Category: Essential Economics for Business: Ch 09

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Truce between Boeing and Airbus


Boeing and Airbus have called a truce in their 17-year battle over subsidies. During this period, both have accused each other of unfair government subsidies to their respective plane makers.

The long-running trade dispute

In October 2004, the USA requested the establishment of a WTO panel to consider whether Airbus was providing unfair subsidies to develop its new super-jumbo – the A380. This provoked a counter-request by Airbus, claiming unfair subsidies of $27.3 billion for Boeing by the US government since 1992. In July 2005, two panels were set up to deal with the two sets of allegations.

In June 2010, the WTO panel circulated its findings on Boeing’s case against Airbus. It found Airbus guilty of using some illegal subsidies to win contracts through predatory pricing, but dismissed several of Boeing’s claims because many of the subsidies were reimbursable at commercial rates of interest. However, some of the ‘launch aid’ for research and development was given at below market rates and so violated WTO rules. The report evoked appeal and counter-appeal from both sides, but the WTO’s Appellate Body reported in May 2011 upholding the case that ‘certain subsidies’ provided by the EU and member states were incompatible with WTO rules. In June 2011, the EU accepted the findings.

In March 2011, the WTO panel circulated its findings on Airbus’s case against Boeing. The EU claimed that ten specific measures amounted to subsidies to Boeing, which were inconsistent with the WTO’s rules on subsidies (the SCM agreement). It upheld three of ten alleged breaches, including subsidies between 1989 and 2006 of at least $5.3 billion. These subsidies were adjudged to have resulted in adverse effects to the EU’s interests, specifically in lost sales, especially to third-country markets, and in significantly suppressing the price at which Airbus was able to sell its aircraft.

But these rulings were not the end of the matter. Various appeals and counter-appeals were lodged by both sides with varying degrees of success. Also the disputes extended to other wide-bodied jets and to narrow-bodied ones too with claims by both sides of unfair subsidies and tax breaks.

On 9 June 2017 the WTO’s compliance panel rejected several EU claims that the USA had failed to withdraw all illegal subsidies to Boeing. However, it also found that the USA had not complied with an earlier ruling to abolish illegal tax breaks. Both sides claimed victory. Airbus claimed that the ruling had seen the WTO condemn non-compliance and new subsidies. In particular, it focused on the WTO ruling that Washington State subsidies had resulted in a significant loss of sales for Airbus. On the other hand, a Boeing press release spoke of a US win in a major WTO compliance ruling. Boeing claimed that that ruling meant that the United States had complied with ‘virtually all’ of the WTO’s decisions in the counter-case that the EU had filed against the USA in 2006.

On 27 June 2017, as expected, the EU challenged the WTO decision. This meant that the EU’s case would go back to the WTO’s appellate body, which was still considering a separate US case over state aid to Airbus.

On 15 May 2018, the WTO ruled that Airbus did not use unfair subsidies for narrow-bodied jets, such as the A320, which competes with the 737, but did for wide-bodied jets. The EU said that it would comply with the WTO ruling over the support for wide-bodied jets.

In 2019, the WTO ruled that the EU had illegally provided support to Airbus. The USA responded with tariffs of up to $7.5bn on a range of goods imported from the EU. In a parallel case, the WTO ruled that the US benefits to Boeing also violated trade rules, authorising the EU to impose tariffs on US imports worth roughly $4bn. Then in March 2020, the USA imposed a 15% tariff on Airbus aircraft.

The truce

Agreement was reached on 15 June 2021 in trade talks between the USA and the EU in Brussels. Both sides recognised that the dispute had been a negative-sum game, with both sides losing. It was thus agreed to suspend for five years all tariffs on aircraft and on a range of other goods, such as EU cheese and wine and US tobacco and spirits. The agreement did not include ending EU tariffs on US steel, however.

It was also agreed to work on an overarching agreement on subsidies, which would allow fair support by governments on both sides, and to co-operate in finding ways to counter unfair state investment in aircraft by China. US Trade Representative Katherine Tai said that the agreement ‘includes a commitment for concrete joint collaboration to confront the threat from China’s ambitions to build an aircraft sector on non-market practices’. China’s state-sponsored aerospace manufacturer, the Commercial Aircraft Corporation of China, or Comac, sees its C919, now in late stages of development, as a direct rival to the Airbus A320neo and the Boeing 737 Max.

To work out the details of US-EU collaboration, a working group will be set up. It will consider ways of ensuring that finance is provided on market terms, that R&D funding is transparent and that support given to aircraft manufactures will be equivalent by each side and will avoid harming the other side. It will consider just how the two sides can co-operate to address unfair competition from elsewhere.

