Category: Essential Economics for Business: Ch 09

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Let me Google it for you…

How would your life be without the internet? For many of you, this is a question that may be difficult to answer – as the internet has probably been an integral part of your life, probably since a very young age. We use internet infrastructure (broadband, 4G, 5G) to communicate, to shop, to educate ourselves, to keep in touch with each other, to buy and sell goods and services. We use it to seek and find new information, to learn how to cook, to download music, to watch movies. We also use the internet to make fast payments, transfer money between accounts, manage our ISA or our pension fund, set up direct debits and pay our credit-card bills.

I could spend hours writing about all the things that we do over the internet these days, and I would probably never manage to come up with a complete list. Just think about how many hours you spend online every day. Most likely, much of your waking time is spent using internet-based services one way or another (including apps on your phone, streaming on your phone, tablet or your smart TV and similar). If your access to the internet was disrupted, you would certainly feel the difference. What if you just couldn’t afford to have computer or internet access? What effect would that have on your education, your ability to find a job, and your income?

Martin Jenkins, a former homeless man, now entrepreneur, thinks that the magnitude of this effect is rather significant. In fact, he is so convinced about the importance of bringing the internet to poorer households, that he recently founded a company, Neptune, offering low-income households in the Bronx district of New York free access to online education, healthcare and finance portals. His venture was mentioned in a recent (and very interesting) BBC article – a link to which can be found at the end of this blog. But is internet connectivity really that important when it comes to economic and labour market outcomes? And is there a systematic link between economic growth and internet penetration rates?

These are all questions that have been the subject of intensive debate over the last few years, in the context of both developed and developing economies. Indeed, the ‘digital divide’ as it is known (the economic gap between the internet haves and have nots) is not something that concerns only developing countries. According to a recent policy brief published by the New York City Comptroller:

More than one-third (34 percent) of households in the Bronx lack broadband at home, compared to 30 percent in Brooklyn, 26 percent in Queens, 22 percent in Staten Island, and 21 percent in Manhattan.

The report goes on to present data on the percentage of households with internet connection at home by NYC district, and it does not take advanced econometric skills for one to notice that there is a clear link between median district income and broadband access. Wealthier districts (e.g. Manhattan Community District 1 & 2 – Battery Park City, Greenwich Village & Soho PUMA), tend to have a significantly higher share of households with broadband access, than less affluent ones (e.g. NYC-Brooklyn Community District 13 – Brighton Beach & Coney Island PUMA) – 88% of total households compared with 58%.

But, do these large variations in internet connectivity matter? The evidence is mixed. On the one hand, there are several studies that find a clear, strong link between internet penetration and economic growth. Czernich et al (2011), for instance, using data on OECD countries over the period 1996–2007, find that “a 10 percentage point increase in broadband penetration raised annual per capita growth by 0.9–1.5 percentage points”.

Another study by Koutroumpis (2018) examined the effect of rolling out broadband in the UK.

For the UK, the speed increase contributed 1.71% to GDP in total and 0.12% annually. Combining the effect of the adoption and speed changes increased UK GDP by 6.99% cumulatively and 0.49% annually on average”. (pp.10–11)

The evidence is less clear, however, when one tries to estimate the benefits between different types of workers – low and high skilled. In a recent paper, Atasoy (2013) finds that:

gaining access to broadband services in a county is associated with approximately a 1.8 percentage point increase in the employment rate, with larger effects in rural and isolated areas.

But then he adds:

most of the employment gains result from existing firms increasing the scale of their labor demand and from growth in the labor force. These results are consistent with a theoretical model in which broadband technology is complementary to skilled workers, with larger effects among college-educated workers and in industries and occupations that employ more college-educated workers.

Similarly, Forman et al (2009) analyse the effect of business use of advanced internet technology and local variation in US wage growth, over the period 1995–2000. Their findings show that:

Advanced internet technology is associated with larger wage growth in places that were already well off. These are places with highly educated and large urban populations, and concentration of IT-intensive industry. Overall, advanced internet explains over half of the difference in wage growth between these counties and all others.

How important then is internet access as a determinant of growth and economic activity and what role does it have in bridging economic disparities between communities? The answer to this question is most likely ‘very important’ – but less straightforward than one might have assumed.

