Tag: competition

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Does profit maximisation lead to maximum profit? The case of Boeing

The traditional theory of the firm assumes that firms are profit maximisers. Although, in practice, decision-makers in firms are driven by a range of motives and objectives, profit remains a key objective for most firms – if not maximising profit, at least trying to achieve profit growth so as to satisfy shareholders, retain confidence in the company and prevent the share price from falling. After all, if the company is profitable, it is easier to fund investment, either from ploughed-back profit, borrowing or new share issue. And greater investment will help to drive profits in the future.

But does the pursuit of profit and shareholder value as the number-one objective actually lead to higher profit? It could be that a prime focus on other things such as consumer satisfaction, product design and value, innovation, safety, worker involvement and the local community could lead to greater long-term profit than an aggressive policy of marketing, cost cutting and financial rejigging – three of the commonest approaches to achieving greater profits.

Boeing disasters

In 2018 and 2019 there were two fatal crashes involving the new 737 MAX-8 aircraft. On 29 October 2018, Indonesia’s Lion Air Flight 610 crashed into the Java Sea; all 189 people on board died. On 10 March 2019, Ethiopian Airlines Flight 302 similarly crashed; all 157 people on board died. Both disasters were the result of a faulty automatic manoeuvring system. The company and its CEO, Dennis Muilenburg, knew about issues with the system, but preferred to keep planes flying while they sought to fix the issue. Grounding them would have cost the company money. But taking this gamble led to two fatal crashes. This damaged the company’s reputation and cost it billions of dollars.

The US Securities and Exchange Commission (SEC) investigated the cases and found that the company had made false statements about the plane’s safety and had put ‘profits before people’. But putting profits first ended up in a huge fall in profits, with the 737 MAX grounded for 20 months.

Since the crashes there have been several other issues with various critical systems, including stabilisation, engines, flight control systems, hydraulics and wiring. In December 2023, Boeing asked airlines to inspect its 737 MAX planes for a potential loose bolt in the rudder control system.

On 5 January 2024, Alaska Airlines Flight 1282 experienced an emergency. A window panel on the 737 MAX-9 aircraft, which replaced an unused emergency exit door, blew out and the cabin depressurised. Fortunately the plane was still climbing and had reached only just under 5000m – less than half of the cruising altitude of over 11 500m. The plane rapidly descended and safely returned to Portland International Airport without loss of life. Had the incident occurred at cruising altitude, the rush of air out of the plane would have been much greater. Passengers would be less likely to be wearing their seat belts and several people could have been sucked out.

The Federal Aviation Administration (FAA) temporarily grounded 171 MAX-9s for inspections. It found that several planes had loose bolts holding the panels in place and could potentially have suffered similar blow outs.

Profits rather than safety?

Critics have claimed that the corporate culture at Boeing prioritised profit over safety. This was made worse in 2001 when company headquarters moved from Seattle to Chicago but production remained at Seattle. The culture at headquarters became sharply focused on financial success. Boeing was under intense competition from Airbus, which announced its more fuel-efficient version of the A320, the A320neo, in 2010, with launch planned for 2015. Boeing’s more fuel-efficient version of the 737, the 737 MAX, was announced in 2011, scheduled for first delivery in 2017. Since then, Boeing has been keen to get the 737 MAX to customers as quickly as possible. Also, Boeing has sought to cut manufacturing costs to keep prices competitive with Airbus.

Despite warnings from some Boeing employees that this competition was leading to corners being cut that compromised safety, Boeing management continued to push for more rapid and cheaper production to fight the competition from Airbus.

The aircraft industry is regulated in the USA by the Federal Aviation Administration (FAA). In 2020, the House Committee on Transportation and Infrastructure produced a detailed report on the industry. It found that the FAA delegated too much safety certification work to Boeing. This was a case of regulatory capture. It was also accused of sharing the goal of promoting the production of US-based Boeing in its competition with European-based Airbus.

