Category: Essentials of Economics: 8e Ch 05

Concerns have been expressed about the UK’s relatively poor record of upgrading broadband services so that households can receive ultrafast connectivity. Some commenters have argued that future economic growth prospects will be harmed if the UK continues to lag behind its leading rivals.

Much of the fixed line system that allows people to connect to broadband was originally installed many years ago for the land-line telephone network. The so called ‘final mile’ consists of copper-based wiring that is carried from street cabinets to the premises of the end-user. This wiring is transported via a huge network of telegraph poles and cable ducts (small underground tunnels).

In order for people to gain connectivity to ultrafast broadband this copper based wiring needs to be replaced by fibre optic cables. This is commonly referred to as Fibre to the Premises (FTTP). Unfortunately, the UK has a relatively poor record of installing FTTP. Japan and Korea were forecast to have 70% and 63% coverage by the end of 2015 as opposed to just 2% in the UK.

Why is the UK’s record so poor? Many observers blame it on the structure of the industry. In other network industries, such as those for gas pipeline and electricity grids, the business responsible for managing the infrastructure, National Grid, is a regulated monopoly. This company does not directly supply services to consumers using the network it is responsible for maintaining. Instead, customers are supplied by the retail sector of the industry, where firms compete for their business. This sector includes the so-called ‘big six’ (British Gas; npower; SSE; Scottish Power; EDF; E.On) and a number of smaller suppliers such as Ovo Energy and Ebico.

The structure of the fixed line telecommunications sector is very different. The company that manages the ‘final mile’, Openreach, is a subsidiary of BT. BT also competes with other Internet Service Providers (ISPs), such as TalkTalk and Sky, to supply broadband to customers using this network. Its market share of 32 per cent makes it the largest player in the broadband market. Sky and TalkTalk have market shares of 22 per cent and 14 per cent respectively. Virgin Media also supplies 20 per cent of this market using its own network of ducts and cables.

Given that in most cases ISPs such as Sky and TalkTalk are stuck with the network Openreach provides, BT may have limited incentives to invest. It can still earn a good return from its infrastructure of copper-based wiring and avoid installing expensive FTTP. Dido Harding, the chief executive of TalkTalk, argued that:

“We need to separate Openreach from the rest of BT to create a more competitive, pro-investment market”

Ofcom, in its recent review of the market, has taken a different approach. Rather than creating an entirely separate monopoly business to manage the network (i.e. splitting Openreach from BT), the regulator instead opted for a policy of encouraging competition between different suppliers that deploy fibre optic cables. It states in the report that:

“We believe competition between different networks is the best way to drive investment in high-quality, innovative services for customers.”

This competition could come from ISPs such as TalkTalk and Sky or other smaller network providers such as CityFibre and Gigaclear.

One major problem with this approach is that potential new entrants might be deterred from entering the market because of the very high initial costs involved in building a new network in order to deploy FTTP. In particular, the costs of digging up the roads and laying the ducts are considerable. Matt Yardley, author of a study on the industry, said:

“It is widely accepted that civil works such as digging trenches account for up to 80% of broadband deployment costs.”

One way of reducing these costs and encouraging more competition is to allow rival firms access to the existing ducts and poles that are currently managed by Openreach. Once access has been obtained, these firms could effectively rent space inside the ducts and lay fibre optic cables alongside the existing copper-based wiring. Vodafone reported that a similar policy in Spain had reduced its capital expenditure of building FTTP by 40 per cent compared with constructing its own network of ducts and poles.

Ofcom first introduced this type of policy in 2010 when it launched its Physical Infrastructure Access (PIA) initiative. Unfortunately it has proved to be relatively unsuccessful with very little demand for PIA from rival firms. The success of this type of policy will depend on a number of factors including (1) the prices charged by Openreach to access and rent space inside the ducts; (2) the simplicity of any relevant administration; and (3) the availability and reliability of information about the ducts. With this last point, key issues include:

Where they are located .
How much space is available: i.e. is there enough space for firms to lay fibre optic cables alongside the existing wiring?
What condition they are in: i.e. are they flooded or clogged up with sand and mud, which will involve expensive work to make them usable again?