Article

References

Questions

  1. Is there a link between economic growth and internet access? Discuss, using examples.
  2. Explain the arguments for and against government intervention to subsidise internet access of poorer households.
  3. How important is the internet to you and your day to day life? Take a day offline (yes, really – a whole day). Then come back and write about it.
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Laying down the rules to address climate change: the outcome of COP24

In 2015, at the COP21 climate change conference in Paris, an agreement was reached between the 195 countries present. The Paris agreement committed countries to limiting global warming to ‘well below’ 2°C and preferably to no more than 1.5°C. above pre-industrial levels. To do this, a ‘cap-and-trade’ system would be adopted, with countries agreeing to limits to their emissions and then being able to buy emissions credits to exceed these limits from countries which had managed to emit below their limits. However, to implement the agreement, countries would need to adopt a ‘rulebook’ about how the permitted limits would be applied, how governments would measure and report emissions cuts, how the figures would be verified and just how a cap-and-trade system would work.

At the COP24 meeting from 2 to 15 December 2018 in Katowice, Poland, nearly 14 000 delegates from 196 countries discussed the details of a rulebook. Despite some 2800 points of contention and some difficult and heated negotiations, agreement was finally reached. Rules for targeting, measuring and verifying emissions have been accepted. If countries exceed their limits, they must explain why and also how they will meet them in future. Rich countries agreed to provide help to poor countries in curbing their emissions and adapting to rising sea levels, droughts, floods and other climate-induced problems.

But no details have been agreed on the system of carbon trading, thanks to objections from the Brazilian delegates, who felt that insufficient account would be made of their country’s existing promises on not chopping down parts of the Amazon rainforest.

Most seriously, the measures already agreed which would be covered by the rulebook will be insufficient to meet the 2°C, let alone the 1.5°C, target. The majority of the measures are voluntary ‘nationally determined contributions’, which countries are required to submit under the Paris agreement. These, so far, would probably be sufficient to limit global warming to only around 3°C, at which level there would be massive environmental, economic and social consequences.

There was, however, a belief among delegates that further strong international action was required. Indeed, under the Paris agreement, emissions limits to keep global warming to the ‘well below 2°C’ level must be agreed by 2020.

Climate change is a case of severe market failure. A large proportion of the external costs of pollution are borne outside the countries where the emitters are based. This creates a disincentive for countries acting alone to internalise all these externalities through the tax system or charges, or to regulate them toughly. Only by countries taking an international perspective and by acting collectively can the externalities be seen as a fully internal problem.

Even though most governments recognise the nature and scale of the problem, one of the biggest problems they face is in persuading people that it is in their interests to cut carbon emissions – something that may become increasingly difficult with the rise in populism and the realisation that higher fuel and other prices will make people poorer in the short term.

Articles

Questions

  1. To what extent can the atmosphere been seen as a ‘global commons’?
  2. What incentives might be given for business to make ‘green investments’?
  3. To what extent might changes in technology help businesses and consumers to ‘go green’?
  4. Why might international negotiations over tackling climate change result in a prisoner’s dilemma problem? What steps could be taken to tackle the problem?
  5. How would an emissions cap-and-trade system work?
  6. Investigate the Brazilian objections to the proposals for emissions credits. Were the delegates justified in their objections?
  7. What types of initiative could businesses take to tackle ‘supply chain emissions’?
  8. How could countries, such as the USA, be persuaded to reduce their reliance on coal – an industry lauded by President Trump?
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PFI RIP?

One of the announcements in the recent UK Budget was the ending of the Private Finance Initiative (PFI), including its revised form, PF2. PFI was introduced by the Conservative government in 1992. Subsequently, it was to become central to the Labour government’s ‘Third-way’ approach of using the private sector to deliver public projects and services.

PFI involves a public–private partnership (PPP). The private sector builds and/or runs public projects, such as new schools, hospitals, roads, bridges, student accommodation, and so on. The public sector, in the form of government departments, NHS foundation trusts, local authorities, etc., then pays the private sector company a rent for the infrastructure or pays the company to provide services. The benefit of PFI is that it allows private-sector capital to be used for new projects and thus reduces the need for government to borrow; the disadvantage is that it commits the public-sector body to payments over the long-term to the company involved.

As the chart shows, PFI became an important means of funding public service provision during the 2000s. In the 10-year period up to financial year 2007/08, more than 50 new projects were being signed each year.

As the number of projects grew and with them the long-term financial commitments of the public sector, so criticisms mounted. These included:

  • Quality and cost. It was claimed that PFI projects were resulting in poorer quality of provision and that cost control was often poor, resulting in a higher burden for the taxpayer in the long term.
  • Credit availability. PFI projects are typically dependent on the private partner using debt finance to acquire the necessary funds. Therefore, credit conditions affect the ability of PFI to fund the delivery of public services. With the credit crunch of 2008/9, many firms operating PFI projects found it difficult to raise finance.
  • The financial health of the private partner. What happens if the private company runs into financial difficulties. In 2005, the engineering company Jarvis only just managed to avoid bankruptcy by securing refinancing on all 14 of its PFI deals.

