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Issue 29/3 November 2010

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Today’s Issue Includes:

1) Can UK growth survive the coalition cuts? By Hetal Mehta, UK Economist, Daiwa Capital Markets Europe Limited.

UK GDP figures often surprise commentators in one way or another, and the latest figures were no different. The preliminary estimate from the Office for National Statistics put Q3 growth at 0.8%Q/Q, twice the rate most expected. Not only that, but growth was apparently broad based. The services sector continued to expand at a healthy pace, with growth quite evenly spread between the sub-sectors, while construction growth did not decline as much as expected given the exceptional pick up in Q2. And even though manufacturing growth fell markedly from Q2, it remained well above its long-run average.

Yet, coming on the back of the 1.2%Q/Q GDP growth seen in Q2, a key question is whether the UK economy is set to continue what has become a rapid recovery. Expectations that will be the case, however, ignore the still substantial headwinds facing the UK economy. Most notable of these is the unprecedented fiscal consolidation the government remains intent on implementing. While there is little disagreement that there are long-run benefits from debt reduction, there is considerable debate amongst economists as to whether the short-term impact will follow a traditional Keynesian trajectory, whereby activity falls and unemployment rises, or whether tightening fiscal policy could lead to a so-called ‘expansionary fiscal contraction’. (1)

In our view, the chances that the sort of tightening being put in place by the government proves expansionary are very slim. In those rare episodes where such a phenomenon has been seen, there have been a number of critical factors at play that the UK cannot rely on this time round. Most crucially, fiscal tightening, particularly if the emphasis falls mainly on spending cuts rather than tax hikes (as is the case in the UK presently), is usually coupled with a reduction in interest rates. However, the Bank of England base interest rate is already at its effective floor. At the same time, for all the talk from the Chancellor, George Osborne, that he has brought the country ‘back from the brink of bankruptcy’, the risk of the UK defaulting was never remotely plausible. Certainly, the gilt market never thought the UK was on the verge of bankruptcy, with yields even before the June Budget very low by historic standards. So, interest rates have little realistic room to fall much further.

Chart 1: 10Y gilt yields

chart 1: 10Y gilt yields

Source: Haver Analytics

Hand-in-hand with lower interest rates, of course, should go a weaker exchange rate, and in turn, an export-led recovery. But while sterling fell substantially even before the coalition government took office, unlike some previous successful fiscal consolidations, including that in the 1990s where a potent combination of currency depreciation in the aftermath of ERM ejection and booming world trade prevailed, this time there remain few signs of an export-led recovery. Indeed, the deceleration in the manufacturing sector in Q3 suggests that the contribution from net trade was likely to have again been disappointing, and we are not optimistic that the contribution will pick up significantly in the near term.

Another channel through which fiscal consolidation could possibly boost growth is through increasing consumer and business confidence. But this is most applicable to countries where the fiscal position is improved from something much more precarious than anything the UK faces. Indeed, surveys suggest that, if anything, consumer confidence has been dented by the deficit reduction plans. On top of that, while UK households were willing and able to borrow and spend freely after the last recession, they are not in a position to contribute very much this time. Indeed, many of those households that still have access to credit – which according to the latest lending data show are not many – are weighed down with the debt of the previous decade, and a subdued outlook for the labour market will not help either, especially since 500,000 public sector workers are due to lose their jobs as part of the consolidation plans. Furthermore, restricted credit and consumer caution are contributing to a renewed slump in the housing market.

Finally, and perhaps most fundamentally, unlike the previous four post-war recessions, which were primarily as a result of contractionary monetary policy, the recent recession has its roots in a financial crisis, leaving a legacy of overloaded household balance sheets and bust banks. History teaches us that recoveries from these recessions tend to be slow, tentative and protracted. (2)

So, all in all, the government’s fiscal consolidation is not likely to prove the exception rather than the rule. If anything, it is going to be a longer, harder slog to claw back the ground lost to this recession than experienced in recent history, particularly given that much of the rest of the world is embarking on fiscal consolidation at the same time. As such, we expect growth to slow in the coming quarters. Even though consumers are likely to bring forward spending ahead of the upcoming VAT increase in January, we think it is unlikely that growth will hold up at a similar pace in Q4 to that seen in the middle of the year. And we envisage growth slowing further still as we head into 2011, and expect GDP growth of just 1.6%Y/Y for next year.

