldman (19/6/16)
Blockchain and open innovation: What does the future hold Tech City News, Jamie QIU (17/10/16)
Banks will not adopt blockchain fast Financial Times, Oliver Bussmann (14/10/16)
Blockchain-based IoT project does drone deliveries using Ethereum International Business Times, Ian Allison (14/10/16)

Questions

  1. What do you understand by the ‘sharing economy’?
  2. Give some current examples of the sharing economy? What other goods or services might be suitable for sharing if the technology allowed?
  3. How could blockchain technology be used to cut out the co-ordinating role carried out by companies such as Uber, eBay and Airbnb and make their respective services a pure sharing economy?
  4. Where could blockchain technology be used other than in the sharing economy?
  5. How can blockchain technology not only record property rights but also enforce them?
  6. What are the implications of blockchain technology for employment and unemployment? Explain.
  7. How might attitudes towards using the sharing economy develop over time and why?
  8. Referring to the first article above, what do you think of Toyota’s use of blockchain to punish people who fall behind on their car payments? Explain your thinking.
  9. Would the use of blockchain technology in the sharing economy make markets more competitive? Could it make them perfectly competitive? Explain.

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.

Concerns have been expressed about the UK’s relatively poor record of upgrading broadband services so that households can receive ultrafast connectivity. Some commenters have argued that future economic growth prospects will be harmed if the UK continues to lag behind its leading rivals.

Much of the fixed line system that allows people to connect to broadband was originally installed many years ago for the land-line telephone network. The so called ‘final mile’ consists of copper-based wiring that is carried from street cabinets to the premises of the end-user. This wiring is transported via a huge network of telegraph poles and cable ducts (small underground tunnels).

In order for people to gain connectivity to ultrafast broadband this copper based wiring needs to be replaced by fibre optic cables. This is commonly referred to as Fibre to the Premises (FTTP). Unfortunately, the UK has a relatively poor record of installing FTTP. Japan and Korea were forecast to have 70% and 63% coverage by the end of 2015 as opposed to just 2% in the UK.

Why is the UK’s record so poor? Many observers blame it on the structure of the industry. In other network industries, such as those for gas pipeline and electricity grids, the business responsible for managing the infrastructure, National Grid, is a regulated monopoly. This company does not directly supply services to consumers using the network it is responsible for maintaining. Instead, customers are supplied by the retail sector of the industry, where firms compete for their business. This sector includes the so-called ‘big six’ (British Gas; npower; SSE; Scottish Power; EDF; E.On) and a number of smaller suppliers such as Ovo Energy and Ebico.

The structure of the fixed line telecommunications sector is very different. The company that manages the ‘final mile’, Openreach, is a subsidiary of BT. BT also competes with other Internet Service Providers (ISPs), such as TalkTalk and Sky, to supply broadband to customers using this network. Its market share of 32 per cent makes it the largest player in the broadband market. Sky and TalkTalk have market shares of 22 per cent and 14 per cent respectively. Virgin Media also supplies 20 per cent of this market using its own network of ducts and cables.

Given that in most cases ISPs such as Sky and TalkTalk are stuck with the network Openreach provides, BT may have limited incentives to invest. It can still earn a good return from its infrastructure of copper-based wiring and avoid installing expensive FTTP. Dido Harding, the chief executive of TalkTalk, argued that:

“We need to separate Openreach from the rest of BT to create a more competitive, pro-investment market”

Ofcom, in its recent review of the market, has taken a different approach. Rather than creating an entirely separate monopoly business to manage the network (i.e. splitting Openreach from BT), the regulator instead opted for a policy of encouraging competition between different suppliers that deploy fibre optic cables. It states in the report that:

“We believe competition between different networks is the best way to drive investment in high-quality, innovative services for customers.”

This competition could come from ISPs such as TalkTalk and Sky or other smaller network providers such as CityFibre and Gigaclear.

One major problem with this approach is that potential new entrants might be deterred from entering the market because of the very high initial costs involved in building a new network in order to deploy FTTP. In particular, the costs of digging up the roads and laying the ducts are considerable. Matt Yardley, author of a study on the industry, said:

“It is widely accepted that civil works such as digging trenches account for up to 80% of broadband deployment costs.”

One way of reducing these costs and encouraging more competition is to allow rival firms access to the existing ducts and poles that are currently managed by Openreach. Once access has been obtained, these firms could effectively rent space inside the ducts and lay fibre optic cables alongside the existing copper-based wiring. Vodafone reported that a similar policy in Spain had reduced its capital expenditure of building FTTP by 40 per cent compared with constructing its own network of ducts and poles.

Ofcom first introduced this type of policy in 2010 when it launched its Physical Infrastructure Access (PIA) initiative. Unfortunately it has proved to be relatively unsuccessful with very little demand for PIA from rival firms. The success of this type of policy will depend on a number of factors including (1) the prices charged by Openreach to access and rent space inside the ducts; (2) the simplicity of any relevant administration; and (3) the availability and reliability of information about the ducts. With this last point, key issues include:

Where they are located .
How much space is available: i.e. is there enough space for firms to lay fibre optic cables alongside the existing wiring?
What condition they are in: i.e. are they flooded or clogged up with sand and mud, which will involve expensive work to make them usable again?

Firms did complain about the pricing structures and bureaucratic nature of the administration process under the PIA scheme. However, their most significant concerns were about the uncertainty that was created by the lack of information about the ducts and poles. For example, analysts from the consultancy firm, Reburn, argued that if a firm contacted Openreach to try to obtain access to the network it was informed that:

“We don’t know what condition the ducts and poles are in. Please pay £10 000 for a survey. Also unfortunately we are rather busy and we can only start in six weeks.”