Two days later, an almost identically worded deal was reached between the USA and the UK to end tariffs on a range of goods and join the EU-USA co-operation on aircraft manufacture.

Articles

Questions

  1. Choose any one particular complaint to the WTO by either Boeing or Airbus and assess the arguments used by the WTO in its ruling.
  2. Are subsidies by aircraft manufacturers in the interests of (a) passengers; (b) society in general?
  3. Is collaboration between Boeing and Airbus in the interests of (a) passengers; (b) society in general?
  4. How is game theory relevant to the long-running disputes between Boeing and Airbus and to their relationships in the coming years?
  5. Would cheaper aircraft from China be in the interests of (a) passengers; (b) society in general?
  6. Explain what is meant by ‘strategic trade theory’. How is it relevant to aircraft manufacture?
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Positive supply-side effects from the COVID-19 pandemic

One of the major economic concerns about the COVID-19 pandemic has been the likely long-term scarring effects on economies from bankruptcies, a decline in investment, lower spending on research and development, a loss of skills, discouragement of workers, disruption to education, etc. The result would be a decline in potential output or, at best, a slower growth. These persistent effects are known as ‘hysteresis’ – an effect that persists after the original cause has disappeared.

In a speech by Dave Ramsden, the Bank of England’s Deputy Governor for Markets & Banking, he argued that, according to MPC estimates, the pandemic will have caused a loss of potential output of 1.75%. This shortfall may seem small at first sight, so does it matter? According to Ramsden:

The answer is definitely yes for two reasons. First, a 1¾% shortfall as a share of annual GDP for the UK … represents roughly £39 billion – for context, that’s about half of the education budget. And second, that 1¾% represents a permanent shortfall, or at least a very persistent one, on top of the impact of the immediate downturn. If you lose 1¾% of GDP every year for ten years, then in total you have lost 17.5% of one year’s GDP, or around £390bn in 2019 terms

However, as the IMF blog linked below argues, there may be positive supply-side effects which outweigh these scarring effects, causing a net rise in potential GDP growth. There are two possible reasons for this.

The first is that the pandemic may have hastened the process of digitalisation and automation. Examples include ‘video conferencing and file sharing applications to drones and data-mining technologies’. According to evidence from a sample of 15 countries cited in the blog, a 10% rise in such intangible capital investment is associated with about a 4½% rise in labour productivity. ‘As COVID-19 recedes, the firms which invested in intangible assets, such as digital technologies and patents may see higher productivity as a result.’

The second is a reallocation of workers and capital to more productive sectors. Firms in some sectors, such as leisure, hospitality and retail, have relatively low labour productivity. Many parts of these industries have declined during the pandemic, especially those with high labour intensity. At the same time, there has been a rise in employment in firms where output per worker is higher. Such sectors include e-commerce and those where remote working is possible. The greater the reallocation from low labour-productivity to high labour-productivity sectors, the more will overall labour productivity rise and hence the more will potential output increase.

The size of these two effects will depend to a large extent on expectations, incentives and government policy. The blog cites four types of policy that can help investment and reallocation.

  • Improved insolvency and restructuring procedures to enable capital in failed firms to be reallocated to sectors with potential for growth.
  • Promoting competition to enable the exit and entry of firms into expanding sectors and to prevent powerful firms from blocking the process.
  • Refocusing policy from retaining labour in existing jobs to reskilling workers for new jobs, thereby improving labour mobility from declining to expanding sectors.
  • Addressing financial bottlenecks, so as to ensure adequate access to financing for viable firms.

Whether there will be a net increase or decrease in productivity from the pandemic very much depends on the extent to which firms and workers are able and willing to take advantage of new opportunities and the extent to which government supports investment in and reallocation to high-productivity sectors.

Blogs, articles and speeches

Questions

  1. Can actual economic growth be greater than potential economic growth (a) in the short run; (b) in the long run?
  2. Give some example of scarring effects from the COVID-19 pandemic.
  3. What effects might short-term policies to tackle the recession caused by the pandemic have on longer-term potential economic growth?
  4. What practical policies could governments adopt to encourage the positive supply-side effects of the pandemic? To what extent would these policies have negative short-term effects?
  5. Why might (endogenous) financial crises result in larger and more persistent reductions in potential output than exogenous crises, such as a pandemic or a war?
  6. Distinguish between interventionist and market-orientated supply-side policies to encourage the reallocation of labour and capital to higher-productivity sectors.
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Bounce back for the UK economy but with cloudy horizons

The OECD has recently published its six-monthly Economic Outlook. This assesses the global economic situation and the prospects for the 38 members of the OECD.

