5. Managerial economics/Theory of the firm
5.1
5.2
5.3
5.4
5.5
5.6
5.7
5.8
5.9
5.10
5.11
5.12
5.13
5.14
Economist article
Digging in/On the track of
a monopoly
Direct from source/Out of
vogue/The price of
powder/Sniffy customers
Direct from source/Out of
vogue
A thicker blue line/The
law and the profits
Who needs paper?
Out of rooms
Outsourcing as you sleep
The battle of the bourses
Concept
Market power
Market power
Market power
Market power
Costs
Contracting-out
Contracting-out
Competitive market
dynamics
The rush/Precious but
Competitive market
precarious
dynamics
Flying from the computer
Competitive market
dynamics
The price of powder/Sniffy Monopolistic competition
customers
How the west got lost
Monopolistic competition
and subsidy
Media’s two tribes:
Price discrimination
Charging for content
They’re watching you
Price discrimination
Economist work-out 5.1
Read the attached articles: Article A - ‘Digging in’ (The Economist, September 4
2010, page 78) and Article B - ‘On the track of a monopoly’ (The Economist, April
24 2010, page 36).
Some questions to consider
Article A:
1. How could China restricting supplies of ‘rare earths’ for export be seen as a way of
creating market power in the supply of finished goods which use ‘rare earths’ as
inputs?
2. How does the article suggest that its market power may be eroded?
Article B:
3. Why could supply of the rail infrastructure from the train service to Macchu Picchu
be considered a natural monopoly?
4. How is Peru Rail using its control of the rail line as a source of market power in the
market for supplying rail travel to Macchu Picchu?
5. What trade-off in efficiency is caused by having a monopoly supplier of rail travel
because there is a natural monopoly in rail infrastructure? Do you think it is
necessary to have a monopoly supplier of rail travel as a consequence of there being a
natural monopoly in rail infrastructure?
This article (‘Digging in’, The Economist, September 4 2010, page 78) is reproduced
with kind permission of The Economist for use only for teaching purposes
(www.economist.com).
Digging in
BEHIND the rise of resource-poor countries like Japan, South Korea and China into
industrial giants has been the readiness of other countries to sell them critical
commodities, albeit sometimes at excruciating cost. An unfolding collision around a
group of elements known as "rare earths" is seen by some as a test of China's
willingness to reciprocate.
Rare earths have become increasingly important in manufacturing sophisticated
products including flat-screen monitors, electric-car batteries, wind turbines and
aerospace alloys. Over the summer prices for cerium (used in glass), lanthanum
(petrol refining), yttrium (displays) and a bunch of other –iums have zoomed upward
(see chart) as China, which accounts for almost all of the world's production, squeezes
supply. In July it announced the latest in a series of annual export reductions, this
time by 40% to precisely 30,258 tonnes. That is 15,000-20,000 tonnes less than
consumption by non-Chinese producers, says Judith Chegwidden of Roskill
Information Services, a consultancy.
China has cited "environmental" concerns as the reason for the export quotas. That is
less implausible than it sounds. Rare earths are dangerous and costly to extract
responsibly; China's techniques have been anything but. It has deposits in two
regions: Inner Mongolia, where rare earths are a by-product of iron-ore production,
and in the south of the country, where they are found in various clays. Although the
extraction process in each location differs, they share a need for highly toxic
chemicals. Horror stories abound about poisoned water supplies and miners.
But since the spike in rare-earth prices seems not to have taken hold within China,
many see another, more nefarious calculation behind the export quotas. Controlling
the supply of rare earths means that China can also control their processing and use in
finished goods, which would fit a broader effort to drive its manufacturers from lowto high-value goods.
If that is the Chinese plan, time is limited. High prices have already begun to propel a
supply response elsewhere in the world. Ms Chegwidden says announcements of rareearth projects around the world have accelerated in recent months. Molycorp, an
American firm which in various guises dates back to the early 1950s, intends to
restart what was once the world's largest source of rare earths, a mine in California
closed in 2002 over environmental concerns and the then unjustifiable cost of
correcting them. In July it raised $394m in an initial public offering; its shares have
risen by 20% since.
Similarly, Lynas Corporation of Western Australia has seen its shares rise eight-fold
since early 2009, shortly before a state-owned Chinese company attempted to make
an investment that was itself blocked by the Australian government. Toyota is
reported to be close to securing key supplies in Vietnam; Sumitomo, another Japanese
firm, is moving forwards in Kazakhstan. "The problem of supply is easily solved,"
says John Kaiser of Kaiser Bottom-Fish Online, a website on mining. "It just takes
three to five years and billions of dollars." China has long seen commodities in terms
of security of supply. It may yet persuade others to follow suit.
This article (‘On the track of a monopoly’, The Economist, April 24 2010, page 36) is
reproduced with kind permission of The Economist for use only for teaching purposes
(www.economist.com).
On the track of a monopoly
EARLIER this month the railway link to Machu Picchu, the ruined Inca citadel that is
Peru's foremost tourist attraction, reopened after a two-month gap caused by floods
that washed away stretches of the line in January. For the moment just 900
passengers a day--less than a third of the normal number--can be carried, and they are
bused from Cusco, travelling only the last stretch by train. PeruRail, the operator,
hopes to restore normal service next month. But repairing the line is not its only
problem.
The railway involves a natural monopoly: the only other way of getting to the ruins
is a four-day hike along the Inca Trail. When it privatised the line in 1999, the
government of President Alberto Fujimori was eager to attract foreign investment. It
granted a 30-year concession to PeruRail, which is managed and half-owned by
Orient-Express Hotels, a Bermuda-based company.
PeruRail invested in new trains, but even so its monopoly has been highly lucrative. It
carries 1.1m passengers a year and fares for the 110km (70 miles) journey from
Cusco start at $96. Orient Express owns luxury hotels and trains around the world. It
lost $69m last year, but made a profit of $12.8m from PeruRail and four hotels in
Peru. One is a formerly state-owned hotel overlooking the ruins at Machu Picchu
where rooms now start at $825 a night.
Three other companies would like to run train services on the line to Machu Picchu,
but they have been thwarted by a string of lawsuits from PeruRail. One of the
newcomers, Inca Rail, a Peruvian company, finally began offering services in
November; another, Andean Railways, a Peruvian-American venture, plans to start
soon.
They got a boost last month when a preliminary report from Indecopi, Peru's
competition watchdog, accused PeruRail and two related firms of a "predatory
strategy" involving sham litigation to force rivals out of business, and recommended
they be fined $10.8m. PeruRail says it will fight the recommendation, which it claims
is without merit.
A final ruling from Indecopi's antitrust tribunal will not come for another year. Since
capacity at the ruins is limited, so is the scope for more services to Machu Picchu
itself. But competition might well lower fares and bring more tourists to the valleys
on either side.
Economist work-out 5.1
Solutions
Article A:
1. How could China restricting supplies of ‘rare earths’ for export be seen as a way of
creating market power in the supply of finished goods which use ‘rare earths’ as
inputs?
China currently accounts for all global production of rare earths. Rare earths are an
essential input for manufacturing products such as flat-screen monitors, electric car
batteries and wind turbines. Hence by restricting exports of rare earths, and thereby
restricting those rare earths to use within China, there is a reduction in the number of
suppliers who will compete with Chinese manufacturers of goods such as flat-screen
monitors. As the article suggests: ‘Controlling the supply of rare earths means that
China can also control their processing and use in finished goods...’.
2. How does the article suggest that its market power may be eroded?
Restricting exports of rare earths from China has caused an increase in the world price
of those products. This increase in price (and the necessity of rare earths for Japanese
firms such as Toyota to be able to make products such as electric car batteries) has
caused entry of new suppliers to the rare earth market – such as Molycorp and Lynas
Corporation. The entry of new suppliers will mean that Chinese suppliers using rare
earths to make products such as electric car batteries will ultimately face renewed
competition.
Article B:
3. Why could supply of the rail infrastructure from the train service to Macchu Picchu
be considered a natural monopoly?
It is a natural monopoly because one supplier is able to supply the rail infrastructure
more cheaply than having more than one supplier. In this case, if there is one supplier,
it will need to build one rail line. If there is another supplier it would also need to
build a rail line. Hence (assuming both rail lines cost the same amount to build) the
average cost of having two suppliers of rail infrastructure will be twice that of having
a single supplier.
4. How is Peru Rail using its control of the rail line as a source of market power in the
market for supplying rail travel to Macchu Picchu?
Peru Rail has been able to use its ownership of the rail line to achieve market power
in the market for supplying rail travel by not allowing other potential suppliers of rail
travel to Macchu Pichu to use the rail line.
5. What trade-off in efficiency is caused by having a monopoly supplier of rail travel
because there is a natural monopoly in rail infrastructure? Do you think it is
necessary to have a monopoly supplier of rail travel as a consequence of there being a
natural monopoly in rail infrastructure?
The trade-off is that: It is efficient to have just a single supplier of the rail line
infrastructure; but by having a single supplier of rail infrastructure the likelihood of
there being a lack of competition in the market for rail travel is increased.
It doesn’t seem necessary to have a monopolist supplier of rail travel just because it is
efficient to have a monopolist supplier of the rail line. The Peruvian government
could allow Peru Rail to own the rail line, but then regulate that access should be
allowed to the rail line for any suppliers wanting to provide rail travel (for example,
what times they can run on the rail line, and how much they need to pay to Peru Rail
for using the rail line). By doing this it can potentially achieve efficiency in both
markets – by having a monopolist supplier of the rail infrastructure, but a competitive
market for supply of rail travel to Macchu Pichu.
Economist work-out 5.2
Read the attached articles ‘Direct from source’ (Article A, The Economist, April 19
2008, pages 74-75); ‘Out of Vogue’ (Article B, The Economist, September 29 2007,
pages 68-69); and (Article C - ‘The price of powder’, The Economist, November 27
2004, pages 65-66, and Article D - ‘Sniffy business’, The Economist, March 7 2009,
pages 28-29).
Article A
1. What has caused the greater scope for product differentiation in the market for
coffee beans? How would you compare the market power of suppliers in African
countries such as Ethiopia with suppliers in Latin American countries? How would
you expect that this would affect the profit-maximising price that each supplier can
charge?
Article B
2. How has the market power of magazines in the United States and Europe been
affected by the internet? Explain your answer using the concepts of barriers to entry
and product differentiation.
Articles C and D
3. From the articles what would you describe as the main sources of market power for
wholesale dealers of cocaine?
This article (‘Direct from source’, The Economist, April 19 2008, pages 74-75) is
reproduced with kind permission of The Economist for use only for teaching purposes
(www.economist.com).
Direct from source
COFFEE prices are the highest they have been for a decade. As consumers in India
and China develop a taste for the drink, prices are likely to keep rising. Meanwhile
something new is happening in developed markets. Europeans, Americans and
Japanese are switching to higher-quality coffee. Discerning consumers now demand
authenticity: they want stories about where their coffee beans come from. So the best
coffees will increasingly be differentiated, like fine wines and spirits, and sold at
previously unthinkable prices.
The move from instant-coffee powder to luxury beans is in some ways reminiscent of
what happened when the Scotch-whisky industry shifted from cheap blends to
expensive single malts, each with its own story. But where the whisky revolution was
masterminded by distillers, the coffee revolution is a messier insurgency. Gourmets
and specialist roasters have pushed up expectations. Governments, activists and
"ethical" coffee suppliers have worked to get higher prices.
All this is good news for coffee farmers in east Africa. Altitude, climate, soil and
genetic diversity give the region an inherent advantage in quality. With lower-grade
Latin American coffee dominating the market, there is scope for the best coffees from
Ethiopia, Kenya, Tanzania and Rwanda to establish themselves.
Ethiopia is the largest African producer. Its coffee sales last year were $425m,
representing 36% of export earnings. It has a story to tell: an Ethiopian goatherd,
Kaldi, is said to have discovered coffee's stimulating properties in the 9th century.
