Category: Economics: Ch 06

The traditional theory of the firm assumes that firms are profit maximisers. Although, in practice, decision-makers in firms are driven by a range of motives and objectives, profit remains a key objective for most firms – if not maximising profit, at least trying to achieve profit growth so as to satisfy shareholders, retain confidence in the company and prevent the share price from falling. After all, if the company is profitable, it is easier to fund investment, either from ploughed-back profit, borrowing or new share issue. And greater investment will help to drive profits in the future.

But does the pursuit of profit and shareholder value as the number-one objective actually lead to higher profit? It could be that a prime focus on other things such as consumer satisfaction, product design and value, innovation, safety, worker involvement and the local community could lead to greater long-term profit than an aggressive policy of marketing, cost cutting and financial rejigging – three of the commonest approaches to achieving greater profits.

Boeing disasters

In 2018 and 2019 there were two fatal crashes involving the new 737 MAX-8 aircraft. On 29 October 2018, Indonesia’s Lion Air Flight 610 crashed into the Java Sea; all 189 people on board died. On 10 March 2019, Ethiopian Airlines Flight 302 similarly crashed; all 157 people on board died. Both disasters were the result of a faulty automatic manoeuvring system. The company and its CEO, Dennis Muilenburg, knew about issues with the system, but preferred to keep planes flying while they sought to fix the issue. Grounding them would have cost the company money. But taking this gamble led to two fatal crashes. This damaged the company’s reputation and cost it billions of dollars.

The US Securities and Exchange Commission (SEC) investigated the cases and found that the company had made false statements about the plane’s safety and had put ‘profits before people’. But putting profits first ended up in a huge fall in profits, with the 737 MAX grounded for 20 months.

Since the crashes there have been several other issues with various critical systems, including stabilisation, engines, flight control systems, hydraulics and wiring. In December 2023, Boeing asked airlines to inspect its 737 MAX planes for a potential loose bolt in the rudder control system.

On 5 January 2024, Alaska Airlines Flight 1282 experienced an emergency. A window panel on the 737 MAX-9 aircraft, which replaced an unused emergency exit door, blew out and the cabin depressurised. Fortunately the plane was still climbing and had reached only just under 5000m – less than half of the cruising altitude of over 11 500m. The plane rapidly descended and safely returned to Portland International Airport without loss of life. Had the incident occurred at cruising altitude, the rush of air out of the plane would have been much greater. Passengers would be less likely to be wearing their seat belts and several people could have been sucked out.

The Federal Aviation Administration (FAA) temporarily grounded 171 MAX-9s for inspections. It found that several planes had loose bolts holding the panels in place and could potentially have suffered similar blow outs.

Profits rather than safety?

Critics have claimed that the corporate culture at Boeing prioritised profit over safety. This was made worse in 2001 when company headquarters moved from Seattle to Chicago but production remained at Seattle. The culture at headquarters became sharply focused on financial success. Boeing was under intense competition from Airbus, which announced its more fuel-efficient version of the A320, the A320neo, in 2010, with launch planned for 2015. Boeing’s more fuel-efficient version of the 737, the 737 MAX, was announced in 2011, scheduled for first delivery in 2017. Since then, Boeing has been keen to get the 737 MAX to customers as quickly as possible. Also, Boeing has sought to cut manufacturing costs to keep prices competitive with Airbus.

Despite warnings from some Boeing employees that this competition was leading to corners being cut that compromised safety, Boeing management continued to push for more rapid and cheaper production to fight the competition from Airbus.

The aircraft industry is regulated in the USA by the Federal Aviation Administration (FAA). In 2020, the House Committee on Transportation and Infrastructure produced a detailed report on the industry. It found that the FAA delegated too much safety certification work to Boeing. This was a case of regulatory capture. It was also accused of sharing the goal of promoting the production of US-based Boeing in its competition with European-based Airbus.

Effects on profits

But rather than a focus on profit leading to greater profits, safety issues have led to groundings of 737s, a fall in sales and a fall in profits. The first chart shows deliveries of 737s slightly lagging A320s from 2010 to 2018. Since then deliveries of 737s have fallen well behind A320s. In terms of orders for all planes, Boeing was ahead of Airbus in 2018 (893 compared with 747). Since then, Boeing has significantly lagged behind Airbus and in 2019 and 2020 cancellations exceeded new orders. The January 2024 incident and subsequent groundings are likely to erode confidence, orders and profits even further.

