Category: Essential Economics for Business: Ch 09

20 July 201320 July 2013

The London Olympics legacy: a cost–benefit analysis

Did the benefits of the London Olympics outweigh the costs? The government’s UK Trade and Industry (part of the Department of Business, Innovation & Skills) has just published a report, London 2012, Delivering the economic legacy, which itemises the economic benefits of the games one year on. It claims that benefits to date are some £9.9 billion.

This compares with costs, estimated to be somewhere between £8.9 billion and £9.3 billion, although this figure does not include certain other costs, such as maintenance of the stadium. Nevertheless, according to the figures, even after just a year, it would seem that the Games had ‘made a profit’ – just.

The £9.9 billion of benefits consist of £5.9 billion of additional sales, £2.5 billion of additional inward investment and £1.5 billion of Olympic-related high value opportunities won overseas. Most of these can be seen as monetary external benefits: in other words, monetary benefits arising from spin-offs from the Games. The ‘internal’ monetary benefits would be largely the revenues from the ticket sales.

In a separate report for the Department of Culture, Media & Sport, Report 5: Post-Games Evaluation, it has been estimated that the total net benefits (net gross value added (GVA)) from 2004 to 2020 will be between £28 billion and £41 billion.

But benefits are not confined just to internal and external monetary benefits: there are also other externalities that are non-monetary. The Culture, Media & Sport report identified a number of these non-monetary externalities. The Summary Report itemises them. They include:

• The health and social benefits of more people participating in sport
• Inspiring a generation of children and young people
• A catalyst for improved elite sporting performance in the UK
• Setting new standards for sustainability
• Improved attitudes to disability and new opportunities for disabled people to participate in society
• Greater social cohesion as communities across the UK engaged with the Games
• Increased enthusiasm for volunteering
• Accelerated physical transformation of East London
• Beneficial socio-economic change in East London
• Important lessons learned for the co-ordination and delivery of other large-scale public and public/private projects

But with any cost–benefit analysis there are important caveats in interpreting the figures. First there may be monetary and non-monetary external costs. For example, will all the effects on social attitudes be positive? Might greater competitiveness in sport generate less tolerance towards non sporty people? Might people expect disabled people to do more than they are able (see)? Second, the costs generally precede the benefits. This then raises the question of what is the appropriate discount rate to reduce future benefits to a present value.

Perhaps the most serious question is that of the quantification of benefits. It is important that only benefits that can be attributed to the Games are counted and not benefits that would have occurred anyway, even if connected to the Games. For example, it is claimed in the UK Trade & Industry report that much of the Olympic park and stadium for the Winter Olympics in Russia was “designed and built by British businesses”. But was this the direct result of the London Olympics, or would this have happened anyway?

Another example is that any inward investment by any company that attended the London Olympics is counted in the £2.5 billion of additional inward investment (part of the £9.9 billion). As the London Evening Standard article below states:

In London, it credited the Games with helping seal the deal for the £1.2 billion investment in the Royal Albert Docks by Chinese developer ABP, the £1 billion investment in Croydon by Australian shopping centre developer Westfield with UK firm Hammerson and the £700 million investment in Battersea Nine Elms by Dalian Wander Group.

It is highly likely that some or all of these would have gone ahead anyway.

Then there are the £5.9 billion of additional sales. These are by companies which engaged with the Olympics. But again, many of these sales could have taken place anyway, or may have displaced other sales.

Many cost–benefit analyses (or simply ‘benefit analyses’) concern projects where there are strong vested interests in demonstrating that a project should or should not go ahead or, in this case, have gone ahead. The more powerful the vested interests, the less likely it is that the analysis can be seen as objective.

Questions

Distinguish between gross and net benefits; monetary and non-monetary externalities; direct costs (or benefits) and external costs (or benefits).
How should the discount rate be chosen for a cost–benefit analysis?
Give some examples of monetary and non-monetary external costs of the Games.
What are the arguments for and against including non-monetary externalities in a cost–benefit analysis?
Why might the £9.9 billion figure for the monetary benefits of the Games up to the present time be questioned?