Firms did complain about the pricing structures and bureaucratic nature of the administration process under the PIA scheme. However, their most significant concerns were about the uncertainty that was created by the lack of information about the ducts and poles. For example, analysts from the consultancy firm, Reburn, argued that if a firm contacted Openreach to try to obtain access to the network it was informed that:

“We don’t know what condition the ducts and poles are in. Please pay £10 000 for a survey. Also unfortunately we are rather busy and we can only start in six weeks.”

Matthew Hare, the chief executive of Gigaclear, argued that it was like going to a shop where the assistant says:

“Give me some money, and I’ll tell you whether you can have it or not.”

In response to these criticisms Ofcom has introduced a number of changes to PIA, which has been re-named Duct and Pole Access (DPA). In particular, it has imposed a new requirement on Openreach to create a database that provides information on the location, condition and capacity of its ducts and poles. The database must be made available to rival ISPs and network providers. DPA must also be provided on the same timescales, terms and conditions to all businesses including other parts of BT – this is referred to as ‘equivalence of inputs’.

The first big test of this policy is in Southend where City Fibre is hoping to deploy 50km of fibre optic cables using DPA. However, reports in the media have suggested that the initial surveys have found very limited capacity in some of the ducts, which would make DPA impossible.

It will be interesting to see how the trial in Southend progresses. If it is successful, then DPA may be viable for about 40 per cent of premises in the UK. If it fails, then Ofcom might ultimately have to force Openreach to be completely separated from BT.

Articles

How the gothic city of York became a broadband battleground The Telegraph, Kate Palmer (22/5/16)
City Fibre first to mount BT challenge after Openreach is told to share network The Telegraph, Kate Palmer (1/3/16)
Challenges as CityFibre Moot Using BT Cable Ducts in Southend-on-Sea ISPreview, Mark Jackson (2/5/16)
CityFibre to build pure fibre infrastructure for Southend Networking (5/4/16)
Ofcom tells BT to open up infrastructure to rivals The Guardian, Rob Davies (26/2/16)

Questions

  1. Draw an average total cost curve to illustrate the economics of building a network of ducts and poles. Label the minimum efficient scale.
  2. To what extent does DPA create a contestable market?
  3. For DPA to deliver productive efficiency, what must be true about the economies of scale of laying fibre optic cables?
  4. In the run-up to Ofcom’s review of the telecoms industry, many commentators described Openreach as being a natural monopoly. To what extent do you agree with this argument?
  5. What are the advantages of marginal cost pricing? What issues might a regulator face if it tried to impose marginal cost pricing on a natural monopoly?
  6. Using a diagram, explain how the network of ducts and poles might be a natural monopoly in rural areas but not in densely populated urban areas.
  7. Discuss how Ofcom has tried to increase the level of separation between Openreach and BT.

According to the BBC’s Joe Lynam, “Britain has the most competitive and dynamic retail environment in the world, which attracts shoppers globally.” It is perhaps this fact which may save BHS, with new owners being attracted by such an opportunity. BHS is soon expected to file for administration, with debts of more than £1.3 billion and having failed to secure the loan needed to keep it afloat. If this company collapses, it will bring an end to the life of an 88 year old giant.

The British retail scene has certainly changed over the past decade, with names such as Woolworths and Comet disappearing – could BHS be the next casualty of the changing retail climate? In the world of retail, tastes change quickly and those stores who fail to change with the times are the ones that suffer. One of the factors behind the downfall of BHS is the ‘dated’ nature of its stores and fashions. As clothing outlets such as Zara, Oasis and Next have continued to change with the times, commentators suggest that BHS continues with a trading offer from the 1980s. With the online shopping trend, many household names adapted their strategy, but BHS failed to do so and the second chance that BHS asked the public for when Sir Philip Green, its former owner, sold BHS in 2015 hasn’t materialised.