As you can see from the second chart, profits fell substantially in 2019, and with COVID fell again in 2020. They have not recovered to previous levels since. Depending on how the market responds to the issue of loose panel bolts on the MAX-9, profits could well fall again in 2024. There will almost certainly be a further erosion of confidence and probably of orders.

The Boeing story is a salutary lesson in how not to achieve long-term profit. A focus on design, quality and reliability may be a better means to achieving long-term profit growth than trying to appeal to shareholders by increasing short-term profits through aggressive cost cutting and hoping that this will not affect quality.

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Questions

  1. Why is the pursuit of long-run profit likely to result in different decisions from the pursuit of short-run profit?
  2. How has Airbus’s strategy differed from that of Boeing?
  3. How would you summarise Boeing management’s attitude towards risk?
  4. Is it important to locate senior management of a company at its manufacturing base?
  5. What is regulatory capture? Is it fair to say that the FAA was captured by Boeing?
  6. Should Boeing scrap the 737 MAX and design a new narrow-body plane?

You may have recently noticed construction workers from different businesses digging up the roads/pavements near where you live. You may also have noticed them laying fibre optic cables. Why has this been happening? Does it make economic sense for different companies to dig up the same stretch of pavement and lay similar cables next to one another?

For many years the UK had one national fixed communication network that was owned by British Telecom (BT) – the traditional phone landline made from copper wire. This is now operated by OpenReach – part of the BT group but a legally separate division. In addition to this national infrastructure, Virgin Media (formed in 2007 from the merged cable operators, Telewest and NTL) has gradually built up a rival fixed broadband network that now covers just over 50 per cent of the country.

Although customers have only had very limited choice over which fixed communication network to use, they have had far greater choice over which Internet service provider (ISP) to sign up for. This has been possible as the industry regulator, Ofcom, forces OpenReach to provide rival ISPs such as Sky Broadband, TalkTalk and Zen with access to its network.

Expansion of the fibre optic network

Recent government policy has tried to encourage and incentivise the replacement of the copper wire network with one that is fully fibre. This is often referred to as Fibre to the Premises (FTTP) or Fibre to the Home (FTTH). A fixed network of fully fibre broadband enables much faster download speeds and many argue that it is vital for the future competitiveness of the UK economy.

Replacing the existing fixed communication network with fibre optic cables is expensive. It can involve major civil works: i.e. the digging up of roads and pavements to install new ducts to lay the fibre optic cables inside.

Over a hundred companies, that are not part of either OpenReach or Virgin Media O2 (the parent company of Virgin Media), have recently been digging up pavements/roads and laying new fibre optic cables. Known as alternative network providers (altnets) or independent networks, these businesses vary in size, with many of them securing large loans from banks and private investors. By the middle of 2023, 2.5 million premises in the UK had access to at least two or more of these independent networks.

After a slow initial response to the altnets, OpenReach has recently responded by rapidly installing FTTP. The business is currently building 62 000 connections every week and plans to have 25 million premises connected by the end of 2026. In July 2022, Virgin Media O2 announced that it was establishing a new joint venture with InfraVia Capital Partners. Called Nexfibre, this business aims to connect 5 million premises to FTTP by 2026.

Is the fibre optic network a natural monopoly?

Some people argue that the fixed communication network is an example of a natural monopoly – an industry where a single firm can supply the whole market at a lower average cost than two or more firms. To what extent is this true?

An industry is a natural monopoly where the minimum efficient scale of production (MES) is larger than the market demand for the good/service. This is more likely to occur where there are significant economies of scale. Digging up roads/pavements, installing new ducts and laying fibre optic cable are clear examples of fixed costs. Once the network is built, the marginal cost of supplying customers is relatively small. Therefore, this industry has significant economies of scale and a relatively large MES. This has led many people to argue that building rival fixed communication networks is wasteful duplication and will lead to higher costs and prices.

However, when judging if a sector is a natural monopoly, it is always important to remember that a comparison needs to be made between the MES and the size of the market. An industry could have significant economies of scale, but not be an example of a natural monopoly if the market demand is significantly larger than the MES.

In the case of the fixed communication network, the size of the market will vary significantly between different regions of the country. In densely populated urban areas, such as large towns and cities, the demand for services provided via these networks is likely to be relatively large. Therefore, the MES could be smaller than the size of the market, making competition between network suppliers both possible and desirable. For example, competition may incentivise firms to innovate, become more efficient and reduce costs.