16 July 201316 July 2013

Apple found guilty of coordinating the fixing of e-book prices

Apple was last week found guilty in the US for its role in the fixing of e-book prices. A subsequent hearing will now be held to determine the damages that Apple will be forced to pay. However, Apple vehemently denies the allegations and looks set to appeal the decision.

To understand what the US Department of Justice (the European Commission has also brought a case) is objecting to, we need to look back to how pricing in this rapidly growing market has evolved over time.

Until the end of 2009 e-books were sold under a wholesale pricing model. Here, publishers charge retailers a wholesale price per book and retailers are then free to charge final consumers whatever price they choose. This all changed in the US (there were also similar developments in Europe) during an eventful period of a few days in January 2010 when Apple unveiled its iPad for April release.

The publisher Macmillian proposed that Amazon switch to an agency pricing model under which the publisher sets the retail price. This is typically referred to by economists as Resale Price Maintenance (RPM). Interestingly, RPM has a long history in the book industry. In the UK for example, throughout most of the last century publishers set prices under the Net Book Agreement, until this broke down in the mid 1990s. In addition, in some countries, for example Germany, books continue to be sold under RPM.

Macmillan also threatened Amazon that if it preferred to keep wholesale pricing it would delay the supply of e-book releases to them. Amazon initially responded by refusing to stock Macmillan titles. However, soon after Amazon ceded to Macmillan’s proposal. Despite this, Amazon made clear its dissatisfaction to its customers:

We have expressed our strong disagreement and the seriousness of our disagreement by temporarily ceasing the sale of all Macmillan titles. We want you to know that ultimately, however, we will have to capitulate and accept Macmillan’s terms because Macmillan has a monopoly over their own titles, and we will want to offer them to you even at prices we believe are needlessly high for e-books.

It turned out that 5 of the 6 major publishers (including Macmillan) had already agreed the same agency terms to sell e-books for Apple devices. Like Macmillan, the other publishers all then also imposed agency pricing on Amazon. Furthermore, crucial to the contracts agreed with Apple was a so called ‘most-favoured customer’ clause which guaranteed that e-books would not be sold elsewhere at prices below those charged to Apple customers. Effectively, therefore, this clause made it necessary for the publishers to impose agency terms on Amazon. The Department of Justice objected to this and believed consumers would be harmed due to higher prices. All of the publishers involved eventually decided to settle the case, leaving Apple alone to fight the case in court.

In the decision Judge Cote concluded that:

the publisher defendants conspired with each other to eliminate retail price competition in order to raise e-book prices, and that Apple played a central role in facilitating and executing that conspiracy. Without Apple’s orchestration of this conspiracy, it would not have succeeded as it did in the Spring of 2010.

It is interesting to consider the reasons why the publishers would be keen to take control of the prices Amazon charges for e-books. Evidence suggests that Amazon was frequently retailing e-books at substantial discounts and even below wholesale costs. One explanation for this is that Amazon was keen to increase demand for Kindle devices. The publishers, on the other hand, might well be concerned about the implications of Amazon dominating the e-book market. Potentially, this would give Amazon significant bargaining power over them.

Of course, such dominance might also have knock-on effects on consumer prices in the long-run. Whether the publishers will be permitted to use agency pricing to mitigate such concerns in the future remains unclear and depends on whether the competition authorities object to agency pricing per se or just the coordinated way in which it was achieved.

As the articles below demonstrate, opinion is strongly divided for and against the judgement against Apple.

EU raids ebook publishers in price fixing investigation The Guardian, Benedicte Page and Leigh Phillips (4/3/11)
Apple Faces Damages Trial Over E-Book Antitrust Violation Bloomberg Businessweek, Bob Van Voris, Adam Satariano and David McLaughlin (10/7/13)
Apple played ‘central role’ in ebook price-fixing conspiracy, says federal judge The Guardian, Amanda Holpuch (11/7/13)
US: Apple found guilty, but what happens next? Competition Policy International (11/7/13)
Why It’s Insane That No One Cares About Apple’s Price-Fixing Conspiracy (AAPL) Seattle pi, Jim Edwards (13/7/13)
Apple Learns The Hazards Of Innovation With E-Book Antitrust Ruling Forbes, Daniel Fisher (10/7/13)

Questions

What are the important features of the e-book market?
What are the key differences between the traditional and e-book markets?
To what extent do Amazon and Apple have different incentives in the e-book market?
Do you think Resale Price Maintenance is more likely to harm competition in the market for traditional or e-books?
What do you think might be the short and long-run implications of this decision?