PF2

Recognising these problems, in 2011 the government set up a review of PFI. The result was a revised form of PFI, known as ‘PF2’. PF2 projects involved tighter financial control, with the government acting as a minority co-investor; more robust tendering processes, with bidders required to develop a long-term financing solution, where bank debt does not form the majority of the financing of the project; the removal of cleaning, catering and other ‘soft services’.

Despite the government’s intention that PPPs remain an important plank of its funding of public services, the number of new PFI/PF2 projects has nonetheless declined sharply during the 2010s as the chart shows. Of the 715 PPP projects as of 31 March 2017, 631 had been signed before May 2010. Indeed, in 2016/17 only 1 new project was signed.

The collapse of Carillion

Concerns over PPPs remained despite the reforms under PF2. These were brought dramatically into focus with the collapse of Carillion plc (see the blog, Outsourcing, PFI and the demise of Carillion). Carillion was a British company focused on construction and facilities management (i.e. support services for organisations). It was a significant private-sector partner in PPP projects. By 2014 it had won 60 PPP projects in the UK and Canada, including hospitals, schools, university buildings, prisons, roads and railways.

However, Carillion had increasing burdens of debt, caused, in part, by various major acquisitions, including McAlpine in 2008. Events came to a head when, on 15 January 2018, an application was made to the High Court for a compulsory liquidation of the company.

A subsequent report for the House of Commons Public Administration and Constitutional Affairs Committee in light of the collapse of Carillion found that procurement procedures were fundamentally flawed. It found that contracts were awarded based on cost rather than quality. This meant that some contracts were not sustainable. Between 2016 and the collapse of Carillion the government had been forced to renegotiate more than £120m of contracts so that public services could continue.

The ending of PPPs?

On 18 January 2018, the National Audit Office published an assessment of PFI and PF2. The report stated that there were 716 PFI and PF2 projects at the time, 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 had slowed significantly, reducing from, on average, 55 deals each year in the five years to 2007/8 to only one in 2016/17.’

At its conference in September 2018, the Labour shadow chancellor, John McDonnell, said that, if elected, a Labour government would not award any new PFI/PF2 contracts. He claimed that PFI/PF2 contracts were set to cost the taxpayer £200bn over the coming decade. Labour policy would be to review all existing PFI/PF2 contracts and bring the bulk of them fully back into the public sector.

Then in the Budget of 29 October 2018, the Chancellor announced that no further PFI/PF2 projects would be awarded, although existing ones would continue.

I have never signed off a PFI contract as chancellor, and I can confirm today that I never will. I can announce that the government will abolish the use of PFI and PF2 for future projects.

We will honour existing contracts. But the days of the public sector being a pushover, must end. We will establish a centre of excellence to actively manage these contracts in the taxpayers’ interest, starting in the health sector.

But does this mean that there will be no more public-private partnerships, of which PFI is just one example? The answer is no. As the Chancellor stated:

And in financing public infrastructure, I remain committed to the use of public-private partnership where it delivers value for the taxpayer and genuinely transfers risk to the private sector.

But just what form future PPPs will take is unclear. Clearly, the government will want to get value for money, but that depends on the mechanisms used to ensure efficient and high-quality projects. What is more, there is still the danger that the companies involved could end up with unsustainable levels of debt if economic circumstances change and it will still involve a burden on the taxpayer for the future.

Articles

Questions

  1. Find out how PF2 differs from PFI and assess the extent to which it overcame the problems identified with PFI.
  2. The government is not bringing back existing PFI contracts into the public sector, whereas the Labour Party would do so – at least with some of them. Assess the arguments for and against bringing PFI contracts ‘in-house’.
  3. Find out why Carillion collapsed. To what extent was this due to its taking on PFI contracts?
  4. What were the main findings of the National Audit Office’s assessment of PFI and PF2?
  5. The government still supports the use of public-private partnerships (PPPs). What form could these take other than as PFI/PF2 contracts? Would the problems associated with PFI/PF2 also apply to PPPs in general?
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Nudging for better or for worse

One of the key developments in economics in recent years has been the growing influence of behavioural economics. We considered some of the insights of behavioural economics in a blog in 2016 (A nudge in the right direction?). As the post stated, ‘Behavioural economists study how people’s buying, selling and other behaviour responds to various incentives and social situations. They don’t accept the simplistic notion that people are always rational maximisers.’ The post quoted from a Livemint article (see first linked article below):

According to behavioural economists, the human brain neither has the time nor the ability to process all the information involved in decision making, as assumed by the rational model.