Research undertaken for the government by the consultancy business, Frontier Economics, found that at least a third of UK households live in areas where competition between three or more different networks is economically desirable.

By contrast, in more sparsely populated rural areas, demand for the services provided by these networks will be smaller. The fixed costs per household of installing the network over longer distances will also be larger. Therefore, the MES is more likely to be greater than the size of the market.

The same research undertaken by Frontier Economics found that around 10 per cent of households live in areas where the fixed communication network is a natural monopoly. The demand and cost conditions for another 10 per cent of households meant it is not commercially viable to have any suppliers.

Therefore, policies towards the promotion of competition, regulation, and government support for the fixed communication network might have to be adjusted depending on the specific demand and cost conditions in a particular region.

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Questions

  1. Explain the difference between fixed and wireless communication networks.
  2. Draw a diagram to illustrate a profit-maximising natural monopoly. Outline some of the implications for allocative efficiency.
  3. Discuss some of the issues with regulating natural monopolies, paying particular attention to price regulation.
  4. The term ‘overbuild’ is often used to describe a situation where more than one fibre broadband network is being constructed in the same place. Some people argue that incumbent network suppliers deliberately choose to use this term to imply that the outcome is harmful for society. Discuss this argument.
  5. An important part of government policy in this sector has been the Duct and Pole Access Strategy (DPA). Illustrate the impact of this strategy on the average cost curve and the minimum efficient scale of production for fibre broadband networks.
  6. Draw a diagram to illustrate a region where (a) it is economically viable to have two or more fibre optic broadband network suppliers and (b) where it is commercially unviable to have any broadband network suppliers without government support.
  7. Some people argue that network competition provides strong incentives for firms to innovate, to become more efficient and reduce costs. Draw a diagram to illustrate this argument.
  8. Explain why many ‘altnets’ are so opposed to OpenReach’s new ‘Equinox 2’ pricing scheme for its fibre network.

Artificial intelligence is having a profound effect on economies and society. From production, to services, to healthcare, to pharmaceuticals; to education, to research, to data analysis; to software, to search engines; to planning, to communication, to legal services, to social media – to our everyday lives, AI is transforming the way humans interact. And that transformation is likely to accelerate. But what will be the effects on GDP, on consumption, on jobs, on the distribution of income, and human welfare in general? These are profound questions and ones that economists and other social scientists are pondering. Here we look at some of the issues and possible scenarios.

According to the Merrill/Bank of America article linked below, when asked about the potential for AI, ChatGPT replied:

AI holds immense potential to drive innovation, improve decision-making processes and tackle complex problems across various fields, positively impacting society.

But the magnitude and distribution of the effects on society and economic activity are hard to predict. Perhaps the easiest is the effect on GDP. AI can analyse and interpret data to meet economic goals. It can do this much more extensively and much quicker than using pre-AI software. This will enable higher productivity across a range of manufacturing and service industries. According to the Merrill/Bank of America article, ‘global revenue associated with AI software, hardware, service and sales will likely grow at 19% per year’. With productivity languishing in many countries as they struggle to recover from the pandemic, high inflation and high debt, this massive boost to productivity will be welcome.

But whilst AI may lead to productivity growth, its magnitude is very hard to predict. Both the ‘low-productivity future’ and the ‘high-productivity future’ described in the IMF article linked below are plausible. Productivity growth from AI may be confined to a few sectors, with many workers displaced into jobs where they are less productive. Or, the growth in productivity may affect many sectors, with ‘AI applied to a substantial share of the tasks done by most workers’.

Growing inequality?

Even if AI does massively boost the growth in world GDP, the distribution is likely to be highly uneven, both between countries and within countries. This could widen the gap between rich and poor and create a range of social tensions.

In terms of countries, the main beneficiaries will be developed countries in North America, Europe and Asia and rapidly developing countries, largely in Asia, such as China and India. Poorer developing countries’ access to the fruits of AI will be more limited and they could lose competitive advantage in a number of labour-intensive industries.

Then there is growing inequality between the companies controlling AI systems and other economic actors. Just as companies such as Microsoft, Apple, Google and Meta grew rich as computing, the Internet and social media grew and developed, so these and other companies at the forefront of AI development and supply will grow rich, along with their senior executives. The question then is how much will other companies and individuals benefit. Partly, it will depend on how much production can be adapted and developed in light of the possibilities that AI presents. Partly, it will depend on competition within the AI software market. There is, and will continue to be, a rush to develop and patent software so as to deliver and maintain monopoly profits. It is likely that only a few companies will emerge dominant – a natural oligopoly.