1 July 20135 July 2013

A payday inquiry

When people take out loans they typically do so to spend and with the UK economy in its current state, many would argue that this is a good thing. The ‘payday loan’ industry took advantage of the weak economy and the squeezed households in the UK and for the past few years, we have seen constant adverts that will appeal to many households. But, is the industry as competitive as the adverts would have us believe?

An inquiry into this industry has been on-going for some time, and it has now been referred to the Competition Commission, due to ‘deep-rooted problems with the way competition works’. For some, a payday loan is a short term form of finance, but for others it has become a way of living that has led to a debt spiral. Frank McKillop, policy manager at Abcul said:

There is a clear demand for instant credit and across the country we are increasingly seeing members who have debts with multiple payday lenders and a record of rolling over debts, or going to one payday lender to clear the debt to another.

One problem identified by the OFT is that customers have found it difficult to compare costs and this has led, in some cases, to customers paying back significantly more than they originally thought. Customers being unable to repay loans will ring warning bells for many people, with no-one wanting a return to the height of the credit crunch.

The OFT has criticized payday loan companies for competing not on costs, but on the speed of approval and using certain unapproved tactics as part of their advertising. The selling point of such companies is that you can have the money in a very short time period. However, the criticism is that this leads to loans being given to those who are unable to afford them. Key credit checks are not being done and with late night texts being sent to often financially vulnerable people, it is no wonder that complaints have been received. In a statement, the OFT said:

The competitive pressure to approve loans quickly may give firms an incentive to skimp on the affordability assessment which is designed to prevent irresponsible lending and protect consumers.

[the business models of companies were] predicated on making loans which are unaffordable, leading to borrowers paying far more than expected through rollovers, additional interest and other charges.

While payday loans are legal and there are many companies offering them, it is what they are competing over, which seems to be in question. The industry itself has begun to change its practices, providing more information to customers, only allowing loans to be rolled over three times and the potential to freeze repayments if the customer gets into financial difficulty. If more stringent checks are completed and hence timing does not become the only grounds for competition, then the problems above may become less significant. With the ongoing OFT inquiry into the practices of the payday loan industry and the continuing demand for such financing, it is likely that we will see much more of both the good and the bad that it has to offer. The following articles consider the investigation.

Webcasts

Balls warns against payday loans ‘blank cheque’ BBC News (27/6/13)
Payday lender investigation could be delayed by bureaucracy Telegraph, Steve Hawkes (27/6/13)
Payday lenders to face ‘tougher restrictions’ on advertising BBC News, Simon Gompertz (1/7/13)
Payday lending rates BBC News, Julio Martino and Stella Creasy (2/7/13)

Articles

Regulator to investigate payday loan industry Financial Times, Elaine Moore and Robert Cookson (27/6/13)
Q&A: Payday loans BBC News (31/5/13)
Payday loans: reining in an industry that is a law unto itself Guardian (27/6/13)
Payday loans industry to face competition inquiry BBC News (27/6/13)
Payday loans firms face competition inquiry Sky News (27/6/13)
Payday loans market faces competition inquiry Guardian, Hilary Osborne (27/6/13)
OFT refers payday loans to Competition Commission Scotsman, Jane Bradley (27/6/13)
Five reasons why we all need to worry about payday lenders Telegraph, Emma Simon (27/6/13)

OFT documents
Payday lending compliance review Office of Fair Trading (27/6/13)

Questions

Into which market structure would you place the payday loans industry? Make sure you justify your answer.
What is the role of the (a) the OFT and (b) the Competition Commission? Do these authorities overlap?
What part does advertising play in this industry?
To what extent is the payday loan industry a possible cause of another credit crunch?
Why has the OFT referred this industry to the Competition Commission?
To what extent are payday loans an essential part of an economy?