With administrators ready to be brought in and thousands of jobs hanging in the balance, the administrators will be looking at methods to attract funding, new owners or so-called ‘cherry pickers’ who may be interested in buying up the more profitable stores. Some of their stores remain in prime locations and deliver a tidy profit and it is perhaps these gems, together with the tradition that British Home Stores brings that may yet see the company saved. The outcome for BHS will not only affect the jobs of its employees, but will affect the pensions of thousands of workers. The BHS pension fund currently has a deficit of £576 million and so the Pension Protection Fund will have to look closely at the situation before thinking about issues a contribution notice to those connected with the fund.

A deal was on the cards last week, with BHS owner Dominic Chappell in talks with Mike Ashley’s Sports Direct, but the high debts and pensions deficit appears to have deterred this deal. The failing fortunes of BHS have now come back to haunt former owner, Sir Philip Green, who in March 2015, sold the business for just £1. Sir Philip may return to save the day, but the options for this once giant of the British high street are rather limited. The following articles consider the fortunes of BHS.

BHS seeks Sports Direct lifeline as it heads for collapse The Guardian, Graham Ruddick (24/04/16)
BHS expected to file for administration on Monday BBC News (25/04/16)
Thousands of BHS workers face anxious wait amid administration fears The Telegraph (25/04/16)
BHS administration: ‘Imminent bankruptcy’ puts 11,000 jobs at risk Independent, Peter Yeung (25/04/16)
Up to 11,000 jobs face the axe as BHS is expected to announce collapse of chain after efforts to find rescuer failed Mail Online, Neil Craven (24/04/16)
BHS nears collapse putting 11,000 jobs at risk Sky News (25/04/16)
BHS set to file for administration after sales talks fail Financial Times, Murad Ahmed (25/04/16)

Questions

  1. Using a demand and supply diagram, can you explain some of the factors that have contributed to the difficult position that BHS finds itself in?
  2. Now, can you use a diagram showing revenues and profits and explain the current position of BHS?
  3. What type of market structure does BHS operate in? Can this be used to explain why it is in its current position?
  4. How has the company failed in adapting its business strategy to the changing times?
  5. Looking back at the history of BHS, can you apply the product life cycle to this store?
  6. If another company is considering purchasing BHS, or at least some of its stores, what key information will it need and what might make it likely to go ahead with such a purchase?

There has been a link between Sainsbury’s and Argos, with Sainsbury’s offering Argos concessions in some stores. But now, we’re looking at a much more significant link, with Sainsbury’s offering £1.3 billion for control of Home Retail Group’s Argos.

Many have questioned the sense of this offer, wondering what Sainsbury’s will gain from purchasing Argos, but Sainsbury’s has indicated it will boost sales, give itself access to a more advanced delivery network and Argos customers. Argos has worked hard to update its image, moving towards a more technology based catalogue and promising same day delivery in a bid to compete with companies, such as Amazon.

Online delivery is a costly business, with suggestions that retailers make losses on each delivery and hence pay customers to shop online. This move by Sainsbury’s may therefore be an investment in expanding its online delivery services and using the infrastructure that Argos already has. This will therefore help Sainsbury’s to invest in this sought after customer service, without having to invest millions into providing the infrastructure in the first place. This move may give Sainsbury’s a first mover advantage in the grocery sector, which may force other competitors to follow suit.

We could write for hours on the ins and outs of this potential deal and undoubtedly commentators will argue both for and against it. The following articles consider the good and bad sides and the future of grocery retailers in the UK.