Then there is the likely growth of inequality between individuals. The reason is that AI will have different effects in different parts of the labour market.

The labour market

In some industries, AI will enhance labour productivity. It will be a tool that will be used by workers to improve the service they offer or the items they produce. In other cases, it will replace labour. It will not simply be a tool used by labour, but will do the job itself. Workers will be displaced and structural unemployment is likely to rise. The quicker the displacement process, the more will such unemployment rise. People may be forced to take more menial jobs in the service sector. This, in turn, will drive down the wages in such jobs and employers may find it more convenient to use gig workers than employ workers on full- or part-time contracts with holidays and other rights and benefits.

But the development of AI may also lead to the creation of other high-productivity jobs. As the Goldman Sachs article linked below states:

Jobs displaced by automation have historically been offset by the creation of new jobs, and the emergence of new occupations following technological innovations accounts for the vast majority of long-run employment growth… For example, information-technology innovations introduced new occupations such as webpage designers, software developers and digital marketing professionals. There were also follow-on effects of that job creation, as the boost to aggregate income indirectly drove demand for service sector workers in industries like healthcare, education and food services.

Nevertheless, people could still lose their jobs before being re-employed elsewhere.

The possible rise in structural unemployment raises the question of retraining provision and its funding and whether workers would be required to undertake such retraining. It also raises the question of whether there should be a universal basic income so that the additional income from AI can be spread more widely. This income would be paid in addition to any wages that people earn. But a universal basic income would require finance. How could AI be taxed? What would be the effects on incentives and investment in the AI industry? The Guardian article, linked below, explores some of these issues.

The increased GDP from AI will lead to higher levels of consumption. The resulting increase in demand for labour will go some way to offsetting the effects of workers being displaced by AI. There may be new employment opportunities in the service sector in areas such as sport and recreation, where there is an emphasis on human interaction and where, therefore, humans have an advantage over AI.

Another issue raised is whether people need to work so many hours. Is there an argument for a four-day or even three-day week? We explored these issues in a recent blog in the context of low productivity growth. The arguments become more compelling when productivity growth is high.

Other issues

AI users are not all benign. As we are beginning to see, AI opens the possibility for sophisticated crime, including cyberattacks, fraud and extortion as the technology makes the acquisition and misuse of data, and the development of malware and phishing much easier.

Another set of issues arises in education. What knowledge should students be expected to acquire? Should the focus of education continue to shift towards analytical skills and understanding away from the simple acquisition of knowledge and techniques. This has been a development in recent years and could accelerate. Then there is the question of assessment. Generative AI creates a range of possibilities for plagiarism and other forms of cheating. How should modes of assessment change to reflect this problem? Should there be a greater shift towards exams or towards project work that encourages the use of AI?

Finally, there is the issue of the sort of society we want to achieve. Work is not just about producing goods and services for us as consumers – work is an important part of life. To the extent that AI can enhance working life and take away a lot of routine and boring tasks, then society gains. To the extent, however, that it replaces work that involved judgement and human interaction, then society might lose. More might be produced, but we might be less fulfilled.

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Questions

  1. Which industries are most likely to benefit from the development of AI?
  2. Distinguish between labour-replacing and labour-augmenting technological progress in the context of AI.
  3. How could AI reduce the amount of labour per unit of output and yet result in an increase in employment?
  4. What people are most likely to (a) gain, (b) lose from the increasing use of AI?
  5. Is the distribution of income likely to become more equal or less equal with the development and adoption of AI? Explain.
  6. What policies could governments adopt to spread the gains from AI more equally?

Shipping and supply chains generally have experienced major problems in 2021. The global pandemic disrupted the flow of trade, and the bounce-back in the summer of 2021 saw supply chains stretched as staff shortages and physical capacity limits hit the transport of freight. Ships were held up at ports waiting for unloading and onward transportation. The just-in-time methods of delivery and stock holding were put under considerable strain.

The problems were compounded by the blockage of the Suez canal in March 2021. As the blog, JIT or Illegit stated “When the large container ship, the Ever Given, en route from Malaysia to Felixtowe, was wedged in the Suez canal for six days in March this year, the blockage caused shipping to be backed up. By day six, 367 container ships were waiting to transit the canal. The disruption to supply cost some £730m.”