Effects on profits

But rather than a focus on profit leading to greater profits, safety issues have led to groundings of 737s, a fall in sales and a fall in profits. The first chart shows deliveries of 737s slightly lagging A320s from 2010 to 2018. Since then deliveries of 737s have fallen well behind A320s. In terms of orders for all planes, Boeing was ahead of Airbus in 2018 (893 compared with 747). Since then, Boeing has significantly lagged behind Airbus and in 2019 and 2020 cancellations exceeded new orders. The January 2024 incident and subsequent groundings are likely to erode confidence, orders and profits even further.

As you can see from the second chart, profits fell substantially in 2019, and with COVID fell again in 2020. They have not recovered to previous levels since. Depending on how the market responds to the issue of loose panel bolts on the MAX-9, profits could well fall again in 2024. There will almost certainly be a further erosion of confidence and probably of orders.

The Boeing story is a salutary lesson in how not to achieve long-term profit. A focus on design, quality and reliability may be a better means to achieving long-term profit growth than trying to appeal to shareholders by increasing short-term profits through aggressive cost cutting and hoping that this will not affect quality.

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Questions

  1. Why is the pursuit of long-run profit likely to result in different decisions from the pursuit of short-run profit?
  2. How has Airbus’s strategy differed from that of Boeing?
  3. How would you summarise Boeing management’s attitude towards risk?
  4. Is it important to locate senior management of a company at its manufacturing base?
  5. What is regulatory capture? Is it fair to say that the FAA was captured by Boeing?
  6. Should Boeing scrap the 737 MAX and design a new narrow-body plane?
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The UK’s national fixed broadband network – wasteful duplication or effective competition?

You may have recently noticed construction workers from different businesses digging up the roads/pavements near where you live. You may also have noticed them laying fibre optic cables. Why has this been happening? Does it make economic sense for different companies to dig up the same stretch of pavement and lay similar cables next to one another?

For many years the UK had one national fixed communication network that was owned by British Telecom (BT) – the traditional phone landline made from copper wire. This is now operated by OpenReach – part of the BT group but a legally separate division. In addition to this national infrastructure, Virgin Media (formed in 2007 from the merged cable operators, Telewest and NTL) has gradually built up a rival fixed broadband network that now covers just over 50 per cent of the country.

Although customers have only had very limited choice over which fixed communication network to use, they have had far greater choice over which Internet service provider (ISP) to sign up for. This has been possible as the industry regulator, Ofcom, forces OpenReach to provide rival ISPs such as Sky Broadband, TalkTalk and Zen with access to its network.

Expansion of the fibre optic network

Recent government policy has tried to encourage and incentivise the replacement of the copper wire network with one that is fully fibre. This is often referred to as Fibre to the Premises (FTTP) or Fibre to the Home (FTTH). A fixed network of fully fibre broadband enables much faster download speeds and many argue that it is vital for the future competitiveness of the UK economy.

Replacing the existing fixed communication network with fibre optic cables is expensive. It can involve major civil works: i.e. the digging up of roads and pavements to install new ducts to lay the fibre optic cables inside.

Over a hundred companies, that are not part of either OpenReach or Virgin Media O2 (the parent company of Virgin Media), have recently been digging up pavements/roads and laying new fibre optic cables. Known as alternative network providers (altnets) or independent networks, these businesses vary in size, with many of them securing large loans from banks and private investors. By the middle of 2023, 2.5 million premises in the UK had access to at least two or more of these independent networks.

After a slow initial response to the altnets, OpenReach has recently responded by rapidly installing FTTP. The business is currently building 62 000 connections every week and plans to have 25 million premises connected by the end of 2026. In July 2022, Virgin Media O2 announced that it was establishing a new joint venture with InfraVia Capital Partners. Called Nexfibre, this business aims to connect 5 million premises to FTTP by 2026.

Is the fibre optic network a natural monopoly?

Some people argue that the fixed communication network is an example of a natural monopoly – an industry where a single firm can supply the whole market at a lower average cost than two or more firms. To what extent is this true?