12 June 201312 June 2013

Tackling market power in the UK power industry

The UK electricity supply market is an oligopoly. Over 95% of the market is supplied by the ‘big six’: British Gas (Centrica), EDF Energy, E.ON, npower (RWE), Scottish Power (Iberdrola) and SSE. The big six also generate much of the electricity they supply; they are vertically integrated companies. Between them they generate nearly 80% of the country’s electricity. There are a further two large generators, Drax Power Limited and GDF Suez Energy UK, making the generation industry an oligopoly of eight key players.

Ofgem, the energy market regulator, has just published a report on the wholesale electricity market, arguing that it is insufficiently liquid. This, argues the report, acts as a barrier to entry to competitor suppliers. It thus proposes measures to increase liquidity and thereby increase effective competition. Liquidity, according to the report, is:

… the ability to quickly buy or sell a commodity without causing a significant change in its price and without incurring significant transaction costs. It is a key feature of a well-functioning market. A liquid market can also be thought of as a ‘deep’ market where there are a number of prices quoted at which firms are prepared to trade a product. This gives firms confidence that they can trade when needed and will not move the price substantially when they do so.

A liquid wholesale electricity market ensures that electricity products are available to trade, and that their prices are robust. These products and price signals are important for electricity generators and suppliers, who need to trade to manage their risks. Liquidity in the wholesale electricity mark et therefore supports competition in generation and supply, which has benefits for consumers in terms of downward pressure on bills, better service and greater choice.

So how can liquidity be increased? Ofgem is proposing that the big six publish prices for two years ahead at which they are contracting to purchase electricity from generators in long-term contracts. These bilateral deals with generators are often with their own company’s generating arm. Publishing prices in this way will allow smaller suppliers to be able to seek out market opportunities. The generating companies will not be allowed to refuse to contract to supply smaller companies at the prices they are being forced to publish.

In addition, Ofgem is proposing that generators would have to sell 20% of output in the open market instead of through bilateral deals. As it is, however, some 30% of output is currently auctioned on the wholesale spot market (i.e. the market for immediate use).

But it is pricing transparency plus small suppliers being able to gain access to longer-term contracts that are the two key elements of the proposed reform.

Articles

UK utilities face having to disclose long-term deals Reuters, Karolin Schaps and Rosalba O’Brien (12/6/13)
Ofgem set to ‘break stranglehold’ in the energy market BBC News, John Moylan (12/6/13)
Ofgem plan ‘to end energy stranglehold’ BBC Today Programme, John Moylan and Ian Marlee (12/6/13)
Ofgem outlines proposals to ‘break stranglehold’ of big six energy suppliers on electricity market The Telegraph (12/6/13)
Ofgem widens investigation into alleged rigging of gas and power markets The Guardian, Terry Macalister (6/6/13)
Ofgem moves to break stranglehold of ‘big six’ energy suppliers Financial Times, Guy Chazan (12/6/13)
Ofgem to crackdown on Big Six energy suppliers in bid to cut electricity prices Independent, Simon Read (12/6/13)

Reports and data

Opening up Electricity Market to Effective Competition Ofgem Press Release (12/6/13)
Wholesale power market liquidity: final proposals for a ‘Secure and Promote’ licence condition – Draft Impact Assessment Ofgem (12/6/13)
Electricity statistics Department of Energy & Climate Change
The Dirty Half Dozen Friends of the Earth (Oct 2011)

Questions

What barriers to entry exist in (a) the wholesale and (b) the retail market for electricity?
Distinguish between spot and forward markets. Why is competition in forward markets particularly important for small suppliers of electricity?
How will ‘liquidity’ be increased by the measures Ofgem is proposing?
To what extent does vertical integration in the energy industry benefit consumers of electricity?
What is a price reporting agency (PRA)? What anti-competitive activities have been taking place in the short-term energy market and why may PRAs not be ‘fit for purpose’?
Do you think that the measures Ofgem is proposing will ensure that the big generators trade fairly with small suppliers? Explain.
What are the dangers in the proposals for the large generators?