Already, 40% of its production is premium coffee. Until recently, however, that did
not yield higher prices for farmers. When the commodity price was low, villages
starved.
An agreement signed last year between Starbucks, the world's biggest coffee chain,
and the Ethiopian government has been touted as a big step forward. Starbucks had
objected to the government's plan to trademark the names of three local coffee
varieties. The firm worried that having to license these trademarks would introduce
legal complexities that might deter it and others from buying trademarked beans,
thereby hurting farmers. Critics think the numbers used by activists to shame
Starbucks were shaky. Others argue that farmers would gain a lot more if African
governments were bullied into cutting bureaucracy and building infrastructure.
What is beyond doubt is that the three varieties in question--Harar, Yegarcheffe, and
Sidamo--are among the finest beans in the world. The hope is that trademarking these
regional varieties will establish them as brand names and enable farmers to demand
higher prices. Might geographical indicators, like the appellation contrôlèe system in
French wine, have been a better option? The head of the Ethiopian Intellectual
Property Office, Getachew Mengistie, thinks not. The coffee varieties were not
strictly regional, he explains, so a wine-style designation would have made no sense.
Nor was the money or time available to pursue a complicated certification process.
Instead, Ethiopia has quickly licensed its brands to 70 suppliers worldwide, including
Starbucks.
Licensees agree to use the brand names and to educate consumers about the
characteristics of the different varieties. By allowing licensees to use the trademarks
without paying royalties, Ethiopia is, in effect, trading their use for free marketing.
(Colombia, for example, runs advertisements in rich countries to promote its coffees,
which Ethiopia cannot afford.)
Rick Peyser of Green Mountain Coffee Roasters, an American supplier which counts
Yegarcheffe among its premium coffees, thinks it will be only a matter of time before
the trademarks start to improve the lives of farmers. Ethiopia is now planning to
extend the trademark approach into new areas, such as traditional medicines and
certain types of teff, the country's usefully gluten-free staple cereal crop. But coffee,
an unparalleled genetic resource, with over 5,000 varieties, will remain the biggest
earner.
This article (‘Out of vogue’, The Economist, September 29 2007, pages 68-69) is
reproduced with kind permission of The Economist for use only for teaching purposes
(www.economist.com).
Out of vogue
This week bankers have a perfect excuse to pore over pictures of scantily clad models,
fast cars and film stars: Emap, a British media firm that straddles consumer
magazines, radio and trade exhibitions, is up for sale, and bids are due by early
October. Emap has 50 magazine titles, which produced revenues of £408m ($773m)
in the year to March 2007, and its sale will attract international attention. Foreign
publishers are expected to bid, as are private-equity firms. The outcome will be a
timely judgement on the prospects for consumer-magazine publishers in the
developed world.
In America and Europe magazine publishers have a common lament: total circulation
is either flat or declining slightly as people devote more time to the internet, and an
ever greater share of advertising spending is going online. Magazine units are mostly
a drag on growth for their parents. Time Inc, the world's biggest magazine company,
has to fend off rumours that its parent, Time Warner, will sell it. People in the
industry expect that Time Warner will soon sell IPC Media, its British magazine
subsidiary. In Germany publishers reckon that Bertelsmann, a media conglomerate,
may sell Gruner + Jahr, its magazine unit, when its new chief executive takes over in
January 2008.
"It's a long, slow sunset for ink-on-paper magazines," says Felix Dennis, a publishing
entrepreneur, "but sunsets can produce vast sums of money." He recently sold his
firm's American arm, which publishes Maxim, a racy men's magazine, to Quadrangle
Capital Partners, a private-equity business, for a reported $240m.
The business model for consumer magazines is under pressure from several directions
at once, both online and off. Magazines have become more expensive to launch, and
the cost of attracting and keeping new subscribers has risen. In America newsstand
sales have been worryingly weak, partly because supermarkets dominate distribution
and shelf-space is in short supply.
The internet's popularity has hit men's titles the hardest. FHM, Emap's flagship "lads"
magazine, for instance, lost a quarter of its circulation in the year to June, its lingerieclad lovelies finding it hard to compete with online porn. Not long ago consumer
magazines were Emap's prize asset, but slowing growth from the division contributed
to the company's decision to put itself up for sale. Men's magazines are in trouble in
most developed-world markets. In France, America and Italy, the three biggest
magazine markets for Lagardère Active, part of Lagardère, a French conglomerate,
men have quickly switched from magazines to online services, says Carlo d'Asaro
Biondo, the division's head of international operations. "We have solved the problem
in the automotive sector with new web services," he says, "but no magazine publisher
has cracked the problem as a whole yet."
There are good reasons why magazine owners should not feel despondent, however.
For readers, many of the pleasing characteristics of magazines--their portability and
glossiness, for instance--cannot be matched online. And magazines are not losing
younger readers in droves in the way that newspapers are. According to a study
carried out last year by the digital arm of Ogilvy Group, a communications company,
appetite for magazines is largely unchanged between older "baby boomers" and
young "millennials".
On the advertising side, magazines are faring much better than newspapers, which are
losing big chunks of revenue as classified advertising shifts online. Advertisers like
the fact that in many genres, such as fashion, readers accept and value magazine ads
and even consider them part of the product.
Unfortunately, magazine publishers have been slow to get onto the internet. "Eighteen
months ago the internet was something they worried about after 4pm on Friday," says
Peter Kreisky, a consultant to the media industry, "but now it's at the heart of their
business model." Meredith, a magazine publisher from the mid-west of America with
old-fashioned brands such as Better Homes and Gardens, recently held an internet
"boot-camp" for its executives to teach them internet basics.
To their credit, big magazine firms are doing far more than replicating their print
products online. Whereas newspapers have concentrated on transferring print
journalism to the internet, magazines offer people useful, fun services online-Lagardère's Car and Driver website, for instance, offers virtual test drives, and Better
Homes and Gardens online has a 3D planning tool to help people redesign their
homes.
Magazine firms disagree on whether to take existing brands online or try to do
something new for the internet. Condé Nast believes it can cast a wider net by
creating themed websites that use some magazine content but also go beyond to
appeal to a bigger market. "You've got to have scale on the internet, and magazine
brands can be limiting online," says Sarah Chubb, president of CondéNet, the firm's
internet division, which runs a number of portals such as STYLE.com. Some
magazine editors have objected. Anna Wintour, the editor-in-chief of Vogue, is said
to have noted the popularity of STYLE.com and asked why it couldn't be called
Vogue.com. (American Vogue will in fact get its own website soon.)
Time Inc, in contrast, has stuck to its big magazine brands with People.com and with
SI.com, its website for Sports Illustrated. The price, competitors say, is that Time Inc
cannot do the sort of sarcastic, bitchy celebrity gossip that people like on the internet
for fear of tarnishing the brand of People, and therefore cedes first place for
entertainment to TMZ.com (also owned by Time Warner), which excels at it. But
People.com is able to charge advertisers a premium, points out John Squires,
executive vice-president of Time Inc, because of the quality of its brand. And surfers
are highly engaged with People online: in June each visitor to the site looked at an
average of 85 pages, compared with 13 for TMZ.com. In financial terms, says Mr
Squires, People.com would now rank among the firm's most profitable monthly
magazines.
The internet still brings magazine companies a fraction of what they earn in print.
Publishers have found that websites are good at winning and keeping subscribers, but
few pay their own way. If Emap closed down all its magazine sites tomorrow, says a
publishing executive, the company would make more money. Even though magazine
firms have built attractive sites, says Andreas von Buchwaldt of OC&C Strategy
Consultants in Hamburg, huge independent communities on the internet have often
already formed, and it is hard for magazine brands to achieve leading positions. In six
countries in Europe including France and Germany, for instance, an internet-only
brand, auFeminin.com, dominates the women's category.
Before the credit crunch, observers expected some or all of Emap to go to private
equity. Now publishing firms are perhaps better placed to win. It is possible that no
one will pay a good price for consumer magazines at the moment. That would add to
the industry's gloom. But it might also encourage media conglomerates to stick at
magazines and have a proper go at revamping them for the digital age.
This article (‘The price of powder’, The Economist, November 27 2004, pages 65-66)
is reproduced with kind permission of The Economist for use only for teaching
purposes (www.economist.com).
The price of powder
FOLLOWING a quiet spell, Britain's war on drugs seems to be heating up. This week,
the Home Office unveiled legislation that will create a Serious Organised Crime
Agency (SOCA), which, it is promised, will conduct "a specialist and relentless
attack" on racketeers. Suspected traffickers will be compelled to produce documents
and drug kingpins encouraged to inform on one another. Other legislation will force
more addicts into treatment.
Hopes are high, which is surprising given the failure of previous efforts. Street prices
of Class A drugs have fallen steadily in recent years (see chart) and the number of
users has risen. Drug traffickers are running slicker businesses. "We dealt with a team
a while ago that had a director of operations and a director of finance, and they
actually called them that," says Bill Hughes, the appointed director-general of SOCA.
More importantly, they are running a different kind of business.
The drugs trade used to be dominated by stable, vertically integrated outfits
resembling mini-Mafia families. That was a response to the risks of doing business.
Drug buyers may be undercover police officers; promises to pay may be broken (these
are criminals, after all); trusted contacts may be jailed and rivals get shopped. Stable
partnerships reduced these risks, as did recruitment from a shallow ethnic pool. But
market forces have gradually pushed these cumbersome organisations out of business.
Competition in the cocaine trade has cut margins to minuscule levels, considering the
risks involved. Powder cocaine from central America is sold in multiple-kilogram
loads for £15,000-30,000 ($28,000-56,000). But the price for a single kilogram,
£18,000-32,000, is barely higher, and the retail price not much more than that. Last
year, the National Criminal Intelligence Service estimated that cocaine was selling for
£56 per gram (equivalent to £56,000 per kilo) but the current London price is said to
be around £40 per gram.
The falling price of powder is especially striking considering the supply problems of
recent years. The United Nations Office of Drug Control (UNODC) estimates that
global coca leaf production has fallen every year since 1999, from 353,000 to 236,000
tonnes. And, unlike heroin, cocaine is perishable, which means it cannot be stockpiled
against lean times.
Margins are fatter in the heroin trade. Importers, many of them London-based Turks,
sell multi-kilo loads to white British middlemen at £16,000-22,000 per kilo. The
middlemen, who rarely deal in any other product, sell on to retailers at prices up to
£33,000 for a single kilo, enhancing profits further by adulterating the drug. Heroin is
then cut again before being sold on the street for the equivalent of £60,000 per kilo.
The reason why the cocaine price has fallen so much is that the market is opening
up. Dave King, a drugs specialist at the National Crime Squad, says that the Londonbased Colombian importers who traditionally controlled the import and wholesale
trades now contract freely with British entrepreneurs. A recent trend is for Britons
living in Spain to deal directly with Central American suppliers before selling on to
Colombians in London or directly to an army of middlemen.
New importation routes open frequently, sometimes as a result of police activity.
Operation Airbridge, a co-operative Jamaican and British venture, proved so
successful that traders have explored other routes through the Caribbean.
Improvements in Spanish policing have encouraged traffickers to ship cocaine
through Africa, where it can be bundled with other drugs likely to interest the same
consumer. One of the biggest domestic seizures this year came from a warehouse in
west London. Among a shipment of pineapples and vegetables from Ghana were ten
kilos each of cocaine and marijuana.
By contrast, the heroin trade is more closed and less innovative. Mr King believes
that is partly because demand for heroin is more inflexible than demand for other
drugs. Reliability of supply is more important than price, which means there is less
shopping around at any stage of the supply chain. Another barrier to greater
competition is linguistic. To move cocaine from producer to market, English and
Spanish are essential; to move Ecstasy, it helps to speak Dutch. But as many as 120
languages, from Italian to Pashto, are spoken by those involved in the heroin trade.
That makes it tricky to seek out new sources or new routes.