An industry is a natural monopoly where the minimum efficient scale of production (MES) is larger than the market demand for the good/service. This is more likely to occur where there are significant economies of scale. Digging up roads/pavements, installing new ducts and laying fibre optic cable are clear examples of fixed costs. Once the network is built, the marginal cost of supplying customers is relatively small. Therefore, this industry has significant economies of scale and a relatively large MES. This has led many people to argue that building rival fixed communication networks is wasteful duplication and will lead to higher costs and prices.

However, when judging if a sector is a natural monopoly, it is always important to remember that a comparison needs to be made between the MES and the size of the market. An industry could have significant economies of scale, but not be an example of a natural monopoly if the market demand is significantly larger than the MES.

In the case of the fixed communication network, the size of the market will vary significantly between different regions of the country. In densely populated urban areas, such as large towns and cities, the demand for services provided via these networks is likely to be relatively large. Therefore, the MES could be smaller than the size of the market, making competition between network suppliers both possible and desirable. For example, competition may incentivise firms to innovate, become more efficient and reduce costs.

Research undertaken for the government by the consultancy business, Frontier Economics, found that at least a third of UK households live in areas where competition between three or more different networks is economically desirable.

By contrast, in more sparsely populated rural areas, demand for the services provided by these networks will be smaller. The fixed costs per household of installing the network over longer distances will also be larger. Therefore, the MES is more likely to be greater than the size of the market.

The same research undertaken by Frontier Economics found that around 10 per cent of households live in areas where the fixed communication network is a natural monopoly. The demand and cost conditions for another 10 per cent of households meant it is not commercially viable to have any suppliers.

Therefore, policies towards the promotion of competition, regulation, and government support for the fixed communication network might have to be adjusted depending on the specific demand and cost conditions in a particular region.

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Questions

  1. Explain the difference between fixed and wireless communication networks.
  2. Draw a diagram to illustrate a profit-maximising natural monopoly. Outline some of the implications for allocative efficiency.
  3. Discuss some of the issues with regulating natural monopolies, paying particular attention to price regulation.
  4. The term ‘overbuild’ is often used to describe a situation where more than one fibre broadband network is being constructed in the same place. Some people argue that incumbent network suppliers deliberately choose to use this term to imply that the outcome is harmful for society. Discuss this argument.
  5. An important part of government policy in this sector has been the Duct and Pole Access Strategy (DPA). Illustrate the impact of this strategy on the average cost curve and the minimum efficient scale of production for fibre broadband networks.
  6. Draw a diagram to illustrate a region where (a) it is economically viable to have two or more fibre optic broadband network suppliers and (b) where it is commercially unviable to have any broadband network suppliers without government support.
  7. Some people argue that network competition provides strong incentives for firms to innovate, to become more efficient and reduce costs. Draw a diagram to illustrate this argument.
  8. Explain why many ‘altnets’ are so opposed to OpenReach’s new ‘Equinox 2’ pricing scheme for its fibre network.
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Does Britain suffer from a lack of competition?

In the last few years there have been growing concerns (see here for example) that markets in the USA are becoming increasingly dominated by a small number of firms. It is feared that the result of this will be a reduction in competition. Consistent with this, evidence suggests that the profits these firms make have increased. Last month The Economist and the Resolution Foundation published evidence (see references below) suggesting a similar picture may be emerging in Britain.

The Economist divided the British economy into 600 sub-sectors and found that in 58% of these the share of total revenue accruing to the 4 biggest firms had increased since 2008. The Resolution Foundation found a similar picture, especially in manufacturing industries where from 2004-16 the top five firms’ share of total revenue increased by over 10%.

Economic theory would suggest that as markets become more concentrated prices are likely to rise and The Economist cites research showing that mark-ups charged by firms in Britain have indeed risen. In addition to consumers facing higher prices, there is also concern that the lack of competition both in the USA and the UK is leading to lower wages being paid to workers. On the other hand, unlike in the USA, the evidence from the UK does not so far suggest there has also been an increase in corporate profits. Instead, it appears that the more successful firms’ profits have increased at the expense of their rivals.