Matthew Hare, the chief executive of Gigaclear, argued that it was like going to a shop where the assistant says:

“Give me some money, and I’ll tell you whether you can have it or not.”

In response to these criticisms Ofcom has introduced a number of changes to PIA, which has been re-named Duct and Pole Access (DPA). In particular, it has imposed a new requirement on Openreach to create a database that provides information on the location, condition and capacity of its ducts and poles. The database must be made available to rival ISPs and network providers. DPA must also be provided on the same timescales, terms and conditions to all businesses including other parts of BT – this is referred to as ‘equivalence of inputs’.

The first big test of this policy is in Southend where City Fibre is hoping to deploy 50km of fibre optic cables using DPA. However, reports in the media have suggested that the initial surveys have found very limited capacity in some of the ducts, which would make DPA impossible.

It will be interesting to see how the trial in Southend progresses. If it is successful, then DPA may be viable for about 40 per cent of premises in the UK. If it fails, then Ofcom might ultimately have to force Openreach to be completely separated from BT.

Articles

How the gothic city of York became a broadband battleground The Telegraph, Kate Palmer (22/5/16)
City Fibre first to mount BT challenge after Openreach is told to share network The Telegraph, Kate Palmer (1/3/16)
Challenges as CityFibre Moot Using BT Cable Ducts in Southend-on-Sea ISPreview, Mark Jackson (2/5/16)
CityFibre to build pure fibre infrastructure for Southend Networking (5/4/16)
Ofcom tells BT to open up infrastructure to rivals The Guardian, Rob Davies (26/2/16)

Questions

  1. Draw an average total cost curve to illustrate the economics of building a network of ducts and poles. Label the minimum efficient scale.
  2. To what extent does DPA create a contestable market?
  3. For DPA to deliver productive efficiency, what must be true about the economies of scale of laying fibre optic cables?
  4. In the run-up to Ofcom’s review of the telecoms industry, many commentators described Openreach as being a natural monopoly. To what extent do you agree with this argument?
  5. What are the advantages of marginal cost pricing? What issues might a regulator face if it tried to impose marginal cost pricing on a natural monopoly?
  6. Using a diagram, explain how the network of ducts and poles might be a natural monopoly in rural areas but not in densely populated urban areas.
  7. Discuss how Ofcom has tried to increase the level of separation between Openreach and BT.

According to the BBC’s Joe Lynam, “Britain has the most competitive and dynamic retail environment in the world, which attracts shoppers globally.” It is perhaps this fact which may save BHS, with new owners being attracted by such an opportunity. BHS is soon expected to file for administration, with debts of more than £1.3 billion and having failed to secure the loan needed to keep it afloat. If this company collapses, it will bring an end to the life of an 88 year old giant.

The British retail scene has certainly changed over the past decade, with names such as Woolworths and Comet disappearing – could BHS be the next casualty of the changing retail climate? In the world of retail, tastes change quickly and those stores who fail to change with the times are the ones that suffer. One of the factors behind the downfall of BHS is the ‘dated’ nature of its stores and fashions. As clothing outlets such as Zara, Oasis and Next have continued to change with the times, commentators suggest that BHS continues with a trading offer from the 1980s. With the online shopping trend, many household names adapted their strategy, but BHS failed to do so and the second chance that BHS asked the public for when Sir Philip Green, its former owner, sold BHS in 2015 hasn’t materialised.

With administrators ready to be brought in and thousands of jobs hanging in the balance, the administrators will be looking at methods to attract funding, new owners or so-called ‘cherry pickers’ who may be interested in buying up the more profitable stores. Some of their stores remain in prime locations and deliver a tidy profit and it is perhaps these gems, together with the tradition that British Home Stores brings that may yet see the company saved. The outcome for BHS will not only affect the jobs of its employees, but will affect the pensions of thousands of workers. The BHS pension fund currently has a deficit of £576 million and so the Pension Protection Fund will have to look closely at the situation before thinking about issues a contribution notice to those connected with the fund.

A deal was on the cards last week, with BHS owner Dominic Chappell in talks with Mike Ashley’s Sports Direct, but the high debts and pensions deficit appears to have deterred this deal. The failing fortunes of BHS have now come back to haunt former owner, Sir Philip Green, who in March 2015, sold the business for just £1. Sir Philip may return to save the day, but the options for this once giant of the British high street are rather limited. The following articles consider the fortunes of BHS.

BHS seeks Sports Direct lifeline as it heads for collapse The Guardian, Graham Ruddick (24/04/16)
BHS expected to file for administration on Monday BBC News (25/04/16)
Thousands of BHS workers face anxious wait amid administration fears The Telegraph (25/04/16)
BHS administration: ‘Imminent bankruptcy’ puts 11,000 jobs at risk Independent, Peter Yeung (25/04/16)
Up to 11,000 jobs face the axe as BHS is expected to announce collapse of chain after efforts to find rescuer failed Mail Online, Neil Craven (24/04/16)
BHS nears collapse putting 11,000 jobs at risk Sky News (25/04/16)
BHS set to file for administration after sales talks fail Financial Times, Murad Ahmed (25/04/16)

Questions

  1. Using a demand and supply diagram, can you explain some of the factors that have contributed to the difficult position that BHS finds itself in?
  2. Now, can you use a diagram showing revenues and profits and explain the current position of BHS?
  3. What type of market structure does BHS operate in? Can this be used to explain why it is in its current position?
  4. How has the company failed in adapting its business strategy to the changing times?
  5. Looking back at the history of BHS, can you apply the product life cycle to this store?
  6. If another company is considering purchasing BHS, or at least some of its stores, what key information will it need and what might make it likely to go ahead with such a purchase?