Heroin traffickers do not constitute a cartel, though. They behave more like members
of an oligopoly, with a mixture of competition and co-operation at the highest levels
of the trade. Paul Evans, chief investigation officer at Customs and Excise, says that
this can extend to emergency relief: "if your shipment hasn't arrived, someone else
will loan you stuff to tide you over."
Such cosy arrangements are likely to break down as new players enter. Turkish
importers have already lost business to Kurds and Albanians--both groups now
scattered across Europe, thanks to instability at home and higher immigration into rich
countries. British-based Colombians squeezed out of the cocaine trade are dabbling in
the more profitable opiates. The dissolving of ethnic and family bonds is likely to
mean still freer trade.
Competition in the drug market is good for the consumer, which means it is bad for
anyone trying to reduce or eliminate drug taking. Against Mafia-style cartels, the
police might have succeeded. They are less likely to prevail against the invisible hand
of the market.
This article (‘Sniffy customers’, The Economist, March 7 2009, pages 28-29) is
reproduced with kind permission of The Economist for use only for teaching purposes
(www.economist.com).
Sniffy customers
OUTNUMBERED and outgunned, the sailors raised their hands. About 300km off
the west coast of Ireland, the yacht Dances With Waves was within hours of
delivering a half-billion-euro payload of cocaine to Cork in time for Christmas. The
vessel had been under surveillance since setting off from Trinidad and Tobago a
month earlier. Inside, Irish police found almost 1.9 tonnes of cocaine. Three British
men are now awaiting trial.
Such seizures are getting more common. European forces intercepted some 120
tonnes of cocaine in 2006, more than double the haul they managed in 2001 and
nearly six times as much as in 1995. But for every boat that is caught, more slip
through. Despite the seizures, the price of cocaine in Europe has been falling (see
chart), leading the UN to conclude that its availability has probably increased. At the
same time, the number of users has rocketed. In Britain, which recently overtook
Spain as Europe's most coke-hungry country, 7.6% of adults claim to have tried it; use
has doubled in the past decade. Most rich European countries report a similar picture,
especially among the young. Overall, Europe now accounts for 17% of global cocaine
seizures. In 1980 the figure was 3%.
Europe's cocaine market is served by an evolving network of trade routes. Shipments
commonly head for the Iberian Peninsula, either hidden in legitimate container vessels
or on board creaking old "motherships", which loiter out at sea while nimbler craft
bring the packages onshore. The traditional hotspot is the north Atlantic coast of
Spain, though in recent years traffickers have also targeted Barcelona and Valencia to
stay ahead of the police. Some three-quarters of European seizures take place in Spain
and Portugal, which also have some of the highest rates of consumption on the
continent.
Like any sensible business, drug-traffickers spread their risk: large shipments are
complemented with little-and-often supply lines, including parcel post and human
mules. That particular ruse has been upset by an advertising campaign run by the
police, warning potential mules of the severity of trafficking sentences. Some still risk
it, but they now command a fee of around $6,000, compared with the $2,000 they
used to do it for. That is enough to make the route unprofitable, police reckon.
But as one route closes, another opens up. In the past four years customs officers have
spotted a sharp rise in the amount of cocaine being smuggled into Europe via west
Africa. Of those seizures where the origin of the cocaine could be identified,
European forces reckon that in 2007 some 22% had been via Africa. As recently as
2004, just 5% had stopped off there. Seizures have risen sharply, too: before 2003,
officials had never intercepted more than a tonne of cocaine each year in Africa. In
2006, they nabbed 15 tonnes. Britain and America have beefed up their presence in
the region, but the traffickers may already have planned their next move: on February
19th the UN warned that a new supply route was emerging in the Balkans.
In Britain, Europe's biggest consumer of narcotics, the Home Office reckons that
drugs are brought in by about 300 major importers, who pass them to 30,000
wholesalers and then to 70,000 street dealers. Cocaine, meaning both the sniffable
powder and smokable "rocks" of crack cocaine (which can be made using a simple
microwave), accounts for about half the value of this industry, being less widely taken
than cannabis but much pricier.
Some rare light was shed on the business by a Home Office study in 2007, in which
222 drug-dealers were interviewed in prison by analysts from Matrix Knowledge
Group, a consultancy, and the London School of Economics. One dealing partnership,
based in London and Spain, bought cocaine from a Colombian importer in 10kg
bundles, which they sold to retailers using an employee whom they paid £500 ($703)
per transaction. A second employee, paid £250 a day, would collect money from the
buyers and pass it to a third member of staff, who would count it (processing up to
£220,000 each day). Other employees would pay the Colombians and smuggle the
rest of the cash, on their bodies, back to Spain.
Most drug businesses are forced to stay small and simple to evade the police. Only
one dealer claimed to be part of an organisation of more than 100 people, and a fifth
were classified by researchers as sole traders. Fear of being uncovered also hampers
recruitment: most dealers stuck to family and friends, and people from the same
ethnic group, when hiring associates. Just like other businessmen, they carried out
criminal-record background checks on potential employees--except that, in this case, a
record was a good thing.
Kevin Marsh, an economist at Matrix Knowledge, argues that most players in the
drug business have a poor knowledge of the market. "Shopping around for new
wholesale suppliers is risky, so many retailers stick to the same one and pay over the
odds," he says. Most of the dealers interviewed knew little about the purity of what
they were buying, and money laundering was usually fairly shambolic. Managing
cashflow is one of dealers' biggest weaknesses, according to one drug specialist at the
Serious Organised Crime Agency (SOCA): "Supply of powder is the most resilient
thing. To destroy the business, you have to go after the money." That, and extradite
foreign dealers, as America has long done. Britain is believed to be negotiating its
first-ever extradition of a Colombian, on drug charges, at the moment.
Times may at last be getting harder for cocaine-dealers. Shortly before Christmas, the
wholesale price in Britain shot up to £40,000 per kilo, the highest in years. Better
policing was one cause; another was the slump of sterling. European retailers' margins
have been chipped away. To protect their profits, dealers are diluting what they sell. A
decade ago, average street-level purity was about 60%; police say it is now nearer
30%. "People think there is a lot of cocaine around, but two thirds of it isn't cocaine at
all," says one SOCA officer.
That would be fine if the remainder were talcum powder. But in the past few years
dealers have turned to pharmaceutical cutting agents such as benzocaine, a topical
anaesthetic, which mimic the effects of cocaine and may be more harmful. Dealers
call such agents "magic" because of their effect on profits. "Grey traders", who
knowingly sell such chemicals to dealers, are starting to be convicted.
Educating drug-takers about what is getting up their noses may lower demand. But
cutting raises bigger questions for drug policy. "We may have to say at some stage
that taking heavily adulterated cocaine is more physically harmful to the user than
taking cocaine that's less adulterated," a senior SOCA official says. "That is not the
case at the moment. But we've got to keep asking the question. I'm aware that the
health equation could one day say: Stop trying to stop cocaine coming in."
Economist work-out 5.2
Solutions
Article A
1. Greater scope for product differentiation in the market for coffee beans appears to
have occurred due to an increasing demand by coffee consumers for high-quality
coffee with distinctive branding. The article suggests that the evolution of
consumers’ demand has been caused by specialist roasters promoting higher quality
coffee beans, and groups such as activists and ethical suppliers who have sought ways
to obtain higher prices for coffee growers.
Market power of African growers of coffee is likely to be higher than for Latin
American growers. Mainly this is due to quality of African specialist coffee being
higher than Latin American coffee (described as ‘lower-grade’ in the article). Higher
quality is a source of product differentiation that is likely to be associated with having
a greater number of potential customers for whom the African coffee is the ‘most
preferred’ product to buy. Having higher market power (represented as a lower price
elasticity of demand) and higher level of demand will mean that profit-maximising
African coffee growers would set higher prices than Latin American growers which
have lower market power.
Article B
2. The most reasonable interpretation of the article is that it is suggesting the market
power of magazine suppliers has been decreased by the internet. For example, the
article suggests that ‘The internet’s popularity has hit men’s titles the
hardest…finding it hard to compete with online porn.’ Hence the internet can be
regarded as allowing the entry to the market of substitute products that are more
preferred by some consumers to magazines. Moreover, the internet has allowed new
suppliers to enter the market to compete with the existing magazines more easily than
by setting up a new magazine - at a lower cost and without the other problems that are
described with setting up a new magazine. Hence the internet has reduced the market
power of magazines by reducing product differentiation and lowering barriers to entry.
Articles C and D
3. One source of market power appears to be that – because the activity of trading
cocaine is illegal – retailers prefer to buy from a wholesaler from whom they have
bought in the past and regard as trustworthy. In other words, a wholesaler could
increase the price it is charging for cocaine, and not lose all its customers since some
retailers will still prefer to buy from a source they regard as trustworthy, rather than
taking the risk of switching to a new wholesaler.
Economist work-out 5.3
Read the attached articles ‘Direct from the source’ (Article A, The Economist, April
19, 2008, pages 74-75), and ‘Out of vogue’ (Article B, The Economist, September 29
2007, pages 68-69.) Article A describes developments in the market for coffee beans,
and Article B describes the evolution of competition and product development in the
market for magazines in the United States and Europe.
Article A
1. What has caused the greater scope for product differentiation in the market for
coffee beans?
2. How would you compare the market power of suppliers in African countries such
as Ethiopia with suppliers in Latin American countries? How do you expect that this
would affect the profit-maximising price each supplier can charge?
3. Explain how the choice about whether to trademark the Harar, Yegarcheffe and
Sidamo varieties of coffee can be seen as involving a tradeoff between creating
barriers to entry and creating product differentiation?
Article B
1. How has the market power of magazines in the United States and Europe been
affected by the internet? Explain your answer using the concepts of barriers to entry
and product differentiation.
2. Can the evolution of the types of products available in this market be characterised
as a process of imitation and innovation?
This article (‘Direct from source’, The Economist, April 19 2008, pages 74-75) is
reproduced with kind permission of The Economist for use only for teaching purposes
(www.economist.com).
Direct from source
COFFEE prices are the highest they have been for a decade. As consumers in India
and China develop a taste for the drink, prices are likely to keep rising. Meanwhile
something new is happening in developed markets. Europeans, Americans and
Japanese are switching to higher-quality coffee. Discerning consumers now demand
authenticity: they want stories about where their coffee beans come from. So the best
coffees will increasingly be differentiated, like fine wines and spirits, and sold at
previously unthinkable prices.
The move from instant-coffee powder to luxury beans is in some ways reminiscent of
what happened when the Scotch-whisky industry shifted from cheap blends to
expensive single malts, each with its own story. But where the whisky revolution was
masterminded by distillers, the coffee revolution is a messier insurgency. Gourmets
and specialist roasters have pushed up expectations. Governments, activists and
"ethical" coffee suppliers have worked to get higher prices.
All this is good news for coffee farmers in east Africa. Altitude, climate, soil and
genetic diversity give the region an inherent advantage in quality. With lower-grade
Latin American coffee dominating the market, there is scope for the best coffees from
Ethiopia, Kenya, Tanzania and Rwanda to establish themselves.
Ethiopia is the largest African producer. Its coffee sales last year were $425m,
representing 36% of export earnings. It has a story to tell: an Ethiopian goatherd,
Kaldi, is said to have discovered coffee's stimulating properties in the 9th century.
Already, 40% of its production is premium coffee. Until recently, however, that did
not yield higher prices for farmers. When the commodity price was low, villages
starved.
An agreement signed last year between Starbucks, the world's biggest coffee chain,
and the Ethiopian government has been touted as a big step forward. Starbucks had
objected to the government's plan to trademark the names of three local coffee
varieties. The firm worried that having to license these trademarks would introduce
legal complexities that might deter it and others from buying trademarked beans,
thereby hurting farmers. Critics think the numbers used by activists to shame
Starbucks were shaky. Others argue that farmers would gain a lot more if African
governments were bullied into cutting bureaucracy and building infrastructure.