Another major event in 2021 was the Glasgow COP26 climate conference and the growing willingness of countries to commit to decarbonising their economies. But whereas electricity can be generated from renewable sources, and factories and land transport, such as cars, vans and trains, can run on electricity, it is not so easy to decarbonise shipping, especially for long journeys. They cannot plug in to the grid or draw down from overhead cables. They have to carry their own fuel sources with them.

So, have the pandemic and the Ever Given incident exposed weaknesses in the global supply chain and in shipping in particular? And, if so, in what ways is shipping likely to adapt? And will the pressure to decarbonise lead to a radical rethinking of shipping and long-distance trade?

These are some of the issues considered in the podcast linked below. In it, “Shipping strategist Mark Williams tells Helen Lewis how examining the challenge of decarbonising shipping reveals a future which looks radically different to today, in a world where population, oil extraction and economic growth have all peaked, and trade is transformed”.

Listen to the podcast and have a go at the questions below which are based directly on it.

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Questions

  1. Why should we care about the shipping industry?
  2. What lessons can be drawn from the Ever Given incident?
  3. What structural changes are needed to make shipping an industry fit for the long-term demands of the global economy?
  4. Distinguish between just-in-time supply chains and just-in-case supply chains.
  5. What are ‘reshoring’ and ‘nearshoring’? How have they been driven by a growth in trade barriers?
  6. What are the implications of reshoring and nearshoring for (a) globalisation and (b) the UK’s trading position post-Brexit?
  7. What is the contribution of shipping to global greenhouse gas emissions? What other pollutants are emitted from the burning of heavy fuel oil (or ‘bunker fuel’)?
  8. What levers exist to persuade shipping companies to decarbonise their vessels?
  9. What alternative ‘green’ fuels are available to power ships?
  10. What are the difficulties in switching to such fuels?
  11. What economies of scale are there in shipping?
  12. How do the ownership patterns in shipping benefit decision making and change in the industry?
  13. Are ammonia or nuclear power the answer to the decarbonisation of shipping? What are their advantages and disadvantages?
  14. Why are President Xi’s views on the future of shipping so important?
  15. How will the decarbonisation of economies affect the demand for shipping?
  16. What is likely to happen to Chinese demand for iron ore and coking coal over the coming years? What effect will it have on shipping?
  17. How and by how much is the European Emissions Trading System likely to contribute to the decarbonisation of shipping?
  18. What is the Sea Cargo Charter? What difference is it likely to make to the decarbonisation of shipping?
  19. In what ways do cargo ships optimise productivity?
  20. What impact is slowing population growth, or even no population growth, likely to have on shipping?

With the bounce-back from the pandemic, many countries have experienced supply-chain problems. For example, the shortage of lorry drivers in the UK and elsewhere (see the blog Why is there a driver shortage in the UK?) has led to empty shelves, fuel shortages and rising prices. The problem has been exacerbated by a lack of stock holding. Holding minimum stocks has been part of the modern system of ‘just-in-time’ (JIT) supply-chain management.

JIT involves involves highly integrated and sophisticated supply chains. Goods are delivered to factories, warehouses and shops as they are needed – just in time. Provided firms can be sure that they will get their deliveries on time, they can hold minimum stocks. This enables them to cut down on warehousing and its associated costs. The just-in-time approach to supply-chain management was developed in the 1950s in Japan and since the 1980s has been increasingly adopted around the world, helped more recently by sophisticated ordering and tracking software.

If supply chains become unreliable, however, JIT can lead to serious disruptions. A hold-up in one part of the chain will have a ripple effect along the whole chain because there is little or no slack in the system. When the large container ship, the Ever Given, en route from Malaysia to Felixtowe, was wedged in the Suez canal for six days in March this year, the blockage caused shipping to be backed up. By day six, 367 container ships were waiting to transit the canal. The disruption to supply cost some £730m.

JIT works well when sources of supply and logistics are reliable and when demand is predictable. The pandemic is causing many logistics and warehousing managers to consider building a degree of slack into their systems. This might involve companies having alternative suppliers they can call on, building in more spare capacity and having their own fleet of lorries or warehousing facilities that can be hired out when not needed but can be relied on at times of high demand.

When the ‘bounce back’ subsides, so may the current supply chain bottlenecks. But the rethinking that has been generated by the current problems may see new patterns emerge that make supply chains more flexible without becoming more expensive.

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Questions

  1. What are the costs and benefits of a just-in-time approach to logistics?
  2. Are current supply chain problems likely to be temporary or are there issues that are likely to persist?
  3. How might the JIT approach be reformed to make it more adaptable to supply chain disruptions?