Chart 2: GDP in recessions

chart 2: GDP in recessions

Source: Haver Analytics and ONS

(1) For a more detailed discussion, see “Will It Hurt? Macroeconomic Effects of Fiscal Consolidation”. Chapter 3 of the IMF’s October 2010 “World Economic Outlook”

(2) See Reinhart, Carmen M. and Rogoff, Kenneth S., (2008) “Is the 2007 U.S. Subprime Crisis So Different? An International Historical Comparison”

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2) Why Should the OFT Care About Price Discrimination? By Maziar Homayounnejad, Queen Elizabeth's School, Barnet

Is price discrimination (PD) a good or a bad thing for society? In other words, when firms charge different prices to different customers for essentially the same product, does this promote or undermine consumer interests? This is an important question for the Office of Trading (OFT), which has to prioritise its efforts and resources only on business conduct that poses the greatest threat to consumer welfare. By evaluating the pros and cons of PD in its various contexts, we can assess more clearly if and when the OFT should intervene.

Evaluation I: Uniform Pricing versus Perfect Price Discrimination and the Achievement of ‘Ramsey Pricing’(1)

Let’s start by reviewing the pricing decision of the standard profit-maximising monopolist.

The firm will charge the same price for each unit (i.e. uniform pricing) and will set the price (or output) such that MR is equated with MC. For simplicity, we shall assume there is constant AC and MC

chart 3

The profit-maximising price will therefore be Pm and the associated output Qm. At this point on the diagram:

  • The firm makes a profit equal to the area vxyw;
  • Consumer surplus is uxv;
  • Producer surplus is vxyw – the same as profit in this case.
  • But is this really the maximum profit available?

    Under uniform pricing, yes. To increase output beyond Qm would mean lowering price, hence losing some of the revenue and profit earned from the existing high-paying customers (i.e. all the customers from points u to x on the demand curve). MC would be greater than MR, so each additional unit sold beyond point Qm would reduce overall profit.

    But to increase price would also mean losing revenue and profit as some high-paying customers would be priced out of the market (e.g. customer x’s consumer surplus is already zero at price Pm, so even a tiny price rise will cause him to exit the market). MR would be greater than MC, meaning greater profit can still be made simply by lowering price and raising output.

    But what if the monopolist could perfectly price discriminate (PPD) by charging each and every customer the maximum he is willing to pay for the good?

    Point u on the demand curve indicates the willingness to pay of the individual who values the good most highly. The monopolist would therefore charge that person a price given by the distance 0u. The individual with the next highest valuation (just to the right of u on the AR curve) is charged a slightly lower price and so on, all the way down to customer x, who is also charged his maximum price, Pm. So far, the monopolist has succeeded in capturing the entire consumer surplus from the original set of customers, thereby increasing profits from vxyw to uxyw. In other words, the firm has secured additional profits amounting to uxv.

    But even more profit is now available. The monopolist can expand production from Qm to Qc through gradual price cuts only for each new customer acquired between points x and z. So the next customer just to the right of x is charged a price slightly less than Pm and so on, until we get to customer z, who is charged only the marginal cost of production, Pc.

    For the monopolist, this scenario of PPD remains true to the MR = MC condition for profit-maximisation. The D curve has effectively become the MR curve, and is thus equated with MC at point z. Furthermore, PPD will enable the monopolist to capture the entire additional surplus, thereby increasing total profit to uzw.

    So much for the monopolist’s profit-maximisation objective. Society also gains as it avoids the situation of deadweight loss, which would have been xzy under uniform pricing. From an economic efficiency point of view, PPD is therefore allocatively efficient, as some poorer consumers (i.e. those between x and z) who were previously unable to afford the good are now able to purchase it. This benign situation was first discussed in 1927 by the English economist Frank Ramsey, hence it came to be known as ‘Ramsey pricing’.

    This same argument applies equally well to the more common third-degree PD.

    chart 4

    Here, the monopolist train operator has identified two markets each with a different willingness to pay (i.e. PED). The higher price of PA will enable the firm to recover a larger proportion of fixed costs from commuters, hence allowing it to charge students the lower price of PB (even if this lower price only covers the marginal cost of serving those students).

    If the firm had to set a uniform price, it would most likely charge the higher price of PA, depriving students of its service. Hence with PD, the poorer consumers (students) get to purchase a service they would not otherwise have been able to afford. Once again, we see Ramsey pricing making the industry more allocatively efficient. In such a case, PD should be applauded by the OFT, which need not intervene in the market or be concerned in any way with its workings.

    Evaluation II: Profit-Maximisation as a Benign Factor

    When the monopolist practises PD, consumer surplus is extracted and turned into producer surplus. Profits are therefore maximised at the expense of consumer welfare although, as we have seen, total welfare does rise. However, could this situation eventually be in the interests of consumers who are left with little or no surplus?

    The answer is yes. If the monopolist re-invests its additional supernormal profits to improve product quality or to develop newer technologies, this may arguably benefit consumers in the long-run.

    For example, a pharmaceutical firm may sell a range of cancer drugs, charging high prices to private hospitals, lower prices to the NHS and even lower prices to charities supplying medicine to the third world. In such a case, the substantial profit made from the private sector, combined with the additional profits made from the NHS and the charities, can go into R&D to develop newer and more advanced cancer drugs.