What is beyond doubt is that the three varieties in question--Harar, Yegarcheffe, and
Sidamo--are among the finest beans in the world. The hope is that trademarking these
regional varieties will establish them as brand names and enable farmers to demand
higher prices. Might geographical indicators, like the appellation contrôlèe system in
French wine, have been a better option? The head of the Ethiopian Intellectual
Property Office, Getachew Mengistie, thinks not. The coffee varieties were not
strictly regional, he explains, so a wine-style designation would have made no sense.
Nor was the money or time available to pursue a complicated certification process.
Instead, Ethiopia has quickly licensed its brands to 70 suppliers worldwide, including
Starbucks.
Licensees agree to use the brand names and to educate consumers about the
characteristics of the different varieties. By allowing licensees to use the trademarks
without paying royalties, Ethiopia is, in effect, trading their use for free marketing.
(Colombia, for example, runs advertisements in rich countries to promote its coffees,
which Ethiopia cannot afford.)
Rick Peyser of Green Mountain Coffee Roasters, an American supplier which counts
Yegarcheffe among its premium coffees, thinks it will be only a matter of time before
the trademarks start to improve the lives of farmers. Ethiopia is now planning to
extend the trademark approach into new areas, such as traditional medicines and
certain types of teff, the country's usefully gluten-free staple cereal crop. But coffee,
an unparalleled genetic resource, with over 5,000 varieties, will remain the biggest
earner.
This article (‘Out of vogue’, The Economist, September 29 2007, pages 68-69) is
reproduced with kind permission of The Economist for use only for teaching purposes
(www.economist.com).
Out of vogue
This week bankers have a perfect excuse to pore over pictures of scantily clad models,
fast cars and film stars: Emap, a British media firm that straddles consumer
magazines, radio and trade exhibitions, is up for sale, and bids are due by early
October. Emap has 50 magazine titles, which produced revenues of £408m ($773m)
in the year to March 2007, and its sale will attract international attention. Foreign
publishers are expected to bid, as are private-equity firms. The outcome will be a
timely judgement on the prospects for consumer-magazine publishers in the
developed world.
In America and Europe magazine publishers have a common lament: total circulation
is either flat or declining slightly as people devote more time to the internet, and an
ever greater share of advertising spending is going online. Magazine units are mostly
a drag on growth for their parents. Time Inc, the world's biggest magazine company,
has to fend off rumours that its parent, Time Warner, will sell it. People in the
industry expect that Time Warner will soon sell IPC Media, its British magazine
subsidiary. In Germany publishers reckon that Bertelsmann, a media conglomerate,
may sell Gruner + Jahr, its magazine unit, when its new chief executive takes over in
January 2008.
"It's a long, slow sunset for ink-on-paper magazines," says Felix Dennis, a publishing
entrepreneur, "but sunsets can produce vast sums of money." He recently sold his
firm's American arm, which publishes Maxim, a racy men's magazine, to Quadrangle
Capital Partners, a private-equity business, for a reported $240m.
The business model for consumer magazines is under pressure from several directions
at once, both online and off. Magazines have become more expensive to launch, and
the cost of attracting and keeping new subscribers has risen. In America newsstand
sales have been worryingly weak, partly because supermarkets dominate distribution
and shelf-space is in short supply.
The internet's popularity has hit men's titles the hardest. FHM, Emap's flagship "lads"
magazine, for instance, lost a quarter of its circulation in the year to June, its lingerieclad lovelies finding it hard to compete with online porn. Not long ago consumer
magazines were Emap's prize asset, but slowing growth from the division contributed
to the company's decision to put itself up for sale. Men's magazines are in trouble in
most developed-world markets. In France, America and Italy, the three biggest
magazine markets for Lagardère Active, part of Lagardère, a French conglomerate,
men have quickly switched from magazines to online services, says Carlo d'Asaro
Biondo, the division's head of international operations. "We have solved the problem
in the automotive sector with new web services," he says, "but no magazine publisher
has cracked the problem as a whole yet."
There are good reasons why magazine owners should not feel despondent, however.
For readers, many of the pleasing characteristics of magazines--their portability and
glossiness, for instance--cannot be matched online. And magazines are not losing
younger readers in droves in the way that newspapers are. According to a study
carried out last year by the digital arm of Ogilvy Group, a communications company,
appetite for magazines is largely unchanged between older "baby boomers" and
young "millennials".
On the advertising side, magazines are faring much better than newspapers, which are
losing big chunks of revenue as classified advertising shifts online. Advertisers like
the fact that in many genres, such as fashion, readers accept and value magazine ads
and even consider them part of the product.
Unfortunately, magazine publishers have been slow to get onto the internet. "Eighteen
months ago the internet was something they worried about after 4pm on Friday," says
Peter Kreisky, a consultant to the media industry, "but now it's at the heart of their
business model." Meredith, a magazine publisher from the mid-west of America with
old-fashioned brands such as Better Homes and Gardens, recently held an internet
"boot-camp" for its executives to teach them internet basics.
To their credit, big magazine firms are doing far more than replicating their print
products online. Whereas newspapers have concentrated on transferring print
journalism to the internet, magazines offer people useful, fun services online-Lagardère's Car and Driver website, for instance, offers virtual test drives, and Better
Homes and Gardens online has a 3D planning tool to help people redesign their
homes.
Magazine firms disagree on whether to take existing brands online or try to do
something new for the internet. Condé Nast believes it can cast a wider net by
creating themed websites that use some magazine content but also go beyond to
appeal to a bigger market. "You've got to have scale on the internet, and magazine
brands can be limiting online," says Sarah Chubb, president of CondéNet, the firm's
internet division, which runs a number of portals such as STYLE.com. Some
magazine editors have objected. Anna Wintour, the editor-in-chief of Vogue, is said
to have noted the popularity of STYLE.com and asked why it couldn't be called
Vogue.com. (American Vogue will in fact get its own website soon.)
Time Inc, in contrast, has stuck to its big magazine brands with People.com and with
SI.com, its website for Sports Illustrated. The price, competitors say, is that Time Inc
cannot do the sort of sarcastic, bitchy celebrity gossip that people like on the internet
for fear of tarnishing the brand of People, and therefore cedes first place for
entertainment to TMZ.com (also owned by Time Warner), which excels at it. But
People.com is able to charge advertisers a premium, points out John Squires,
executive vice-president of Time Inc, because of the quality of its brand. And surfers
are highly engaged with People online: in June each visitor to the site looked at an
average of 85 pages, compared with 13 for TMZ.com. In financial terms, says Mr
Squires, People.com would now rank among the firm's most profitable monthly
magazines.
The internet still brings magazine companies a fraction of what they earn in print.
Publishers have found that websites are good at winning and keeping subscribers, but
few pay their own way. If Emap closed down all its magazine sites tomorrow, says a
publishing executive, the company would make more money. Even though magazine
firms have built attractive sites, says Andreas von Buchwaldt of OC&C Strategy
Consultants in Hamburg, huge independent communities on the internet have often
already formed, and it is hard for magazine brands to achieve leading positions. In six
countries in Europe including France and Germany, for instance, an internet-only
brand, auFeminin.com, dominates the women's category.
Before the credit crunch, observers expected some or all of Emap to go to private
equity. Now publishing firms are perhaps better placed to win. It is possible that no
one will pay a good price for consumer magazines at the moment. That would add to
the industry's gloom. But it might also encourage media conglomerates to stick at
magazines and have a proper go at revamping them for the digital age.
Economist work-out 5.3
Solutions
Article A
1. Greater scope for product differentiation in the market for coffee beans appears to
have occurred due to an increasing demand by coffee consumers for high-quality
coffee with distinctive branding. The article suggests that the evolution of
consumers’ demand has been caused by specialist roasters promoting higher quality
coffee beans, and groups such as activists and ethical suppliers who have sought ways
to obtain higher prices for coffee growers.
2. Market power of African growers of coffee is likely to be higher than for Latin
American growers. Mainly this is due to quality of African specialist coffee being
higher than Latin American coffee (described as ‘lower-grade’ in the article). Higher
quality is a source of product differentiation that is likely to be associated with having
a greater number of potential customers for whom the African coffee is the ‘most
preferred’ product to buy. Having higher market power (represented as a lower price
elasticity of demand) and higher level of demand will mean that profit-maximising
African coffee growers would set higher prices than Latin American growers which
have lower market power.
3. For the coffee growers in Ethiopia, the article describes how trademarking of the
Harar, Yegarcheffe and Sidamo varieties, would have two main effects. On the one
hand, it was perceived that trademarking would create the legal right for growers to
supply these coffee brands. This would increase barriers to entry, and hence increase
the market power of growers. On the other hand, to the extent that trademarking
deterred large coffee suppliers such as Starbucks from buying these coffee brands, it
could make it more difficult to establish the identity of these coffee brands with
consumers. Hence, the extent of product differentiation, or the scope to attract
consumers to the brands could be diminished. The article describes how the growers
of these brands have decided to forego trademarking (that is, the scope to create
barriers to entry), instead signing licensing agreements with international suppliers
such as Starbucks which requires them to use the brand names and educate consumers
about the characteristics of the different varieties of coffee (that is, seeking to
establish greater product differentiation).
Article B
1. The most reasonable interpretation of the article is that it is suggesting the market
power of magazine suppliers has been decreased by the internet. For example, the
article suggests that ‘The internet’s popularity has hit men’s titles the
hardest…finding it hard to compete with online porn.’ Hence the internet can be
regarded as allowing the entry to the market of substitute products that are more
preferred by some consumers to magazines. Moreover, the internet has allowed new
suppliers to enter the market to compete with the existing magazines more easily than
by setting up a new magazine - at a lower cost and without the other problems that are
described with setting up a new magazine. Hence the internet has reduced the market
power of magazines by reducing product differentiation and lowering barriers to entry.
2. The entry of internet suppliers to supply products to the ‘infotainment’ market –
products that are intended to substitute for magazines using a new medium – can be
characterized as ‘innovation’. That is, by supplying a product that is preferred by
consumers to existing print magazines, the internet suppliers are seeking to acquire
market power and earn positive economic profits. In response magazine suppliers
have sought to ‘imitate’ the new internet suppliers, by taking their own brand-names
online, supplying online versions of their print publications or new products that
develop their print publications. The article does note that the strategy of seeking to
earn positive economic profits through online ‘infotainment’ products thus far does
not seem to have been highly successful. The low profits from internet ‘infotainment’
products may be explained by the relatively low barriers to entry to internet supply.
Despite the low profits from supplying internet products, imitation of these products
by existing magazine suppliers may be seen as being valuable as a defensive strategy,
primarily designed to maintain subscriptions to print magazines.
Economist work-out 5.4
Read the attached articles on ‘A thicker blue line’ (The Economist, August 20 2005),
and ‘The law and the profits’ (The Economist, June 12 2004, page 55). The articles
describe (respectively) competition between police and private security firms, and
between new private universities and existing universities, in the United Kingdom.
Describe what you think is the extent of market power possessed by private security
firms and public universities in the United Kingdom. Explain your answer using the
concepts of elasticity of demand, barriers to entry, and product differentiation.
This article (‘A thicker blue line’, The Economist, August 20 2005) is reproduced
with kind permission of The Economist for use only for teaching purposes
(www.economist.com).
A thicker blue line
EVER since four bombs exploded in London on July 7th, the police have put on a
show of force. Armed officers loiter in front of public buildings, while brightly-clad
police community support officers (PCSOs) patrol station concourses. The point is to
deter terrorists, but there's another message, too. Even before the attacks, the police
admitted that they wanted to dominate the security business. As Sir Ian Blair,
commissioner of London's Metropolitan Police, put it: "We're trying to monopolise
the market."
The chief competition comes from some 130,000 people working for about 2,000
private security companies. They catch shoplifters, patrol housing estates and reassure
the public--everything the police are expected, but have traditionally failed, to do,
which is why private security companies proliferated in the first place.