Why does Sainsbury’s want to buy Argos? BBC News, Katie Hope (01/02/16)
Sainsbury’s agrees terms to buy Home Retail Group in £1.3bn deal The Guardian, Sean Farrell and Sarah Butler (02/02/16)
Sainsbury’s bets on Argos takeover for digital age Reuters, James Davey and Kate Holton (02/02/16)
Sainsbury’s returns with £1.3bn offer for Argos The Telegraph, Jon Yeomans and Ashley Armstrong (02/02/16)
Sainsbury’s could shut up to 200 Argos stores Sky News (12/01/16)
Sainsbury’s strikes deal to buy Home Retail Group Financial Times, Mark Vandevelde, Arash Massoudi and Josh Noble (02/02/16)

Questions

  1. What are the benefits to Sainsbury’s of taking over Argos?
  2. Why have many critics been surprised by this take-over?
  3. What is meant by a first mover advantage?
  4. Do you think that grocery retailers should diversify further or focus on their core business?
  5. Commentators suggest that delivery costs more to retailers than the price charged to consumers. Can you illustrate this using cost and revenue curves?
  6. Online delivery infrastructure is a big fixed cost for a firm. How will this change the shape of a firm’s cost curves and what impact will this have on profits following changes in market output?
  7. Do you think this take over will cause any concerns by competition authorities?

Pork – a favourite food of many Brits, whether it’s as a key ingredient of a roast dinner or a full English Breakfast! But, British pig farmers may be in for a tricky ride and we might be seeing foreign pork on our plates in the months to come. This is because of the falling price of pork, which may be driving local farmers out of the market.

As we know, market prices are determined by the interaction of demand and supply and as market conditions change, this will affect the price at which pork sells at. This in turn will have an impact on the incomes of farmers and hence on farmers’ ability to survive in the market. According to forecasts from Defra, specialist pig farms are expected to see a fall in income by 46%, from £49,400 to £26,500 in 2016. A key driver of this, is the decline in the price of pork, which have fallen by an average of £10 per pig. This loss in income has led to pig farmers facing the largest declines of any type of farm, even beating the declines of dairy farmers, which have been well-documented.

If we think about the forces of demand and supply and how these have led to such declines in prices, we can turn to a few key things. Following the troubles in Russia and the Ukraine and Western sanctions being imposed on Russia, a retaliation of sorts was Russia banning European food imports. This therefore reduced demand for British pork. Adding to this decline in demand, there were further factors pushing down demand, following suggestions about the adverse impact that bacon and ham have on health. If pig farmers in the UK continue with the number of pigs they have and bearing in mind they would have invested in their pig farms before such bans and warnings were issued, then we see supply being maintained, demand falling and prices being pushed downwards.

Zoe Davies, Chief Executive of the National Pig Association said:

“This year is going to be horrendous for the British pig industry … Trading has been tough for at least 18 months now and we are starting to see people leave. We’re already seeing people calling in saying they’ve decided to give up. All we can hope is that more people leave European pig farms before ours do.”

We can also look to other factors that have been driving pig farmers out of business, including a strong pound, the glut of supply in Europe and productivity in the UK. Lily Hiscock, a commentator in this market said:

“It is estimated that the average pig producer is now in a loss-making position after 18 months of positive margins … The key factors behind the fall in markets are the exchange rate, UK productivity and retail demand … Indeed, pigmeat seems to be losing out to cheaper poultry meat in consumers’ shopping baskets … The recent fall in prices may stimulate additional demand, and a strengthening economy could help, but at present these are hopes rather than expectations.”

The future of British pig farms is hanging in the balance. If the economy grows, then demand may rise, offsetting the fall in demand being driven by other factors. We will also see how the exit of pig farmers affects prices, as each pig farmer drops out of the market, supply is being cut and prices rise. Though this is not good news for the farmers who go out of business, it may be an example of survival of the fittest. The following articles consider the market for pork.

Podcast

UK pork market, Poppers, Scrap Metal BBC Radio 4, You and Yours (28/01/16)

Articles

Drop in global pork prices to bottom out – at 10-year lows agrimoney.com (29/01/16)
UK pork crisis looms as pig farmers expect income to half in 2016 Independent, Zlata Rodionova (5/02/16)
British pig farmers et for horrendous year as pork prices fall Western Morning News (17/01/16)

Questions

  1. What are they demand-side and supply-side factors which have pushed down the price of pork?
  2. Illustrate these effects using a demand and supply diagram.
  3. Into which market structure, would you place the pork industry?
  4. Using a diagram showing costs and revenues, explain why pig farmers in the UK are being forced out of the market.
  5. How has the strength of the pound affected pork prices in the UK?