This evidence on profits is line with a number of arguments that suggest we should perhaps be less concerned when markets are dominated by a small number of firms. Large firms may benefit from economies of scale and, being sufficiently large may be necessary for firms to innovate in new products and processes. Furthermore, high market shares may result from the competitive process as a reward for a firm developing a unique product or being more efficient than its rivals.

The Economist cites the supermarket industry as an example where concentrated is high, but competition is intense. Interestingly, this is a market where the British competition authorities have previously been concerned about the level of competition and spent considerable amounts of time investigating.

Despite these two opposing viewpoints, overall, The Economist argues strongly that we should be concerned about the situation in Britain. Not only are prices too high and wages too low, but growth in productivity is slow, even for the leading firms. Furthermore, they make clear that the situation may worsen following Brexit. It is argued that:

leaving the EU’s single market and customs union would reduce trade, easing competitive pressure from abroad.

This is consistent with evidence that joining the EC in the mid 1970s increased foreign competition in the UK and helped to end the low productivity growth that had plagued the economy since the 1930s.

Furthermore, it is suggested that:

to attract investment the government might look more favourably on proposed mergers—and loosening regulations would be easier outside the EU’s competition regime.

Therefore, it is clear that in the future there will be a vital role for the UK’s competition authority to remain independent of political objectives and aim to promote competition. In particular, they must prevent mergers that raise concentration and harm competition and intervene if they believe firms are abusing their dominant positions. Of course, following Brexit the case load of the competition authority in the UK will increase dramatically as they have to take on cases previously dealt with by the European Commission. One estimate is that it will need to look at around 40% more merger cases. It will certainly be interesting to see how competition in markets in Britain evolves over the next few years and the role competition policy plays in regulating this process.

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Questions

  1. Outline the ways in which concentration in a market is usually measured.
  2. Explain the different price levels that arise under the alternative models of market structure.
  3. Why do you think competition is currently so intense in the supermarket industry?
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Google it

The term ‘Google it’ is now part of everyday language. If there is ever something you don’t know, the quickest, easiest, most cost-effective and often the best way to find the answer is to go to Google. While there are many other search engines that provide similar functions and similar results, Google was revolutionary as a search engine and as a business model.

This article by Tim Harford, writing for BBC News, looks at the development of Google as a business and as a search engine. One of the reasons why Google is so effective for individuals and businesses is the speed with which information can be obtained. It is therefore used extensively to search key terms and this is one of the ways Google was able to raise advertising revenue. The business model developed to raise finance has therefore been a contributing factor to the decline in newspaper advertising revenue.

Google began the revolution in terms of search of engines and, while others do exist, Google is a classic example of a dominant firm and that raises certain problems. The article looks at many aspects of Google.

Just google it: The student project that changed the world BBC News, Tim Harford (27/03/17)

Questions

  1. Is Google a natural monopoly? What are the characteristics of a natural monopoly and how does this differ from a monopoly?
  2. Are there barriers to entry in the market in which Google operates?
  3. What are the key determinants of demand for Google from businesses and individuals?
  4. Why do companies want to advertise via Google? How might the reasons differ from advertising in newspapers?
  5. Why has there been a decline in advertising in newspapers? How do you think this has affected newspapers’ revenue and profits?
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Discovering Sky

As an avid sport’s fan, Sky Sports and Eurosport are must haves for me! In the days leading up to the end of January, it was a rather tense time in my house with the prospect of Eurosport being removed from anyone who was a Sky TV subscriber. Thankfully the threat has now gone and tranquility returns, but what was going on behind the scenes?

Whether you have Sky TV, BT, Virgin or any other, we generally take it for granted that we can pick and choose the channels we want, pay our subscription to our provider and happily watch our favourite shows. However, behind the scenes there is a web of deals. While Sky own many channels, such as Sky Sports; BT own others and there are a range of other companies that own the rest. Some companies pay Sky for their channels to be shown, while Sky pays other companies for access to their channels.