7 June 20138 June 2013

The power to veto wind farms

The Clean Energy Bill has been on the agenda for some time and not just in the UK. With climate change an ever growing global concern, investment in other cleaner energy sources has been essential. However, when it comes to investment in wind farms, developers have faced significant opposition. The balancing act for the government appears to be generating sufficient investment in wind farms, while minimising the negative externalities.

The phrase often thrown around with regards to wind farms, seems to be ‘not in my backyard’. That is, people recognise the need for them, but don’t want them to be built in the local areas. The reason is to do with the negative externalities. Not only are the wind farms several metres high and wide, creating a blight on the landscape, but they also create a noise, both of which impose a third party effect on the local communities. These factors, amongst others, have led to numerous protests whenever a new wind farm is suggested. The problem has been that with such challenging targets for energy, wind farms are essential and thus government regulation has been able to over-ride the protests of local communities.

However, planning guidance in the UK will now be changed to give local opposition the ability to override national energy targets. In some sense, more weight is being given to the negative externalities associated with a new wind farm. This doesn’t mean that the government is unwilling to let investment in wind farms stop. Instead, incentives are being used to try to encourage local communities to accept new wind farms. While acknowledging the existence of negative externalities, the government is perhaps trying to put a value on them. The benefits offered to local communities by developers will increase by a factor of five, thus aiming to compensate those affected accordingly. Unsurprisingly, there have been mixed opinions, summed up by Maria McCaffery, the Chief Executive of trade association RenewableUK:

Maria McCaffery, chief executive of trade association RenewableUK, said the proposals would signal the end of many planned developments and that was “disappointing”.

Developing wind farms requires a significant amount of investment to be made upfront. Adding to this cost, by following the government’s advice that we should pay substantially more into community funds for future projects, will unfortunately make some planned wind energy developments uneconomic in England.

That said, we recognise the need to ensure good practice across the industry and will continue to work with government and local authorities to benefit communities right across the country which are hosting our clean energy future.

The improved benefits package by the energy industry is expected to be in place towards the end of the year. The idea is that with greater use of wind farms, energy bills can be subsidised, thereby reducing the cost of living. Investment in wind farms (on-shore and off-shore) is essential. Current energy sources are non-renewable and as such new energy sources must be developed. However, many are focused on the short term cost and not the long term benefit that such investment will bring. The public appears to be in favour of investment in new energy sources, especially with the prospect of subsidised energy bills – but this positive outlook soon turns into protest when the developers pick ‘your back yard’ as the next site. The following articles consider this issue.

Residents to get more say over wind farms The Guardian, Fiona Harvey and Peter Walker (6/6/13)
Local communities offered more say over wind farms BBC News (6/6/13)
Locals to get veto power over wind farms The Telegraph, Robert Winnett (6/6/13)
Wind farms are a ‘complete scam’, claims the Environment Secretary who says turbines are causing ‘huge unhappiness’ Mail Online, Matt Chorley (7/6/13)
New planning guidance will make it harder to build wind farms Financial Times, Jim Pickard, Pilita Clark and Elizabeth Rigby (6/6/13)
Will more power to nimbys be the death of wind farms? Channel 4 News (6/6/13)
Locals given more ground to block wind farms Independent, Tom Bawden (6/6/13)

Questions

What are the negative externalities associated with wind farms?
Conduct a cost-benefit analysis as to whether a wind farm should be constructed in your local area. Which factors have you given greatest weight to?
In question 2 above, were you concerned about the Pareto criterion or the Hicks-Kaldor criterion?
If local communities can be compensated sufficiently, should wind farms go ahead?
If the added cost to the development of wind farms means that some will no longer go ahead, is this efficient?
Why is there a need to invest in new energy sources?
To what extent is climate change a global problem requiring international (and not national) solution?

Category: Essential Economics for Business: Ch 09

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