A modern day hindrance is spam email clogging up your inbox with, for example, offers for cheap drugs or notifications that you will inherit enough money to retire to the Bahamas. A recent paper by Justin Rao and David Reiley in the Journal of Economic Perspectives investigates the economics of spam mail (which, as I discovered, from the article gets it’s name from a Monty Python sketch). Remarkably, they quote figures suggesting that 88% of worldwide email traffic is spam. Their paper then provides a number of interesting insights into the business of spam mail.
First, given that most recipients simply delete it, why is spam mail sent out? For the benefits of sending it to exceed the costs, it must be that somebody is reading and responding to it and the costs must also be reasonably low. Rao and Reiley are able to quantify these costs and benefits. They estimate that if 8.3 million spam emails are sent, only 1.8% (approximately 150,000) will reach the intended recipients’ inboxes, with the remainder being blocked or filtered out. Of these 150,000, just 0.25% (375) are clicked on. Furthermore, these 375 clicks generate just a single sale of the advertised product which is typically sold for around $50. Assuming that free entry of spammers leads to them earning zero economic profit, this means that it costs the spammers around $50 to send the 8.3 million emails.
Second, spam mail clearly imposes a considerable negative externality on society. This includes wasted time for consumers and the costs of the extra server hardware capacity required. Rao and Reiley are also able to quantify the size of the negative externality created. First, they estimate that:
“American firms and consumers experience costs of almost $20 billion annually due to spam.”
This can then be compared to the benefits senders of spam get:
“….. we estimate that spammers and spam-advertised merchants collect gross worldwide revenues on the order of $200 million per year. Thus, the ‘externality ratio’ of external costs to internal benefits for spam is around 100:1.”
They then compare this to estimates for other negative externalities such as car pollution and conclude that the size of the negative externality from spam is significantly greater.
Finally, they also point out that it is predominantly the larger email service providers i.e. Yahoo! Mail, Microsoft Hotmail, and Google Gmail who have both the incentives and resources to fund interventions to eradicate spam. For example, in 2009 Microsoft and Pfizer (the manufacturer of Viagra which faces competition from counterfeit versions often advertised by spam) financially supported the successful operation to shut down the largest spam distributor. Clearly, such operations have large positive spillovers for email users. However, as they also discuss, anti-spam technology also increases the fixed costs of competing as an email provider and they suggest that this has contributed to the increased concentration in the market.
The unpalatable business of spam The undercover economist, Tim Harford (19/07/12)
Huge spam botnet Grum is taken out by security researchers BBC News (19/07/12)
Spammers make a combined $200 million a year while costing society $20 billion BGR, Dan Graziano (28/08/12)
Questions
- Explain why free entry results in zero economic profit.
- Explain how an increase in fixed costs can lead to an increase in concentration.
- Why does Microsoft have large incentives to eradicate spam mail?
- In what ways does the externality created by spam mail differ from other forms of advertising?
- How might government policies alter the costs and benefits of sending spam mail?
Everyone who drives in the UK is required to take out car insurance. Whilst fully comprehensive is voluntary, it is compulsory to have at least third party insurance, which covers damage to other vehicles. Insurance premiums are calculated based on a number of different variables, such that two people driving the same car may face wildly different costs.
Although there are many insurance companies to choose from, this industry has been referred to the Competition Commission by the OFT as it was ‘worried the structure of the market was making costs and premiums unnecessarily high.’
According to Moneysupermarket, the average cost of car insurance reached a high of £554 in April 2011, but have fallen by £76 since. With tight incomes across the UK for many families, high car insurance premiums is another strain and thus this investigation will come at an apt time, even though the findings of the CC may not be reported for 2 years. The Association of British Insurers (ABI) said that the investigation would:
‘bring much-needed reforms to the market that will, in turn, result in lower car insurance premiums for consumers’.
The problem seems to be that when an individual is involved in an accident and sends their car off for repairs, their insurance company doesn’t have much control over the bills they end up paying, which can be inflated by £155 each time. This therefore leads into higher costs for the insurance company, which are then passed on the driver in the form of an increased premium. Other concerns were that courtesy cars were being offered, at an estimated cost of £560 per vehicle (according to the OFT) and that drivers were using these cars for longer than necessary, once again causing costs to rise.
Altogether, it has been suggested that the actions of the insurance company of ‘not-at-fault’ drivers, car hire companies, repairers and brokers push up the prices for ‘at-fault’ drivers’ insurance companies. Given that any insurance company is just as likely to be the ‘at-fault’ insurance company, they all face rising costs.