It forecasts that the UK economy will bounce back strongly from the deep recession of 2020, when the economy contracted by 9.8 per cent. This contraction was deeper than in most countries, with the USA contracting by 3.5 per cent, Germany by 5.1 per cent, France by 8.2 per cent, Japan by 4.7 per cent and the OECD as a whole by 4.8 per cent. But, with the success of the vaccine roll-out, UK growth in 2021 is forecast by the OECD to be 7.2 per cent, which is higher than in most other countries. The USA is forecast to grow by 6.8 per cent, Germany by 3.3 per cent, France by 5.8 per cent, Japan by 2.6 per cent and the OECD as a whole by 5.3 per cent. Table 1 in the Statistical Annex gives the figures.

This good news for the UK, however, is tempered by some worrying features.

The OECD forecasts that potential economic growth will be negative in 2021, with capacity declining by 0.4 per cent. Only two other OECD countries, Italy and Greece, are forecast to have negative potential economic growth (see Table 24 in the Statistical Annex). A rapid increase in aggregate demand, accompanied by a decline in aggregate supply, could result in inflationary pressures, even if initially there is considerable slack in some parts of the economy.

Part of the reason for the supply constraints are the additional barriers to trade with the EU resulting from Brexit. The extra paperwork for exporters has added to export costs, and rules-of-origin regulations add tariffs to many exports to the EU (see the blog A free-trade deal? Not really). Another supply constraint linked to Brexit is the shortage of labour in certain sectors, such as hospitality, construction and transport. With many EU citizens having left the UK and not being replaced by equivalent numbers of new immigrants, the problem is likely to persist.

The scarring effects of the pandemic present another problem. There has been a decline in investment. Even if this is only temporary, it will have a long-term impact on capacity, unless there is a compensating rise in investment in the future. Many businesses have closed and will not re-open, including many High Street stores. Moves to working from home, even if partially reversed as the economy unlocks, will have effects on the public transport industry. Also, people may have found new patterns of consumption, such as making more things for themselves rather than buying them, which could affect many industries. It is too early to predict the extent of these scarring effects and how permanent they will be, but they could have a dampening effect on certain sectors.

Inflation

So will inflation take off, or will it remain subdued? At first sight it would seem that inflation is set to rise significantly. Annual CPI inflation rose from 0.7 per cent in March 2021 to 1.5 per cent in April, with the CPI rising by 0.6 per cent in April alone. What is more, the housing market has seen a large rise in demand, with annual house price inflation reaching 10.2 per cent in March.

But these rises have been driven by some one-off events. As the economy began unlocking, so spending rose dramatically. While this may continue for a few months, it may not persist, as an initial rise in household spending may reflect pent-up demand and as the furlough scheme comes to an end in September.

As far as as the housing market is concerned, the rise in demand has been fuelled by the stamp duty ‘holiday’ which exempts residential property purchase from Stamp Duty Land Tax for properties under £500 000 in England and Northern Ireland and £250 000 in Scotland and Wales (rather than the original £125 000 in England and Northern Ireland, £145 000 in Scotland and £180 000 in Wales). In England and Northern Ireland, this limit is due to reduce to £250 000 on 30 June and back to £125 000 on 30 September. In Scotland the holiday ended on 31 March and in Wales is due to end on 30 June. As these deadlines are passed, this should see a significant cooling of demand.

Finally, although the gap between potential and actual output is narrowing, there is still a gap. According to the OECD (Table 12) the output gap in 2021 is forecast to be −4.6 per cent. Although it was −11.4 per cent in 2020, a gap of −4.6 per cent still represents a significant degree of slack in the economy.

At the current point in time, therefore, the Bank of England does not expect to have to raise interest rates in the immediate future. But it stands ready to do so if inflation does show signs of taking off.

Articles

Data, Forecasts and Analysis

Questions

  1. What determines the rate of (a) actual economic growth; (b) potential economic growth?
  2. What is meant by an output gap? What would be the implications of a positive output gap?
  3. Why are scarring effects of the pandemic likely to be greater in the UK than in most other countries?
  4. If people believed that inflation was likely to continue rising, how would this affect their behaviour and how would it affect the economy?
  5. What are the arguments for and against having a stamp duty holiday when the economy is in recession?
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UK–Australia trade deal: benefits and costs

The UK and Australia are set to sign a free-trade deal at the G7 summit in Cornwall on 11–13 June. This will eventually give tariff-free access to each other’s markets, with existing tariffs being phased out over a 15-year period. It is the first trade deal not based on an existing EU template. The government hopes that it will be followed by trade deals with other countries, including New Zealand, Canada and, crucially, the USA.