One such company is Discovery, which owns a range of channels including TLC, Eurosport, DMAX and Animal planet. Discovery then sells these channels to providers, such as Sky and Virgin, who pay a price for access. The problem was that Sky and Discovery had failed to reach an agreement for these channels and as the deadline of 31st January 2017 loomed, it became increasingly possible that Discovery would simply remove its channels from Sky. This would mean that Sky customers would no longer have access to these channels, while customers with other providers would continue to watch them, as companies such as Virgin still had an agreement in place.

The issue was money. Hours before the deadline, a deal was finally reached such that Discovery will now keep its programmes on Sky for ‘years to come’. Discovery has indicated the final deal was better than had originally been proposed, while Sky indicate that the deal accepted by Discovery was the same as had previously been offered! Although no details of the financial agreement have been released, it seems likely that either Sky increased the price they were willing to pay or Discovery lowered the price it was asking for. Both companies stood to lose if the dispute was not settled, but it’s interesting to consider which company was at more risk. Following the announcement that a deal had been struck, Discovery shares rose by 2.5 per cent, while Sky’s share remained unchanged.

While Sky said that viewing figures on Discovery’s channels had been falling and that it had been over-paying for years, it seems likely that if a deal had not been reached, millions of Sky customers may have considered switching to other providers, who were still able to show Discovery channels. Although Sky has been looking to cut its costs and one way is to cut the price it pays for channels, failure to reach an agreement may have cost it a significant sum in lost revenue, as channels such as Eurosport are hugely popular.

Discovery claimed that the price Sky was paying them was not fair and that it was paying them less for its channels that it did 10 years ago. Susanna Dinnage, Discovery’s Managing Director in the UK said:

“We believe Sky is using what we consider to be its dominant market position to further its own commercial interest over those of viewers and independent broadcasters. The vitality of independent broadcasters like Discovery and plurality in TV is under threat.”

Sky claimed that Discovery was demanding close to £1bn for its programmes and that given that these channels were losing viewers, this price was unrealistic. A spokesman said:

“Despite our best efforts to reach a sensible agreement, we, like many other platforms and broadcasters across Europe, have found the price expectations for the Discovery portfolio to be completely unrealistic. Discovery’s portfolio of channels includes many which are linear-only where viewing is falling …

Sky has a strong track record of understanding the value of the content we acquire on behalf of our customers, and as a result we’ve taken the decision not to renew this contract on the terms offered …

We have been overpaying Discovery for years and are not going to anymore. We will now move to redeploy the same amount of money into content we know our customers value.”

Here we have a classic case of two firms in negotiation; each with a lot to lose, but both wanting the best outcome. There are hundreds of channels with millions of programmes and hence it is a competitive market. So why was it that Discovery could pose such a threat to the huge broadcaster? The following articles consider the dispute and the eleventh hour agreement.

Discovery strikes deal to keep channels on Sky BBC News (1/2/17)
Discovery channel strikes last-minute deal with Sky to stay on TV, saving Animal Planet and Eurosport Independent, Aatif Sulleyman (1/2/17)
Eurosport stays o Sky after late deal is struck with hours to spare between broadcasting giant and Discovery Mail Online, Kieran Gill (1/2/17)
Discovery averts UK blackout with Sky in last-minute deal Bloomberg, Rebecca Penty, Joe Mayes and Gerry Smith (1/2/17)
Is Sky losing Discovery? Eurosport, Animal Planet and other fan favourite set to stay International Business Times, Owen Hughes (1/2/17)
Discovery goes to war with Sky over channel fees with blackout threat The Telegraph, Christopher Williams (25/1/17)

Questions

  1. Can you use game theory to outline the ‘game’ that Sky and Discovery were playing?
  2. Is the ‘threat’ of stopping access to channels credible?
  3. Although we don’t know the final financial settlement, why would Sky have had a reason to increase the price it paid to Discovery?
  4. Why would it be in Discovery’s interests to accept the deal that Sky offered?
  5. Susanna Dinnage suggested that Sky was using its dominant market position. What does this mean and how does this suggest that Sky might be able to behave?
  6. What type of market structure is the pay-TV industry? Think about it in terms of broadcasters, channels and programmes as you might get very different answers!