Until recently, the police believed that private security companies were a necessary,
perhaps even a welcome presence on Britain's streets. Sir Ian explained in a 1998
speech that the police ought to relinquish their monopoly over patrolling and become
an overseer of security services. There was much talk of an "extended police family"
consisting of coppers, guards and local-government workers. That metaphor is still
used; but the police have taken on the role of stern father.
One reason the coppers are so cocky about their ability to dominate the market is that
they have more uniformed bodies. There were 141,000 police officers at the last
count, in March--up from 124,000 in 2000. They are joined by a new army of PCSOs,
currently 6,200 strong but expected to number 24,000 by 2008. The PCSOs receive
less training and fewer powers than sworn officers, which makes them cheaper. It also
means they can stay on the streets and avoid becoming tied up with bureaucracy.
Unlike police officers, PCSOs can easily be sold to local authorities, housing
associations and shopping malls, doing their bidding while remaining under the
nominal control of the police. In London, buyers have been found for more than 600
officers, with most going to Transport for London, which manages the bus network.
At a total cost of about £35,000 ($63,000) per year, they are more expensive than
security guards, but a lot cheaper than sworn officers--and they have other
advantages, such as police radios. Thanks to them, the police can compete against
private providers. "PCSOs have skewed the market," says Richard Childs, a former
chief constable who is now a security consultant.
Another, unfair, aid to the police is that the competition is about to become a lot more
expensive. Government regulations mean that, beginning next March, security guards
will have to undergo four days' training and pass a criminal-record and background
check. That will be expensive for employers and difficult for the immigrant workers
on whom the industry relies. The result, according to the British Security Industry
Association (BSIA), a trade body representing large and medium-sized operators, will
be the immediate departure of around one in ten guards and a wage hike of 12-15%.
Smaller outfits are likely to disappear altogether, says Richard Evans, managing
director of The Watch Security, which was acquired recently by a bigger fish.
Regulation and a new "preferred contractor" scheme will reduce the number of
suppliers--to 300, according to the BSIA; to perhaps 50, according to Bobby Logue,
an industry analyst. That will alleviate competition in a notoriously cut-throat
business, and perhaps even create some local monopolies. Further price increases will
be the result.
Hazel Blears, a home office minister, does not want to see private security companies
wiped out, although she is keen to see them kept in their place. The right to
protection, she says, should not depend on the ability to pay. It's an admirable
sentiment. The trouble is that, in future, there may be less protection to go round.
This article (‘The law and the profits’, The Economist, June 12 2004, page 55) is
reproduced with kind permission of The Economist for use only for teaching purposes
(www.economist.com).
The law and the profits
BRITISH universities like students who pay big fees. They are less happy to deliver
the corresponding service. The hefty fees paid by foreign and postgraduate students
are siphoned off to subsidise research and the unprofitable teaching of British
undergraduates.
That creates a gap, and into it is marching a private company, BPP, which is already
the country's largest provider of professional training. BPP already looks a bit like a
private university: it teaches some 20,000 students in 32 centres in Britain, in subjects
such as accounting and law.
But other bits aren't like a British university at all: there's no sign of state planning;
the staff are better paid, the buildings smarter, technology swisher, morale higher.
Administration is leanly businesslike; there's no money spent on research--just a lot of
high-quality teaching.
"They have a much more focused view in producing something that their client is
after. Universities are not responding to customer demand in the same way," says a
senior partner at one of the five big British law firms that is contracting its training
exclusively to BPP from 2006.
Until recently, BPP did not award degrees: that is the privilege of officially
recognised universities. Now things are changing, chiefly in the booming business of
legal training. From September, it will be offering a postgraduate law degree,
including the courses needed to become a solicitor. It won't, technically, be a degree
from BPP: the firm is renting that right for an undisclosed sum from the University of
Central Lancashire, which is "validating" the course.
That's an odd deal. To get round regulation, the stronger party seeks endorsement
from the weaker one. The Lancastrian courses, at £3,000, are only a third the price of
the BPP ones. Whereas BPP's law teaching is one of only five outfits rated
"excellent" by the Law Society, the solicitor's self-regulating body, Lancashire's is in
the average category of "very good" (anything less than "good" is disastrous).
Carl Lygo, chief executive of the BPP law school, says that these hybrid products,
combining an academic and a professional qualification, are the fastest-growing bit of
the company's business. In 2008, once new rules governing teaching-only universities
are in place, he expects BPP to apply for university status. In the meantime, active
discussions with other impoverished vice-chancellors are under way. "If the market's
there, we'll teach it, so long as it's white-collar," he says.
So what happens now? In America, for-profit universities such as Phoenix have
already made inroads into the higher-education business. So one might think that
British universities might be a bit worried, as an aggressive competitor chomps up
their customers. Not so: the vice-chancellor of one London university whose
postgraduate law courses are seen as a prime competitive target by BPP has never
heard of the company. A senior manager at another law school was shocked to hear
that BPP charged more than its competitors, and paid its staff better. "We take a
holistic approach," he says, brushing aside the idea that BPP might be taking the best
staff and most ambitious students.
Other established outfits are savvier. The College of Law, the country's biggest law
school, has a tight customer focus too. It has persuaded the Law Society to approve
tailor-made courses for the three big law firms that it serves exclusively. BPP says if
the idea works, it will copy it. But a lawyer who has studied at both outfits says BPP
is better: "They know that the main thing is to get you through the exams," she says.
"The other places tell you all this stuff you don't need to know."
Economist work-out 5.4
Solutions
Private universities
The degree of market power of private ‘universities’ (or firm-level elasticity of
demand for the product they supply) in supplying university-level education will
depend on: (a) elasticity of demand for the product of university education; (b) extent
of product differentiation; and (c) barriers to entry to providing university education.
Demand for the product of university education is likely to be relatively inelastic.
There are not strong substitutes, and the education provided is an essential
prerequisite for occupations such as lawyer and doctor.
The article suggests that the private ‘universities have been relatively successful in
developing a product that is differentiated from traditional existing universities – in
particular in the quality of teaching provided. The difficulty for private ‘universities’
though is when they are not officially accredited as universities which is likely to
reduce their attractiveness to students. This is largely the case in the United Kingdom
at present, but not in the United States, where private universities account for a large
share of total students taught at university-level.
Barriers to entry to providing university-level training appear to be relatively low.
The main barrier is the relatively large initial fixed cost required (buildings and staff
hiring), although probably this cost can be minimized by leasing facilities such as
buildings. The other relevant barrier is the need in the United Kingdom for
government approval to be able to use the term ‘university’. However, the rapid
growth of private suppliers of university-level training suggests that barriers are
relatively low.
Overall, it seems that private ‘universities’ have some degree of market power in the
short-run due to the demand for university education being relatively inelastic and
their success in product differentiation. However, low barriers to entry and the
potential for ‘imitation’ by existing universities, suggest that in the long-run private
‘universities’ would have a lower degree of market power.
Private security firms
The degree of market power of private security firms (or firm-level elasticity of
demand for the product they supply) in supplying security services will depend on: (a)
elasticity of demand for the product of security services; (b) extent of product
differentiation; and (c) barriers to entry to providing security services.
Demand for security services seems likely to be relatively inelastic. There are few
substitutes for security staff in providing services such as patrolling housing estates
and shopping centres; and the service is a necessity for housing estates and shopping
centres.
It does not seem from the article that private security services have been highly
successful in developing product differentiation. In fact, it is suggested that police
community support officers are providing a strong substitute for services provided by
private security firms (and may be preferred due to having the backing of the police
force).
Different perspectives on barriers to entry to the security services market come from
the article. On the one hand, it appears to have been relatively easy for police to enter
this market (which lowers market power of the private security firms). On the other
hand, a new set of government regulations and charges are likely to increase the cost
of new private suppliers entering the market (which increases market power of
existing private security firms) and are predicted to increase the price of services
supplied by private security firms.
Market power of private security firms is likely to be relatively low. Although
demand for the product of security services is likely to be inelastic, the lack of product
differentiation by private security firms, and the ease of entry by police to this market,
are both reasons to expect that demand would be elastic at the firm level so that
private suppliers will have a low degree of market power.
Economist work-out 5.5
Read the attached article ‘Who needs paper?’ (The Economist, June 7 2008, p.67).
Some questions to consider
The ‘e-ticket’ system and paper tickets are alternative methods of providing tickets to
airline passengers. Each is produced using a different production method. In the
short-run an airline will be restricted to using one or other of these methods. In the
long-run though it can choose whichever method it wants.
1. What do you think are likely to be the differences in fixed costs and short-run
marginal costs between the production methods for e-tickets and paper tickets?
2. Draw a graph showing how you think short-run average total cost of each
production method will vary with the number of passengers carried.
3. How should a profit-maximising airline make the choice between the alternative
methods of providing tickets to passengers?
4. How do you think the gains from switching to an e-ticket system will vary by the
size of an airline (that is, number of passengers carried)?
This article (‘Who needs paper?’, The Economist, June 7 2008, page 67) is
reproduced with kind permission of The Economist for use only for teaching purposes
(www.economist.com).
Who needs paper?
IT WILL not be long before paper tickets for a plane, train or bus seem as quaint as
propellers, steam and conductors do today. Electronic travel passes are already
widespread in many cities. And on June 1st the airline industry completed its
conversion to electronic tickets, putting yet another nail in the coffin of the paperbased kind.
This has been quite an achievement--not least because it was completed in just four
years. A task force was set up in 2004 by the International Air Transport Association
(IATA), a trade group, to manage the change among the 240 airlines it represents,
covering more than 90% of international flights. Tens of thousands of travel agents
also had to change their systems.
The incentives to move to e-tickets were huge: a paper ticket costs around $10 to
process, whereas an e-ticket costs just $1. IATA's member airlines issue more than
400m tickets a year. The association is now trying to turn the mountain of paperwork
that accompanies air freight into electronic form, too.
For passengers, lost tickets should become a thing of the past. E-tickets can also be
changed more quickly, and they speed up self-service check-in. They can even be
delivered to a mobile device in the form of a two-dimensional bar code, a square
pattern of dots that can be scanned at the gate and used as a boarding pass.
Continental Airlines began testing such a system in Houston in December and is now
extending it to Washington National, Newark and Boston's Logan airport. A similar
approach enables mobile phones to store tickets for sports fixtures or nightclubs.
Where physical tickets do survive, it is likely to be as contactless plastic cards, such
as London's Oyster and Hong Kong's Octopus. An even more sophisticated version of
this technology will be used to grant access to the opening and closing sessions of the
Beijing Olympics. The cards will store personal data including a photograph and the
passport details of the holder. China says this is for security reasons, but it has the
helpful effect of making the ticket non-transferable. In the future, ticket touts will
need to be good at hacking.
Economist work-out 5.5
Solutions
1. What do you think are likely to be the differences in fixed costs and short-run
marginal costs between the production methods for e-tickets and paper tickets?
The production method for e-tickets is likely to involve a relatively high level of FC,
and relatively low and constant level of SRMC. Being able to provide e-tickets
requires a large investment in computer infrastructure and software programming –
This can be considered a FC since the cost of the computer services will not vary with
the number of tickets that are supplied. The SRMC of providing each ticket will
however be low since it involves only electricity costs and costs of monitoring the
system; as well, the cost per extra ticket is not likely to vary greatly with the number
of tickets supplied. By contrast, using a paper ticket system is likely to involve a
relatively lower FC, and a larger SRMC that increases with the number of tickets
supplied. Costs associated with supplying paper tickets are likely to be the costs of
paper and printing the tickets and costs of postage as well as any labour costs where
the tickets are obtained from an airline office. These costs are mainly likely to vary
with the number of tickets supplied, and hence can be regarded as primarily VC. Due
to the increasing organisational complexity of dealing with an increasing volume of
tickets, the level of SRMC is likely to increase with the number of tickets.
2. Draw a graph showing how you think short-run average total cost of each
production method will vary with the number of passengers carried.