Some of the largest companies around the world operate in multiple locations. This allows them to take advantage of wider markets, cheaper transport and of course, lower taxes. In many cases, we see companies selling in one country, but locating their Headquarters in another, where tax rates are cheaper and hence their tax bills are lower. Much criticism has been levelled at such companies, who are accused of not paying their fair share in tax. There has been a crackdown on these companies and the UK is playing a leading role in this tightening of tax laws. Google is the latest company to face a large payment in backdated taxes.

This is a company with a complex structure, which has involved Bermuda as a key location, with its zero rate of corporation tax and a Irish European base. Though locating its business in different countries is legal, it has now agreed to pay HMRC £130 million in back taxes from 2005, following a 6 year investigation. Google will also change its accounting system such that it pays more tax in Britain for sales in this country.

Google may be the first in a line of companies making such changes to its accounting practices following a global drive to tackle the low levels of taxes paid by these large companies. This change in tax rules may bring welcome relief to government coffers, though criticisms remain about the ‘real’ figure that Google owes. As an example of this: in 2013, Google’s UK revenues were $5.6bn. Yet it only paid £20.5m in tax on its UK profits. The Head of Google Europe, Matt Brittin said:

“The rules are changing internationally and the UK government is taking the lead in applying those rules so we’ll be changing what we are doing here. We want to ensure that we pay the right amount of tax.”

Mr Brittin was clear in saying that these back dated taxes are not evidence that they had been paying too little tax in previous years. He confirmed that they were abiding by tax laws at the time and that tax laws are now changing and hence so will the amount of tax they pay. He continued:

“I think there was concern that international companies were paying only in respect of profits that they make and those were the rules and the pressure was to see us pay in respect of the sales we make to UK customers – and the same for other companies…So, we are making a change because we want to continue to comply with the rules and the rules are changing.”

As the push to tighten tax laws changes, with firms paying more tax on sales as well as profits, we may observe more companies changing their accounting structures. The OECD has taken a big step in simplifying international tax laws and the coming years will tell us just how big an impact this will have and whether companies such as Google will face tax bills in other European countries as well. The following articles consider this taxing matter.

Google agrees £130m UK tax deal with HMRC BBC News, Kamal Ahmed (23/01/16)
Google strikes £130m back tax deal Financial Times, John Gapper (22/01/16)
Google strikes deal with UK tax authority Wall Street Journal, Sam Schechner and Stephen Fidler (23/01/16)
Google agrees to pay HMRC £130m in back taxes The Guardian, Kevin Rawlinson (23/01/16)
Google tax labelled ‘derisory’ by Labour’s John McDonnell BBC News (23/01/16)
Google to pay £130 million UK back taxes, critics want more Reuters, Tom Bergin (23/01/16)
Google to pay UK £130m in back taxes The Telegraph (22/01/16)
Google says it will pay £130m in back taxes Independent, Adam Barnett (23/01/16)
Google ‘agrees’ to pay £130m in extra UK tax after outrage when it coughed up just £20m on UK sales of nearly £4bn Mail Online, Imogen Calderwood (22/01/16)
Google agrees to pay $185 million in UK tax settlement Bloomberg, Brian Womack (23/01/16)

Questions

  1. What is the difference between a tax on sales and a tax on profits?
  2. How can companies legally avoid tax? Do you think they have a moral duty to pay tax?
  3. If firms face higher rates of taxation, how will this affect their costs and profits?
  4. Why are the larger multinationals, such as Google more able to engage in tax avoidance schemes?
  5. Do you think the problem of tax avoidance is one of the negative consequences of globalisation?
  6. Is the criticism about the ‘low’ amount of taxes paid to HMRC justified?
  7. The OECD has taken a leading role in tightening international tax policy. Do you think this will negatively impact the competitiveness of the global market place?
  8. What are the costs and benefits to a country of having a low rate of corporation tax?