Back in May, the OFT had already decided that the car insurance market required a more detailed investigation, because of the ‘dysfunctionality’ of the market. Following a public consultation, the industry will now face an investigation by the CC. One additional area that may be of interest to the CC came to light last year, where it was found that insurance companies were claiming against themselves in a bid to drive up premiums. Although the investigation will take some time, it is still a timely review for many drivers, who have seen the cost of motoring reach record highs. The following articles consider the market for car insurance.
Articles
Car insurance market referred to Competition Commission BBC News (28/9/12)
No quick fix for motor insurance abuses, says watchdog Independent, Simon Read (29/9/12)
Car insurance industry faces probe The Press Association (28/9/12)
Competition Commission referral will take time to lower motor insurance premiums The Telegraph, Rosie Murray-West (28/9/12)
UK car insurance probe over-shadows Direct Line IPO Reuters, Matt Scuffham and Myles Neligan (28/9/12)
Car insurance scrutinized over high premiums Sky News (28/9/12)
Rip-off motor insurance firms face competition watchdogs probe over £225million racket Mail Online, Ray Massey (28/9/12)
Questions
- Why are car insurance firms willing to take on other people’s risks?
- What conditions must exist in a market for private companies to provide acr insurance (or insurance of any kind)?
- Why is third-party insurance compulsory, whereas people can opt for fully comprehensive insurance?
- What powers does (a) the OFT and (b) the Competition Commission have? Is it likely that this report will have any impact on car insurance premiums?
- What allegations have been made that help to explain why insurance premiums I this industry have increased?
- Is there an argument for allowing the industry itself to provide its own regulation?
- In which market structure would you place the car insurance industry?
A key economic principle is that rational decision making requires thinking at the margin. This involves a comparison of the additional (or marginal) benefits and costs of an activity.
An example of such rational behaviour would be deciding to drink one more beer or spending one more hour studying only if the additional benefits were greater than the additional costs. The optimum is where marginal benefit equals marginal cost.
And this applies to firms too. A firm maximises its profits by producing the output at which marginal revenue is equal to marginal cost.
However, a recent book by the American business guru Clayton Christensen argues that thinking in this way can be a problem. A recent article in the Guardian describes a story he tells of the time he refused to play for his university basketball team in a national final which took place on a Sunday and therefore conflicted with his religious beliefs. His decision involved sticking to his principles rather than thinking at the margin. For him, whilst the marginal cost of sacrificing these principles just once may well have been small compared to the resulting benefits, the eventual cost would be much higher.
Christensen also suggests that similar arguments can apply to firm decision making. The above article provides an example he uses of decisions made by executives at the Blockbuster video chain. When smaller rivals started offering movies by mail, Blockbuster instead continued to invest in its existing video store business model. This eventually proved disastrous for the company. The explanation given for this is that building on previous investments made more sense than setting up a mail-order arm which would cannibalise their existing business. On the other hand, an alternative explanation may be that executives at Blockbuster were irrationally allowing sunk costs to affect their decision making.
Articles
Clayton Christensen’s “How Will You Measure Your Life?” Harvard Business School, Clayton Christensen (9/5/12)
Clay Christensen’s life lessons BloombergBusinessweek, Bradford Wieners (3/5/12)
Bust Blockbuster goes on the block Guardian, Ben Child (4/4/11)
Questions
- Can you think of a situation where you have decided to stick to your principles rather than think at the margin?
- Why does a firm maximise profit by producing the output at which marginal revenue is equal to marginal cost?
- What do you think are the main costs of setting up a mail-order business?
- Are these costs mainly fixed or variable costs?
- Why is it irrational to take sunk costs into account when making a decision?
- Can you think of a situation where you have been influenced by sunk costs?
After weak Christmas trading, Tesco issued a profit warning – its first in 20 years. Following this, their shares fell in value by some £5bn, but this was met with an announcement of the creation of 20,000 jobs in the coming years, as part of a project to train staff, improve existing stores and open new ones. Yet, Tesco has reported another quarter of falling sales.
Trading times have been challenging and the fact that the UK’s biggest supermarket is struggling is only further evidence to support this. In the 13 weeks to the 26th May 2012, Tesco reported a decline in like-for-like sales of 1.5%. Although much of the £1bn investment in Tesco is yet to be spent, the fact that sales have fallen for a full year must be of concern, not only to its Chief Executive, but also to analysts considering the economic future for the UK.
Consumer confidence remains low and together with tight budgets, shoppers are continuing to be very cautious of any unnecessary spending. Part of Tesco’s recent drive to drum up sales has been better customer service and a continuing promotion war with the other supermarkets. This particular sector is highly competitive and money-off coupons and other such promotions plays a huge part in the competitive process. Whilst low prices are obviously crucial, this is one sector where non-price competition can be just as important.