The e-ticket method has high FC and low/relatively constant SRMC -> Hence
SRATC is likely to decline continuously with the quantity of tickets supplied. The
paper based ticket method has low FC and high/increasing SRMC -> Hence SRATC
is likely to display a U-shaped pattern with the quantity of tickets supplied.
$ SRATCpaper ticket SRATCe‐ticket QX number of tickets 3. How should a profit-maximising airline make the choice between the alternative
methods of providing tickets to passengers?
A profit-maximising airline should choose the method of providing tickets to
passengers that minimises the SRATC for the number of passengers it expects. In the
figure above, this would imply choosing the paper based method for less than Qx
passengers, and choosing the e-ticket method for more than Qx passengers.
4. How do you think the gains from switching to an e-ticket system will vary by the
size of an airline (that is, number of passengers carried)?
The difference between the SRATCs of the e-ticket and paper based methods of
supplying tickets to passengers is increasing with the quantity of passengers carried
by an airline. Hence it seems that the gain in profits from switching from paper based
to e-tickets will be greater for larger airlines than smaller airlines.
Economist work-out 5.6
Read the attached article on ‘Out of rooms’ (The Economist, July 17 2004, page 59).
The article is describing the decision of some hotel chains to sell (and lease back) the
hotel buildings in which they operate. Why is it suggested that hotels have made this
decision? Would you have any concerns about the decision?
This article (‘Out of rooms’, The Economist, July 17 2004, page 59) is reproduced
with kind permission of The Economist for use only for teaching purposes
(www.economist.com).
Out of rooms
YOUR core business is running hotels. Should you own the buildings too?
InterContinental Hotels, British-based but with some 540,000 rooms worldwide, has
decided not. It is not alone.
InterContinental operates worldwide under its own name, and through such brands as
Crowne Plaza and Holiday Inn. Once part of Six Continents, a British brewing, pub
and hotel group, it was demerged in April 2003. Many of its 3,500-plus hotels were
franchises, but those it owned were worth some $6 billion. Since the demerger it has
sold 28 of these for $600m and put 13 others, worth over $200m, on the market. This
week it announced that of the 160-odd it still owns, 20 more, valued on its books at
$950m, are to go. The sales have been widespread: in America, Australia, Britain and
even Vanuatu, a collection of islands in the south Pacific. The new list is headed by
InterContinentals in Chicago and Miami.
Why sell now, when the trade is getting back on its feet after three grim years?
Because the bad times have taught hoteliers a lesson: except in the carefree late1990s, their return on the billions tied up in bricks and mortar was lousy. Far better to
sell, and return some money to shareholders (InterContinental plans an "initial"
$460m buy-back of its shares, of which it has already spent $260m). Then focus on
running the hotels well.
The thought is hardly original. In 1993, American-owned Marriott International
transferred all its hotels, along with much of its debt, into a real-estate investment
trust (REIT), a vehicle allowing public-market investors to put their money in
property. But Marriott and the REIT remain close. A better example is Hilton Group,
British-based owner of the brand outside North America: since 2000 it has slimmed
the $4 billion of hotels it used to own. It still owns about 70 of its 400-plus hotels, but
this is under "close review".
Sale-and-leaseback is the obvious exit route, and can attract financial institutions too,
eager for assets that let them diversify out of shares and bonds. Hilton in 2001 thus
sold $440m of hotels to Royal Bank of Scotland (RBOS), and $515m more in 2002 to
a rival Scottish bank; RBOS had meanwhile put a further $1.75 billion into a deal
with up-market Le Meridien. This week Travelodge, a small British budget-hotel
operator, said it hoped to raise $750m by offloading its entire estate this way. These
deals require caution: Le Meridien accepted terms so tough that when the recession
really bit it had to unscramble the deal. Hoteliers now seek flexible terms that leave
some risk with the financiers.
Franchising is the cheapest way to grow. Hilton Hotels, the North American arm of
the brand, owns some landmark hotels, such as New York's Waldorf-Astoria, but is
mostly a franchise operation; Cendant, an American group with nine brands, is
entirely so. French-based Accor is unusual, owning 20% of its 4,000 hotels, with
more in France, less in unstable countries: a "risk" rather than "return" strategy.
The hotel recovery, by pushing up values, is a new reason to sell. InterContinental's
past sales barely fetched the hotels' book value of $145,000 per room. But future
sales could fetch more, especially if a British version of REITS, due next year,
includes hotels. InterContinental plans also to sell its half-share of a soft-drinks
business left over from its brewing past.
Yet not all hoteliers are retreating to their core skills. Hilton Group made more last
year from its British gaming subsidiary, Ladbrokes, than from hotels--and, having
sold its casinos in 2000, now plans to re-enter that business. Accor likewise earns a
far better return on its fast-growing services, including lunch vouchers and running
company canteens, than its hotels. And, albeit for tax reasons, Marriott is yet to get
entirely out of a company that makes a clean fuel from coal.
Economist work-out 5.6
Solution guide
The article suggests that hotels are selling off the buildings in which they operate due
to the low rate of return. One way to think of this is that the opportunity cost of
income foregone by having funds invested in ownership of the hotel buildings is
greater than the cost of leasing the hotel buildings from an owner. Or alternatively,
the return that the hotels firms can get by selling their buildings and investing those
funds elsewhere, is greater than the return earned from the business that can be
attributed to ownership of the building.
What concerns might there be about this decision? One potential problem is hold-up.
That is, if the hotel building is essential to operation of the hotel, the owner of the
building may be in a very strong bargaining position compared to the operator of the
hotel, and by threatening to not allow the hotel to operate, may be able to force a very
high lease fee from the hotel operator. Two factors may mitigate this problem. First,
a hotel operator is likely to be able to find other substitute buildings from which to
operate the hotel, and this reduces the capacity of the owner of the building in which
they were originally located to charge them a very high lease fee. Second, the article
notes that hotel operators have sought to overcome the problem of hold-up by
entering into franchise arrangements, where the owner of a hotel building is able to
use ‘name’ of the hotel operator in running their own hotel business. A second
problem could be if there are aspects of provision of the building for the hotel that it is
difficult to contract about with the building owner – for example, maintenance
activity – and that may adversely affect the quality of the hotel service. (Other
possible disadvantages of ‘buying’ – coordination problems, or entry deterrence –
seem less relevant in this case.)
Economist work-out 5.7
Read the attached article ‘Outsourcing as you sleep’ (The Economist, February 21
2009, page 69). The article describes how many hotel chains (such as InterContinental)
do not own the buildings from which they operate their hotel businesses, and how
they also contract for the supply of hotel services such as catering.
Some questions to consider
1. What do you think are the main advantages for hotel chains of not owning the
buildings from which they operate?
2. Do you think the hotel chains should have any concerns about out-sourcing of
ownership of the buildings from which they operate?
This article (‘Outsourcing as you sleep’, The Economist, February 21 2009, page 69)
is reproduced with kind permission of The Economist for use only for teaching
purposes (www.economist.com).
Outsourcing as you sleep
Reservations are plunging, but virtual hotel chains should escape the worst
You book a room on the website of a famous international hotel chain. As you arrive
to check in, its reassuring brand name is above the door. Its logo is everywhere: on the
staff uniforms, the stationery, the carpets. But the hotel is owned by someone else-often an individual or an investment fund--who has taken out a franchise on the brand.
The owner may also be delegating the running of the hotel, either to the company that
owns the brand or to another management firm altogether. The bricks-and-mortar may
be leased from a property firm. In some cases, yet another company may be supplying
most of the staff, and an outside caterer may run the restaurants. Welcome to the
virtual hotel.
The franchising of hotels, like the franchising of fast-food restaurants, is half a
century old. But it has received a further boost in the past few years, as the biggest
international hotel chains, under pressure from shareholders to return capital, have put
even their poshest properties up for sale. They are now mainly franchisers and
managers, rather than owners. In return for the fees they charge the hotels' owners,
they provide a glossy brand name and a steady stream of bookings from their online
reservations systems.
Among the keenest adopters of this virtual-hotel model, also called "asset-light", is
InterContinental, a British-based firm which in addition to its eponymous hotel chain
owns the Holiday Inn and Crowne Plaza brands. InterContinental was formed from a
demerger in 2003, just as the business emerged from the dotcom bust. Even then, it
owned only around 200 of the 3,500 hotels that bore its brands. But during the recent
boom it sold most of the remainder, while expanding worldwide through new
franchising and management contracts with hotel developers. It now owns just 16 of
the 4,186 hotels in its system.
The hotel business was doing fine until Lehman Brothers' collapse in September.
Since then bookings have drooped. InterContinental said on February 17th that its
"revpar"--revenue per available room, the industry's benchmark--fell 6.5% in the
fourth quarter. Marriott and Wyndham, two American rivals, have reported similar
falls; Starwood, another American chain, says revpar has dropped by 12.1%. All are
gloomy about this year.
However, the brunt of the recession will be borne by the hotels' owners rather than the
chains that manage and franchise them. Simon Mezzanotte of Société Générale, a
bank, explains that if revpar falls 1% at a hotel, its owner typically suffers a 5%
profits fall. But the management fees (which are usually linked to a mix of the hotel's
revenues and profits) fall by 3%; and franchise fees (which are usually linked only to
revenues) fall by only 1%.
So chains that have adopted the virtual-hotel model should suffer less in the recession.
InterContinental should do better than its peers since around 75% of the rooms in its
system are in franchised hotels, compared with 39% of Starwood's. Starwood wants to
continue virtualising its hotel system: its chief executive, Fritz van Paaschen, says
franchise and management fees were 53% of total revenues last year, up from 18%
five years earlier, and he wants them eventually to rise to 80%.
Many hotel owners, having taken on most of the risk, will collapse into bankruptcy
during the recession. Even so, says Stephen Broome, a consultant at
PricewaterhouseCoopers, the big hotel chains will have few worries: when banks take
possession of a hotel from a bankrupt owner they usually keep it open, as hotels lose
up to half of their resale value once they are closed. Thus the hotel chains will in most
cases continue earning their franchise and management fees. In some cases
bankruptcies will be a source of new business: Hostmark, an American hotelmanagement chain, says that last year it was brought in to run five hotels by lenders
who took possession after the previous owners collapsed.
Although they have offloaded much of the risk posed by the recession, the big hotel
chains have exposed themselves to two new dangers. One is that investors are now
assessing them not just on their revenues, but also on their "pipeline" of future
franchises and management contracts, mostly from hotels under construction. Leslie
McGibbon of InterContinental says his firm is still signing up new hotels at a rate of
two a day, despite the downturn. But beset by falling bookings and scarce financing
for hotel construction, the firm's impressive pipeline, which benefits its share price, is
likely to be squeezed. The other risk is that, when recovery eventually comes, most of
the gains will go to the hotel owners--at least, those that survive.
Economist work-out 5.7
Solutions
1. What do you think are the main advantages for hotel chains of not owning the
buildings from which they operate?
The article suggests that the main advantage in the present economic environment is
that hotel chains have been able to negotiate contracts with the owners of hotel
buildings that protect them to a significant degree against falls in revenue from
decreases in demand for hotel accommodation (that is, hotel owners are bearing most
of the risk of fluctuations in revenue).
More generally, hotel chains may believe that the opportunity cost of income
foregone by having funds invested in ownership of hotel buildings is greater than the
cost of leasing the hotel buildings from an owner. Or alternatively, the return that the
hotels firms can get by selling their buildings and investing those funds elsewhere, is
greater than the return earned from the business that can be attributed to ownership of
the building.
2. Do you think the hotel chains should have any concerns about out-sourcing of
ownership of the buildings from which they operate?
One potential problem is hold-up. That is, if the hotel building is essential to
operation of the hotel, the owner of the building may be in a very strong bargaining
position compared to the operator of the hotel, and by threatening to not allow the
hotel to operate, may be able to force a very high lease fee from the hotel operator.