Instead, people use heuristics. A heuristic technique is any approach to problem-solving, such as deciding what to buy, which is practical and sufficient for the purpose, but not necessarily optimal. For example, people may resort to making the best guess, or to drawing on past experiences of similar choices that turned out to be good or bad. On other accasions, when people are likely to face similar choices in the future, they resort to trial and error. They try a product. If they like it, they buy it again; if not, they don’t.

On other occasions, they may use various rules of thumb: buying what their friends do, or buying products on offer or buying trusted brands. These rules of thumb can lead to estimates that are reasonably close to the utility people will actually get and can save on time and effort. However, they sometimes lead to systematic and predictable misjudgements about the likelihood of certain events occurring.

In traditional models of consumer choice, individuals aim to maximise their utility when choosing between goods, or bundles of goods. The context in which the choices are offered is not considered.

Yet, in real life, we see that context is important; people will often make different choices when they are presented, or framed, in different ways. For example, people will buy more of a good when it is flagged up as a special offer than they would if there is no mention of an offer, even though the price is the same.

The recognition that framing is important to choices has led to the development of nudge theory. Indeed, it underpins many marketing techniques. These seek to persuade people to make a particular choice by framing it in an optimistic way or presenting it in a way that makes it easy to decide.

Governments too use nudge theory. In the UK, the Coalition government (2010–15) established the Behavioural Insights Team (BIT) (also unofficially known as the Nudge Unit) in the Cabinet Office in 2010. A major objective of this team is to use ideas from behavioural economics to design policies that enable people to make better choices for themselves.

The podcast linked below, looks at the use of nudge theory. The presenter, Mary Ann Sieghart looks at how we are being encouraged to change our behaviour. She also looks at the work of UCL’s Love Lab which researches the way we make decisions. As the programme notes state:

Mary Ann is grilled in UCL’s Love Lab to find out how she makes decisions; she finds taking the pound signs off the menu in a restaurant encourages her spend more and adding adjectives to the food really makes it taste better.

Walking through the Nudge Unit, she hears how powerful a tiny tweak on a form or text can get be, from getting people back to work to creating a more diverse police force. Popular with the political left and right, it has been embraced around the world; from Guatemala to Rwanda, Singapore to India it is used to reduce energy consumption, encourage organ donation, combat corruption and even stop civil wars.

But the podcast also looks at some of the darker sides of nudging. Just as we can be nudged into doing things in our interests, so too we can be nudged to do things that are not so. Politicians and businesses may seek to manipulate people to get them to behave in ways that suit the government or the business, rather than the electorate or the consumer. The dark arts of persuasion are also something that behavioural economists study.

The articles below explore some of the areas where nudge theory is used to devise policy to influence our behaviour – for good or bad.

Podcast

Video

Articles

Questions

  1. Explain what are meant by ‘bounded rationality’ and ‘heuristics’.
  2. How may populist politicians use nudge theory in their campaigning?
  3. Give some examples from your own behaviour of decisions made using rules of thumb.
  4. Should we abandon models based on the assumption of rational maximising behaviour (e.g. attempts to maximise consumer surplus or to maximise profit)?
  5. Find out some other examples of how people might be nudged to behave in ways that are in their own interest or that of society.
  6. How might we be nudged into using less plastic?
  7. How might people be nudged to eat more healthily or to give up smoking?
  8. To what extent can financial incentives, such as taxes, fines, grants or subsidies be regarded as nudging? Explain.
  9. Would you advise all GP surgeries and hospital outpatient departments to text reminders to people about appointments? What should such reminders say? Explain.
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Time to address global warming

In December 2015, countries from around the world met in Paris at the United Nations Intergovernmental Panel on Climate Change (IPCC). The key element of the resulting Paris Agreement was to keep ‘global temperature rise this century well below 2 degrees Celsius above pre-industrial levels and to pursue efforts to limit the temperature increase even further to 1.5 degrees Celsius.’ At the same time it was agreed that the IPCC would conduct an analysis of what would need to be done to limit global warming to 1.5°C. The IPPC has just published its report.