Although Tesco sales in the UK have been nothing to shout about – the Chief Executive said their sales performance was ‘steady’ – its total global sales did increase by 2.2%. The Chief Executive, Mr Clarke said:
‘Internationally, like-for-like sales growth proved resilient, despite slowing economic growth in China…Against the backdrop of continued uncertainty in the eurozone, it is pleasing to see that our businesses have largely sustained their performance.’
A boost for UK sales did come with the Jubilee weekend and with the Olympics just round the corner, Tesco will be hoping for a stronger end to the year than their beginning. The following articles consider Tesco’s sales and the relative performance of the rest of the sector.
Tesco’s quarterly sales hit by ‘challenging’ trading BBC News (11/6/12)
Tesco UK arm notches up one year of falling sales Guardian, Zoe Wood (11/6/12)
Tesco upbeat despite new sales dip Independent, Peter Cripps (11/6/12)
Tesco sales seen lower in first quarter Reuters, James Davey(11/6/12)
The Week Ahead: Tesco set to admit it is losing ground to rivals Independent, Toby Green (11/6/12)
Tesco’s performance in the UK forecast to slip again Telegraph, Harry Wallop (10/6/12)
Tesco: What the analysts say Retail Week, Alex Lawson (11/6/12)
Supermarkets issue trading updates The Press Association (9/6/12)
The Week Ahead: Supermarkets prepare to give City food for thought Scotsman, Martin Flanagan (11/6/12)
Asda’s sales growth accelerates Reuters, James Davey (17/5/12)
Asda sales increase helped by Tesco Telegraph, Harry Wallop (18/5/12)
Tesco v. Sainsbury’s in trading update battle Manchester Evening News (11/6/12)
Sainsbury’s out-trades Tesco on UK food sales Independent, James Thompson (10/6/12)
Questions
- Using some examples, explain what is meant by non-price competition.
- Why has Tesco been losing ground to its competitors?
- Given the products that Tesco sells (largely necessities), why have sales been falling, despite household’s tight budgets?
- Into which market structure would you place the supermarket sector? Explain your answer by considering each of the assumptions behind the market structure you choose.
- Why have Tesco’s rivals been gaining ground on Tesco?
- How might this latest sales data affect Tesco’s share prices?
- Based on what the analysts are saying about the food sector, can we deduce anything about the future of the UK economy in the coming months?
With tight incomes, the first things that families tend to cut back on are the more luxury items. Extensions to houses are delayed, interior refurbishments are put off and the old car that was going to be traded in becomes something you can live with for another few years.
Car sales have been adversely affected during the recession, but data for May 2012 show a positive turn. Manufacturers have said that car sales are up by 7.9% compared with May last year. According to the Society of Motor Manufacturers and Traders (SMTT), much of the increased demand has come from private sales, where the increase has been over 14%.
This data may not be the answer to the economic troubles, but it is perhaps an indication that confidence is beginning to return. However, should things go from bad to worse in the eurozone, it isn’t hard to see data for the coming months showing the opposite trend. One other key piece of information to take from this data is the growth in the sales of lower-emissions vehicles. Sales of these were up 31.8% in May 2012 compared to the same time last year. Jonathan Visscher from SMMT said:
‘The green sector is growing fast…Every car manufacturer is going to have a hybrid model on its lists by the end of this year, even Ferrari.’
The continuing upward trend in car sales is by no means guaranteed to continue, especially with things like the expected rise in fuel duty later this year and the ongoing crisis in the eurozone, with Spanish banks potentially looking for help via a bail-out in the not too distant future. The following articles consider the acceleration in car sales.
UK sees biggest annual rise in car sales for nearly 2 years Reuters (8/6/12)
New car sales accelerate ahead Press Association (8/6/12)
UK new car sales accelerated in May, say manufacturers BBC News (8/6/12)
New car sales accelerate ahead Independent, Peter Woodman (8/6/12)
Car registrations accelerate in May Financial Times, John Reed (8/6/12)
Questions
- How would you define a luxury good? What is the relationship with income?
- How could an increase in car sales benefit the economy? How could the multiplier effect have an impact?
- Which factors have contributed towards the growth in low-emissions cars?
- Sales of low-emissions cars have significantly increased. However, why is this increase
- What are some of the key things that can help to bring a recession to an end? Into which general category would you place this increase in car sales?
- Fuel duty is expected to rise later this year. How might this affect the number of new car registrations? What does your answer tell you about the cross elasticity of demand?