But what are the benefits and costs of such a deal?

Trade and comparative advantage

The classic economic argument is that free trade allows countries to benefit from the law of comparative advantage. According to the law, provided opportunity costs of various goods differ in two countries, both of them can gain from mutual trade if they specialise in producing (and exporting) those goods that have relatively low opportunity costs compared with the other country. In the case of the UK and Australia, the UK has a comparative advantage in products such as financial services and high-tech and specialist manufactured products. Australia has a comparative advantage in agricultural products, such as lamb, beef and wheat and in various ores and minerals. By increasing trade in these products, there can be a net efficiency gain to both sides and hence a higher GDP than before.

There is clearly a benefit to consumers in both countries from cheaper products, but the gains are likely to be very small. The most optimistic estimate is that the gain in UK GDP will be around 0.01% to 0.02%. Part of the reason is the physical distance between the two countries. For products such as meat, grain and raw materials, shipping costs could be relatively high. This might result in no cost advantage over imports from much nearer countries, such as EU member states.

But modern trade deals are less about tariffs, which, with various WTO trade rounds, are much lower than in the past. Many imports from Australia are already tariff free, with meat currently having a tariff of 12%. Modern trade deals are more about reducing or eliminating non-tariff barriers, such as differing standards and regulations. This is the area where there is a high degree of concern in the UK. Import-competing sectors, such as farming, fear that their products will be undercut by Australian imports produced to lower standards.

Costs of a trade deal

In a perfectly competitive world, with no externalities, labour mobile between sectors and no concerns about income distribution, eliminating tariffs would indeed provide an efficiency gain. But these conditions do not hold. Small farmers are often unable to compete with food producers with considerable market power. The danger is that by driving out such small farmers, food production and supply might not result in lower long-run prices. Much would depend on the countervailing power of supermarkets to continue bearing down on food costs.

But the question of price is probably the least worrying issue. Meat and grain is generally produced at lower standards in Australia than in the UK, with various pesticides, fertilisers and antibiotics being used that are not permitted in the UK (and the EU). Unless the trade deal can involve UK standards being enforced on products produced in Australia for export to the UK, UK farmers could be undercut by such imports. The question then would be whether labelling of imported food products could alert consumers to the different standards. And even if they did, would consumers simply prefer to buy the cheaper products? If so, this could be seen as a market failure with consumers not taking into account all the relevant health and welfare costs. Better quality food could be seen as a merit good.

Then there are the broader social issues of the protection of rural industries and societies. Labour is relatively immobile from farming and there could be a rise in rural unemployment, which could have local multiplier effects, leading to the decline of rural economies. Rural ways of life could be seriously affected, which imposes costs on local inhabitants and visitors.

Trade itself imposes environmental costs. Even if it were privately efficient to transport products half way around the world, the costs of carbon emissions and other pollution may outweigh any private gains. At a time when the world is becoming increasingly concerned about climate change, and with the upcoming COP26 conference in Glasgow in November, it is difficult to align such a trade deal with a greater commitment to cutting carbon emissions.

Articles

Questions

  1. Why might the UK government be very keen to sign a trade deal with Australia?
  2. Does the law of comparative advantage prove that freer trade is more efficient than less free trade? Explain.
  3. What externalities are involved in the UK trading with Australia? Are they similar to those from trading with the USA?
  4. If a trade deal resulted in lower food prices but a decline in rural communities, how would you establish whether this would be a ‘price worth paying’?
  5. If some people gain from a trade deal and others lose and if it were established that the benefits to the gainers were larger than the costs to the losers, would this prove that the deal should go ahead?
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Rail reorganisation


Back in October 2020 in the blog All change for the railways, we looked at the emergency measures for running the railways in Great Britain following the collapse in rail traffic because of the COVID-19 pandemic. We also looked ahead to plans for reorganising the railways, with the expectation that the current franchising system would be scrapped and replaced with a system whereby the train-operating companies (TOCs) would be awarded a contract to run rail services. They would be paid a performance-related fee. All ticket revenues would go to the government, which would bear the costs and the risks. While this would not be quite renationalisation, it would, in effect, be a contract system where private companies are paid to deliver a public service.