The report, based on more than 6000 scientific studies, has been compiled by more than 80 of the world’s top climate scientists. It states that, with no additional action to mitigate climate change beyond that committed in the Paris Agreement, global temperatures are likely to rise to the 1.5°C point somewhere between 2030 and 2040 and then continue rising above that, reaching 3°C by the end of the century.

According to the report, the effects we are already seeing will accelerate. Sea levels will rise as land ice caps and glaciers melt, threatening low lying coastal areas; droughts and floods will become more severe; hurricanes and cyclones will become stronger; the habits of many animals will become degraded and species will become extinct; more coral reefs will die and fish species disappear; more land will become uninhabitable; more displacement and migration will take place, leading to political tensions and worse.

Two tragedies



 
The problem of greenhouse gas emissions and global warming is a classic case of the tragedy of the commons. This is where people overuse common resources, such as open grazing land, fishing grounds, or, in this case, the atmosphere as a dump for emissions. They do so because there is little, if any, direct short-term cost to themselves. Instead, the bulk of the cost is borne by others – especially in the future.

There is another related tragedy, which has been dubbed the ‘tragedy of incumbents’. This is a political problem where people in power want to retain that power and do so by appealing to short-term selfish interests. The Trump administration lauds the use of energy as helping to drive the US economy and make people better off. To paraphrase Donald Trump ‘Climate change may be happening, but, hey, let’s not beat ourselves up about it and wear hair shirts. What we do will have little or no effect compared with what’s happening in China and India. The USA is much better off with a strong automobile, oil and power sector.’

What’s to be done?

According to the IPCC report, if warming is not to exceed 1.5℃, greenhouse gas emissions must be reduced by 45% by 2030 and by 100% by around 2050. But is this achievable?

The commitments made in the Paris Agreement will not be nearly enough to achieve these reductions. There needs to be a massive movement away from fossil fuels, with between 70% and 85% of global electricity production being from renewables by 2050. There needs to be huge investment in green technology for power generation, transport and industrial production.

In addition, the report recommends investing in atmospheric carbon extraction technologies. Other policies to reduce carbon include massive reforestation.

Both these types of policies involve governments taking action, whether through increased carbon taxes on either producers or consumer or both, or through increased subsidies for renewables and other alternatives, or through the use of cap and trade with emissions allocations (either given by government or sold at auction) and carbon trading, or through the use of regulation to prohibit or limit behaviour that leads to emissions. The issue, of course, is whether governments have the will to do anything. Some governments do, but with the election of populist leaders, such as President Trump in the USA, and probably Jair Bolsonaro in Brazil, and with sceptical governments in other countries, such as Australia, this puts even more onus on other governments.

Another avenue is a change in people’s attitudes, which may be influenced by education, governments, pressure groups, news media, etc. For example, if people could be persuaded to eat less meat, drive less (for example, by taking public transport, walking, cycling, car sharing or living nearer to their work), go on fewer holidays, heat their houses less, move to smaller homes, install better insulation, etc., these would all reduce greenhouse gas emissions.

Finally, there is the hope that the market may provide part of the solution. The cost of generating electricity from renewables is coming down and is becoming increasingly competitive with electricity generated from fossil fuels. Electric cars are coming down in price as battery technology develops; also, battery capacity is increasing and recharging is becoming quicker, helping encourage the switch from petrol and diesel cars to electric and hybrid cars. At the same time, various industrial processes are becoming more fuel efficient. But these developments, although helpful, will not be enough to achieve the 1.5°C target on their own.

Videos and audio

Articles

Report

Questions

  1. Explain the extent to which the problem of global warming is an example of the tragedy of the commons. What other examples are there of the tragedy?
  2. Explain the meaning of the tragedy of the incumbents and its impact on climate change? Does the length of the electoral cycle exacerbate the problem?
  3. With the costs of low or zero carbon technology for energy and transport coming down, is there as case for doing nothing in response to the problem of global warming?
  4. Examine the case for and against using taxes and subsidies to tackle global warming.
  5. Examine the case for and against using regulation to tackle global warming.
  6. Examine the case for and against using cap-and-trade systems to tackle global warming.
  7. Is there a prisoners’ dilemma problem in getting governments to adopt policies to tackle climate change?
  8. What would be the motivation for individuals to ‘do their bit’ to tackle climate change? Other than altering prices or using regulation, how might the government or other agencies set about persuading people to ‘be more green’?
  9. If you were doing a cost–benefit analysis of some project that will have beneficial environmental impacts in the future, how would you set about adjusting the values of these benefits for the fact that they occur in the future and not now?