    Clearly, if the price was uniformly high, only private hospitals would buy the drugs and this would deprive the pharmaceutical firm of the economies of scale gained from selling to the NHS and the charities. In such a case, the firm’s R&D efforts would be severely compromised. If the price was uniformly low, however, the pharmaceutical firm would forgo the additional supernormal profits that would have been gained from the private sector, again hampering R&D efforts.

    Hence to maximise the firm’s potential for innovation and quality, both sub-markets must be acquired and charged the appropriate price. Again, PD in this context works in the consumer’s interest and should be applauded by the OFT.

    Evaluation III: Abuse of a Dominant Position

    However, PD does not always guarantee such benefits. In Assessment of Conduct (2004), the OFT argued that PD may indeed be against consumer welfare if it is exclusionary or exploitative.

    Exclusionary PD

    One example of this is where a vertically integrated firm uses its dominant position in an upstream market to set discriminatory prices, in order to eliminate competition in a related downstream market. This invariably amounts to an abuse of a dominant position, contrary to both UK and EC competition law.

    Consider the following example:

    chart 5

    In this hypothetical supply chain, Heinz competes with HP and ‘W’ in the market for ketchup manufacturing (i.e. the downstream market). However, in the market for growing fresh tomatoes (i.e. the upstream market, which provides an essential input for ketchup manufacturing), Heinz occupies a dominant position and is therefore a price-maker.

    Should Heinz Tomato Farms decide to price discriminate, it is fairly clear which pricing policy will be in their interests. Tomatoes at £50 per tonne to Heinz Ketchup Manufacturing, but £1,000 per tonne to HP and ‘W’ will clearly put Heinz’s downstream competitors at a huge cost disadvantage, thereby causing a ‘margin squeeze’ and possibly eliminating them in the long-run. Such discriminatory pricing would be considered exclusionary and therefore against the interests of consumers. The OFT would be rightly concerned with such nefarious conduct and fully justified in taking action to restrain the dominant firm’s pricing policy.

    In practice, exclusionary PD has been found in a variety of markets. For example,

  • In the Port of Genoa case, the Port (which was owned by P&O Ferries) charged P&O very low fees to dock its vessels, while charging very high docking fees to its rival ferry companies;
  • In the telecoms industry, Telefonica (a former state monopoly in Spain, which still owns the country's telephone exchange network) was fined €151m for 'unfair internet prices'. The firm charged its own broadband division low fees to access the telephone exchange, while charging rival Internet service providers very high wholesale prices to go through the same network;
  • Finally, BSkyB has also been investigated by the OFT for exclusionary PD. The firm was suspected of supplying premium pay TV channels such as Sky Movies and Sky Sports very cheaply to its own distribution company (Sky TV), while charging rival distribution companies (like Cable & Wireless, Telewest, etc) punitively high fees for these same channels.
  • Exploitative PD

    Can PD allow a firm to exploit market power by charging unfairly excessive prices to certain customers? In Competition Policy and Innovation (2001), the OFT elaborated on this issue of exploitative PD.

    At page 6, it argued that where PD deprives ‘captive’ customers of the protection they normally receive from competition among firms for the business of ‘non-captive’ customers, this may simply be designed to unfairly exploit market power.

    Using the Heinz example, we can imagine a situation where tomatoes are also supplied to firms producing packaged salads. Clearly, tomatoes are not an essential ingredient for such a product (salads without tomatoes but with carrots instead may be feasible). And even if they are considered essential, the salad manufacturer has some discretion over the quantity of tomatoes to use (half a tomato if prices are high, two whole tomatoes if cheap). Heinz Tomato Farms will therefore have an incentive to provide this product cheaply to the salad manufacturers.

    On the other hand, manufacturers of tomato ketchup have no choice but to use tomatoes as these are an essential input in their production process. This makes the ketchup manufacturers a ‘captive’ customer of the tomato farm monopoly. Should Heinz charge an excessively high price to the ketchup manufacturers, knowing that they have nowhere else to buy this essential input, this may be deemed exploitative and an abuse of a dominant position.

    In practice, exploitative PD has been found to operate in a variety of markets, especially in retail banking. For example, higher interest rates are often charged to ‘captive’ small firms who have little choice over where they borrow money. In contrast, larger firms who can sell shares, issue bonds or borrow easily from foreign banks are often given lower interest loans from the retail banking sector in the UK. Again, the OFT would rightly be concerned with this situation, which justifies a market study and further action where necessary to prevent exploitation.

    (1) In writing this Evaluation I section, the author would like to thank Geoff Stewart for allowing him to draw extensively from his article, 'Price Discrimination', Economic Review, 20(3), February 2003.


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