The Transport Secretary, Grant Shapps, has just announced the new system in a White Paper, which is indeed the anticipated contract system. The White Paper has drawn on the findings of the Williams Rail Review, independently chaired by Keith Williams.

The new system has the following features:

  • A new public-sector body, Great British Railways (GBR), will be created which will eventually absorb Network Rail.
  • GBR will produce five-year business plans. It will also develop a 30-year strategy to shape the long-term development of the railways and will include plans to decarbonise the whole rail network.
  • It will be in charge of planning and operating rail infrastructure in England, including track, signalling, stations and depots.
  • It will work closely with the devolved rail authorities in Scotland, Wales, London, Merseyside, and Tyne and Wear.
  • It will set timetables, plan train operations, set most fares, sell tickets (at stations and on a new dedicated website) and collect revenues.
  • The ticketing system will be reformed, with a single integrated system of fares across England, and potentially the devolved rail authorities too. The website will show the best and cheapest options for any given journey. New flexible season tickets will be introduced, allowing workers to travel on limited numbers of days: e.g. eight days in any 28-day period. Also, a new single compensation scheme will simplify the system for refunds.
  • Private train-operating companies (TOCs) will run trains over particular routes. They will bid for Passenger Service Contracts (PSCs), which will be awarded by competitive tender. They will be paid a management fee, rather than receiving revenues from ticket sales. The fees will include performance incentives and penalties, which will depend on meeting targets for punctuality, reliability, safety and cleanliness.
  • Rolling stock (trains, locomotives and freight wagons) will continue to be procured from the private sector, which will generally be leased to TOCs. It is hoped that by awarding PSCs for a number of years, TOCs will be encouraged to make large-scale procurements of rolling stock.
  • GBR in England will be divided into five regional divisions, which will be ‘accountable to customers for their journeys; manage PSCs, stations and infrastructure; procure private partners, such as operators and contractors; manage budgets both locally and regionally; integrate track and train at a local level; work with and be responsive to the needs of local and regional partners, and integrate rail with other transport services’.
  • GBR will be held to account by the Office of Rail and Road (ORR), which will monitor its performance.

In its White Paper, the government has recognised that, in many ways, rail privatisation has failed. Page 13 states:

Breaking British Rail into dozens of pieces was meant to foster competition between them and, together with the involvement of the private sector, was supposed to bring greater efficiency and innovation. Little of this has happened. Instead, the fragmentation of the network has made it more confusing for passengers, and more difficult and expensive to perform the essentially collaborative task of running trains on time.

But will the new system bring a better integrated, more efficient, punctual, reliable and greener railway, with more investment, an enlarged network and lower ticket prices? These are certainly aims of the White Paper. But a lot will depend on the details, yet to be finalised.

Crucially, it is not clear the extent to which the rail system will be subsidised. Will any subsidies internalise the positive externalities from rail travel? Also, it is not clear exactly what incentives and penalties will be introduced to encourage efficiency, punctuality, safety and cleanliness.

What is also not clear is the degree of contestability of rail routes and freight operations. Routes are contestable at the time of bidding for PSCs, with more efficient companies able to outbid the less efficient ones. But with changing conditions and the desire to maintain contestability, contracts need to be relatively short. However, it contracts are too short, there is no incentive for TOCs to invest in trains and infrastructure. Thus inherent in the PSC system is a tension between competition and investment.

It does seem that fares and tickets will be simpler, with greater use of ‘tapping in and out’ as in London and in many other countries, allowing fares to be capped when multiple journeys are made in any given time period. Ultimately, however, it is price, frequency, punctuality, comfort and reliability that are the crucial metrics. Success according to these will depend on how well GBR is run, how well the PSC system operates and how much the rail system is subsidised. The jury is out on these questions.

Video

Articles

Documents

Questions

  1. Explain how the franchising system has worked. What problems have arisen with this system?
  2. If the proposed new system also involves contracts being awarded to train-operating companies, how is it better than the old franchising system?
  3. What were the Emergency Measures Agreements (EMAs) introduced in the pandemic and the Emergency Recovery Measures Agreements (ERMAs) which replaced them in September 2020? How similar are they to the proposed system of Passenger Service Contracts (PSCs) with train-operating companies?
  4. Identify the externalities involved in train travel? What is the best way of internalising them?
  5. Argue the case for and against making train travel cheaper by increasing subsidies.
  6. To what extent are individual rail routes natural monopolies? Does a franchising system overcome the problems associated with natural monopolies?