This will be mitigated somewhat where a hotel operator is likely to be able to find
other substitute buildings from which to operate the hotel, and this reduces the
capacity of the owner of the building in which they were originally located to charge
them a very high lease fee. A second problem could be if there are aspects of
provision of the building for the hotel that it is difficult to contract about with the
building owner – for example, maintenance activity – and that may adversely affect
the quality of the hotel service. A third problem – discussed in the article – is that
revenue growth for hotel chains now depends to a greater degree than previously on
expansion in the number of hotels that they operate’ hence there is a greater need for
hotel chains to be expanding the number of hotels that they operate.
Economist work-out 5.8
Read the attached article ‘The battle of the bourses’, The Economist, May 31 2008,
pages 81-83.
Questions to consider
Do you think it is possible to characterise developments in the market for trading
stocks as a process of ‘imitation and innovation’? Why was there an incentive for
new suppliers to enter the market? What were the main types of new entrants to the
market? In what ways did the new suppliers engage in product differentiation to seek
to attract new customers? What are examples of how the incumbent suppliers – after
the entry of new suppliers - have engaged in product differentiation?
This article (‘The battle of the bourses’, The Economist, May 31 2008, pages 81-83)
is reproduced with kind permission of The Economist for use only for teaching
purposes (www.economist.com).
The battle of the bourses
"Arguably, there's never been a better time to be an exchange business," enthused
Clara Furse, chief executive of the London Stock Exchange (LSE), on May 22nd after
unveiling record profits. The past few years have been a golden era for the world's
bourses: their own share prices lifted on a wave of mergers; trading volumes, already
rising smartly, sent into orbit as investors sought to profit from the volatility triggered
by the credit crunch.
But Ms Furse's joy is not unconfined. The LSE's share price has fallen by half since
January. NYSE Euronext, which runs New York's exchange and several European
markets, is down by 30%. Since March the volume of trading it handles has tumbled,
even as the overall market has surged. NASDAQ, its cross-town rival, has seen
turnover drop to its lowest level since 2004. Why is this happening?
The main culprit is competition. In America electronic upstarts have been nipping at
the exchanges' heels for years. They got a fillip last year with the introduction of Reg
NMS, a rule that forces trades to be sent to the venue offering "best execution". (The
European Union's new MiFID directive does much the same.) The old exchanges'
share of the market is rapidly eroding: in America it stood at 73% in April, down from
86% a year before.
The competition comes in two forms. The first is electronic markets that aspire to
become full exchanges. In America BATS and DirectEdge are the trail-blazers,
having grabbed a combined 13% of all matched trades at last count. The leader in
Europe is Chi-X, launched in March 2007, and the closest thing to a pan-European
electronic market. At times its share of British and German trades tops 13% and 6%
respectively. Other platforms, such as the much-hyped Turquoise, are preparing for
their launches.
These networks are typically backed by consortia of banks that were once in bed with
the established exchanges as their member-owners. By stimulating competition, the
banks hope to force the exchanges to cut their fees. These remain particularly
expensive in Europe, where the cost of trading is, on average, three times higher than
in America.
The new lot tout several advantages. With no legacy technology weighing them down,
their platforms are ultra-fast. Chi-X, for instance, can complete trades at up to ten
times the speed of older rivals, and more reliably. This appeals to high-frequency
algorithmic traders at hedge funds and specialist brokers, an increasingly important
constituency for whom a millisecond is an aeon.
They are cheaper, too, not least because they have been offering generous rebates to
"liquidity providers" that post quotes. Chi-X has gone a step further, offering slivers
of equity to its heaviest users. Such user-friendly tactics are hard for the exchanges to
match without angering their shareholders. "They're still struggling to figure out how
much liquidity is sticky and how much price-sensitive," says Larry Tabb of TABB
Group, a consultancy.
Speed and price are not everything, however. In August and January the share of
trades done electronically on NYSE fell from 90% to as low as 60-70%. At times of
stress "people realise milliseconds don't matter", argued Duncan Niederauer, the
exchange's boss, in a recent speech. "It's better to get it right."
The second type of competition comes from "crossing networks" and "dark pools",
two forms of private market used to trade large blocks of shares away from the glare
of the exchanges. Some investors like them because they conceal the buyer's identity
and the price, reducing the risk of the market moving against them as others react.
Dozens of these markets are up and running. In America they are expected to account
for one-fifth of all share-trading in three years' time.
Although this free-for-all provides sought-after anonymity, the market as a whole may
suffer from the fragmentation of liquidity. Banks are starting to address the problem.
This month Goldman Sachs, Morgan Stanley and UBS agreed to offer each other
access to their pools, using computer programs that roam from network to network
looking for matching buy and sell orders. "Technology is solving the problem of
splintered liquidity as it arises," says one participant.
Full mergers among dark pools may be next. Some see parallels with the late 1990s,
when the first generation of electronic-trading networks consolidated, or were bought
by exchanges looking to get ahead in the technological arms race. Both NASDAQ and
the NYSE are cutting deals with dark pools. Mr Niederauer sees an opportunity to
"reaggregate" markets.
Some exchanges are even quietly creating dark pools of their own, buried within their
main market. Their reluctance to publicise this is understandable: although it helps
them to hold on to business, it irks some of their big customers, whose own bids may
be trumped by the service. Other counter-attacking measures are less surreptitious.
Some bourses, such as Deutsche Börse and NASDAQ, have bought options
exchanges, which enjoy bigger margins than pure stockmarkets. NYSE Euronext,
which already has Liffe, a futures exchange, is looking to expand its business in
derivatives (though it also needs to realise the transatlantic market it promised when it
formed in 2006, and to plug gaps in its global network).
The exchanges have two more cards up their sleeves. One is to launch markets that
the upstarts cannot. NASDAQ, for instance, has PORTAL, a marketplace for "144a"
securities, which only sophisticated investors may trade. The other is to develop
listings--the business in which brand counts most--by, for instance, offering in-house
research for smaller stocks.
In America the battle between newcomers and old guard is already firmly joined.
Across the Atlantic horns are only just starting to lock. As the head of trading at one
Wall Street bank puts it: "Some incumbents, particularly in Europe, have had it their
own way for so long that they still don't understand what's coming."
Economist work-out 5.8
Solutions
Do you think it is possible to characterise developments in the market for trading
stocks as a process of ‘imitation and innovation’?
It does seem that this process has occurred. First, the high profits being earned by the
existing (incumbent) exchanges induced entry (imitation) by new exchanges. This
entry caused profits of the existing exchanges to decrease; for example, the share
price of the LSE fell by half between January and May 2008, and the share price of
NYSE Euronext fell by 30% in the same period. New entrants have sought to
compete with existing exchanges by offering lower prices, and improving some
aspects of trading services. Second, the entry of new exchanges has caused the
existing (incumbent) exchanges to engage in product differentiation (innovation) in
order to retain their attractiveness to customers and their market power. For example,
they have introduced services such as providing research on small stocks, which are
not provided by the new exchanges.
Why was there an incentive for new suppliers to enter the market?
The main incentive for entry of new suppliers appears to have been the high levels of
profit being earned by the existing exchanges such as LSE, NYSE Euronext and
NASDAQ.
What were the main types of new entrants to the market?
There were two types of new entrants: electronic markets such as BATS and
DirectEdge in the United States, and Chi-X in Europe; and what are known as
‘crossing networks’ and ‘dark pools’ which are forms of private markets where buyers
and sellers can trade large blocks of shares with the price and identity of buyer being
concealed.
In what ways did the new suppliers engage in product differentiation to seek to attract
new customers?
The new electronic exchanges enable trades to be completed much more quickly than
the existing exchanges. Improving the speed of trade is particularly attractive to highfrequency algorithmic traders. The private markets provide the opportunity to trade
with a greater degree of confidentiality than existing exchanges. This is valuable to
customers who may be concerned that the size of their trade might cause a market
reaction that they want to avoid.
What are examples of how the incumbent suppliers – after the entry of new suppliers have engaged in product differentiation?
Incumbent exchanges have responded in two main ways to the entry of new suppliers.
First, they have themselves engaged in imitation by seeking to have their own
exchange services replicate some of the characteristics of services provided by the
new suppliers. For example, some of the incumbent suppliers have created dark pool
services. Second, the incumbent exchanges have sought to expand their business to
include services which are not offered by the new exchanges – for example, the
marketplace for ‘144a’ securities offered by NASDAQ; and offering research on
smaller stocks to investors using the exchange.
Economist work-out 5.9
Read the attached articles ‘The rush’ (The Economist, April 17 2010, page 41) and
‘Precious but precarious’ (The Economist, January 31 2011, page 40).
Some questions to consider
1.Explain why ‘old gold mining shafts are being reopened around the world’? What
does it imply about the costs of mining gold for different firms that some firms were
already operating and that other firms are only now beginning to reopen?
2. What does your answer to question 1 imply about the long-run market supply curve
for gold?
3. It is suggested that ‘to confirm there are worthwhile deposits of gold expensive
tests must be done...Getting the digging and processing equipment to the site costs
millions..’. What does this imply about the relative size of fixed and variable costs for
a firm? In an environment where there is substantial uncertainty about how much
gold exists in a mine, why might this aspect of costs make it less likely a mine would
reopen?
This article (‘The rush’, The Economist, April 17 2010, page 41) is reproduced with
kind permission of The Economist for use only for teaching purposes
(www.economist.com).
The rush
CLAY WORST is in a hurry. His mine, the Old Wasp, is the only operational gold
mine left in Goldfield, Arizona, a pretty tourist town an hour's drive from Phoenix.
His is a primary gold mine, which means it produces more gold than other valuable
metals like copper. The Wasp produces 75% gold, 25% silver, and he thinks it could
contain as much as $60m-worth.
But at 80 years old, handicapped and with an invalid wife, Mr Worst cannot go any
further underground. He also knows that big mining companies prefer mountains of
low-grade ore to small, high-grade mines like his. His best hope, he reckons, is to find
a small Canadian mining company to team up with. But he admits this is risky. "Gold
mining is a crap shoot to start with. Make some big mistakes and you lose your shirt."
Stories like this are increasingly common across America as gold prices soar. Gold is
trading above $1,100 an ounce compared with $350 in 2002, and with the euro under
pressure thanks to the risk of a Greek default, gold is back in favour for those who
want to diversify away from the dollar.
Goldfield was a leading gold mining hub in the 1850s after the California gold rush
subsided, according to Rob Feldman, a local historian. After several big finds,
Goldfield was for a while America's second-largest producer. Other hubs have
surfaced in Nevada, Colorado and California but Arizona, with some 50 mining
districts including Goldfield, Tucson and Prescott, remains attractive to owners and
out-of-state prospectors.
Bob Schoose is Goldfield's mayor and owns two mines; the Black Queen and the
Mammoth. Every week he sees newcomers, mostly unemployed or bankrupt company
owners arriving in the hope of finding gold. He and other locals call them dreamers.
"They buy picks or pans, camp out near the river but few last more than two weeks."
For local mine owners, however, the prospects of finding gold have never felt more
real.
However, John Mathis of the Thunderbird Global Financial Services Centre in
Glendale, Arizona, remains sceptical. To confirm there are worthwhile deposits of
gold, expensive tests must be done, he says. Getting the digging and processing
equipment to the site costs millions, and then tons of gold must be produced and
preferably other valuable minerals must also be present for a mine to be profitable.
None of this dismays the likes of Mr Worst. If the right operator appears, he will quit
and retire. Mr Schoose, meanwhile, is out prospecting at his own mines each weekend.
It's back-breaking work, he says, but it is the hope of hitting the g old that motivates.
He smiles behind his long beard. "Gold is very, very hard to find but it's there. I can
feel it." This article (‘Precious but precarious’, The Economist, January 31 2011, page 40) is
reproduced with kind permission of The Economist for use only for teaching purposes
(www.economist.com).
Precious but precarious
OLD gold-mining shafts are being reopened around the world, as economic
uncertainty and scepticism about other assets has sent the gold price soaring: the
yellow metal hit a record high of over $1,400 an ounce in December, double its 2007
level (though it has since fallen a little). Abandoned veins in mineral-rich countries
have become viable again--and despite the relatively steep extraction costs, a
miniature gold rush might be under way in Britain, too.
The action and the deposits are concentrated on the Celtic fringe. Since 2007 Galantas
Gold Corporation, a Canadian firm, has been working what is currently Britain's only
gold-producing mine at Omagh, in Northern Ireland, shipping the ore to Canada and
running a small gold-jewellery operation. Extensive electromagnetic prospecting has
been carried out elsewhere in the province. There are proven though mostly
unquantified deposits in Scotland. Only Wales, once the focus of British gold mining,
seems destined to miss out.
Chris Sangster of Scotgold Resources, an Australian outfit that holds assorted
exploration licences in the Scottish Highlands, is confident that his firm will be
mining soon. He expects others to follow, and that Britain will have two more active
mines within five years. Roland Phelps of Galantas thinks over 3m ounces of gold
reserves could be discovered in that period: not much by the standards of big goldproducing nations, but enough for a tidy niche industry.
For all their enthusiasm, however, the prospectors face obstacles, among them
regulation and environmental concerns. Scotgold Resources is struggling to get
permission to reopen an old mine at Cononish, inside the Loch Lomond and the
Trossachs National Park (below). The planning process for the Galantas mine in
Omagh took 11 years.
The hope is that the strict regulatory regime will offer a commercial compensation,
enabling Britain to specialise in "ethical gold", as Mr Phelps puts it. But other
problems might prove less pliable.
Gus Gunn of the British Geological Survey reckons that, apart from Omagh and
Cononish, "nowhere is gold known to be present in quantities that would currently be
economic to mine"; he also thinks it might take a decade to prove and develop other
finds. The mining firms are more bullish--but even they can't confidently predict the
future path of the gold price. Low mineral prices have wrecked British mining before;
if the gold market drops, the country might once again see empty tunnels and broken
dreams
Economist work-out 5.9
Solutions
1.Explain why ‘old gold mining shafts are being reopened around the world’? What
does it imply about the costs of mining gold for different firms that some firms were
already operating and that other firms are only now beginning to reopen?
Gold mining firms are reopening because the price of gold has increased. That some
firms were already operating, but other firms are only now reopening, suggests that
costs differ between firms. Some ‘low cost’ firms can operate profitably when the
price of gold is relatively low (and then of course high); whereas ‘high cost’ firms
will not be profitable when the price of gold is relatively low but are profitable when
the price is relatively high.
$ $
high cost: unprofitable p1 high cost: profitable
p2 low cost: profitable low cost: profitable q
q 2. What does your answer to question 1 imply about the long-run market supply curve
for gold?
The answer to question 1 implies that the LR Market Supply curve will be upwardsloping.
Suppose the market for gold is initially in LR equilibrium (P1,Q1). Then there is an
increase in demand which causes in the SR an increase in the gold price (P2). This
will increase profits of each firm. The existence of positive economic profits will
induce new firms to enter the market. The entry of new firms causes an increase in
supply, and hence a decrease in price. This process continues until no firm that is not
a supplier in the market could make profits by entering the market. Because the new
firms have higher costs than the incumbent suppliers, therefore this condition will be
achieved at a price (P3) that is above the initial equilibrium price (P1). The entry of
new firms means that the new LR equilibrium is at a higher quantity traded than the
initial equilibrium (Q3). Hence the shift from the initial LR equilibrium quantity Q1
to the ultimate LR equilibrium quantity Q3 involves an increase in price. Thus the LR
supply curve is upward-sloping.
$ $
SRS1 p3 MCold SRS2 B p2 p2 A ATCnew ATCold p3 C p1 MCnew p1 D2 D1 Q1 Q3 q
q $ •
p3 p1 LR Supply: No new supplier can make positive economic profits by entering the market •
Q1 Q3 Q
3. It is suggested that ‘to confirm there are worthwhile deposits of gold expensive
tests must be done...Getting the digging and processing equipment to the site costs
millions..’. What does this imply about the relative size of fixed and variable costs for
a firm? In an environment where there is substantial uncertainty about how much
gold exists in a mine, why might this aspect of costs make it less likely a mine would
reopen?
The quote suggests that fixed costs are a relatively large share of total costs. This
implies that a firm would need to produce a relatively large quantity of output in
order to cover its costs. (Remember, for a firm with high fixed costs, ATC will be
high at low levels of output, and low for high levels of output.) Hence, where there is
greater uncertainty about the quantity of gold in a mine, a firm will be less confident
of producing sufficient gold to cover its costs, and therefore it seems less likely that a
mine would be willing to reopen.
Economist work-out 5.10
Read the excerpts from the article ‘Flying from the computer’ (The Economist,
October 1 2005, pages 61-62). This article describes about changes in the market for
retail supply of air flights due to the capacity for on-line flight bookings. The article
also characterizes the market as one where a high degree of competition exists
between suppliers – Hence in answering the questions below, assume that the market
for retail supply of air flights is perfectly competitive.
1. The article suggests lower opportunity costs for consumers to purchase flights due
to being able to purchase tickets on-line (‘Freed from having to ring busy call centres
or queue at high-street travel agents, consumers have gone on-line in droves to find
flights…). How would this reduction in ‘search costs’ affect market demand? What
would be the effect of the change in demand on the long-run equilibrium?
2. Suppose that the capacity for firms to sell tickets on-line reduces the opportunity
cost of supply for firms. How would you represent the effect on marginal cost and
average total cost? Can this explain why ‘as online travel becomes more international,
size begins to matter’? What would be the effect of the change in costs on the longrun equilibrium? Does your answer explain why ‘this year’s travel season…has been
busier than ever’?
This article (‘Flying from the computer’, The Economist, October 1 2005, pages 6162) is reproduced with kind permission of The Economist for use only for teaching
purposes (www.economist.com).
Flying from the computer
THIS year's travel season, now drawing to a close, has been busier than ever, despite
strikes and terrorist threats. The number of people flying within America is expected
to return to the level that existed before September 2001: more than 680m people
flew on domestic flights there last year and by 2015 it could top one billion. European
travellers are also making more trips--for the first time there were more than 1m
flights last year at London's airports. More and more of those trips are being booked
over the internet.
Freed from having to ring busy call centres or queue at high-street travel agents,
consumers have gone online in droves to find flights, hotels, car rentals and other
travel services, making travel one of the most successful forms of e-commerce. The
industry was ideally suited to be an internet business. Most booking information
already existed in computer systems, but it was used by clerks and not directly
available to consumers. By designing websites that ordinary people could use, online
travel agents were able to put product availability and price transparency at their
customers' fingertips. "That was a real revolution," says Dara Khosrowshahi, chief
executive of Expedia, an American company that has grown into the world's biggest
online travel agent.
Even though the online travel business is at most only ten years old, its impact has
been enormous. After the September 11th terrorist attacks on America, online agents
helped airlines and hotels overcome a worldwide travel slump by making bargains
more visible to a greater number of people. And because the internet is the cheapest
way to take a booking, low-cost airlines in Europe and America also encouraged--and
in some cases required--customers to buy their tickets online.
As consumers became more accustomed to buying travel over the internet, suppliers
had to join in too. "The internet has been one of our biggest drivers of change," says
Simon Parks-Smith, the head of product management for British Airways (BA). By
taking bookings directly, suppliers avoid paying fees to agents. This, in turn, is
encouraging the online agents to broaden the range of services they offer.
Such competition is good for consumers, provided it does not force the online travel
industry to consolidate into too few hands. A wave of mergers and takeovers is indeed
taking place as the internet's biggest travel agents expand into overseas markets, often
by buying up smaller competitors. But ultimately the battle between travel suppliers
and online agents will be decided by consumers, who will spend their money on the
best prices and services that are available.
A lot is already known about how people like to shop online for travel. In America,
54% of consumers start with an online travel agent, such as Expedia.com,
Travelocity.com or Orbitz.com, according to a study by Nielsen//NetRatings, which
analyses internet use. The websites of travel suppliers, such as airlines and hotels, are
visited first by 37% of shoppers. The other 9% start planning their trips using
websites run by travel-search firms, such as Kayak.com and SideStep.com. These
work like shopping comparison services: matching users' itineraries with offers and
then directing bookings to the websites of agents and suppliers.
As with other forms of e-commerce, consumers tend to visit more than one website
before they take out their credit cards. The typical American traveller looks at three
websites before making a booking online, according to a study by PhoCusWright, a
market-research company. Consumers surf around to check timetables, prices and
frequent-flyer benefits and to read about resorts and hotels. In America, reckons
PhoCusWright, suppliers and distributors currently each take about half of all online
bookings.
That adds up to a sizeable chunk of the travel industry. Most analysts reckon about
one-third of America's $200 billion travel market will be booked online this year.
Some sectors, such as airlines, will see almost 40% of their bookings coming from
the internet in 2005 (see chart 1)
To see more clearly what is happening, PhoCusWright breaks the travel market into
two parts: leisure combined with "unmanaged" business travel (this is because
individuals booking business trips can be indistinguishable from leisure travellers)
and managed corporate travel (such as bookings made by specialist agencies working
for a company). PhoCusWright predicts that the online part of the leisure/unmanaged
business-travel market in America will be worth some $78 billion by 2006--having
doubled in size since 2003. It expects the value of the managed-corporate market that
goes online to be worth more than $36 billion by next year.
Many online agents are now expanding aggressively into the corporate market. With
a series of bespoke services, they allow employees to make their own bookings
online, but within the rules set by their employer. The services are proving popular.
Expedia claims that as many as 85% of the corporate travellers offered a chance to
book online through its site by their employers do so.
America's massive shift to online travel is being repeated in other parts of the world.
Online services have yet to take off in the huge Asian market, which means that the
potential there is also huge. But in Europe they are growing rapidly. In the year to
May, the number of visitors to travel websites in America grew by 12.7%, says
comScore, a market-research company. This compares with an increase of almost
30% in the number of visitors to British travel websites. Whereas the percentage of
Americans who look and then book has remained at a steady 3.7%, the booking ratio
in Britain grew by 73% to 2.6%. Bob Ivins, comScore's European chief, says this
shows that the American online travel business is maturing and turning into a battle
for market share, whereas Europe's market is still blooming.
The wider availability of e-tickets should speed the development of online travel
everywhere. It will spread even faster once paperless tickets become more widely
accepted for so-called "interline agreements", in which a ticket issued by one carrier is
valid on another carrier for part of the journey. At present the members of the
International Air Transport Association print 300m interline tickets a year. Giovanni
Bisignani, the head of the organisation, hopes that all airlines will switch to eticketing by 2007, because it would save the industry a much-needed $3 billion a
year.
As online travel becomes more international, size begins to matter. Being big gives
online agents advantages in cutting deals with suppliers and in spreading the costs of
their operations over more customers. Smaller companies may not be able to afford
the technical work needed to improve the functionality of their websites, whereas
bigger sites that have the money can get a return on their investment much faster.
This is also driving consolidation in the industry.
Expedia, which took $13.2 billion in gross bookings last year, was launched by
Microsoft in 1996, but later sold to Barry Diller, a former Hollywood mogul, who has
built a conglomerate of mainly internet companies. In early August, Expedia was spun
out of Mr Diller's InterActiveCorp (IAC) as a separately traded public company. It
contains other travel-related internet companies that IAC has bought, such as
Hotels.com, Hotwire and TripAdvisor. Mr Diller believes that Expedia will operate
more effectively and be valued more highly as a separate company. It already owns
several websites in Europe and earlier this year bought a stake in eLong, a leading
Chinese travel website.
Travelocity is owned by Texas-based Sabre Holdings, which also operates a global
distribution and ticketing system used by airlines and hotels. On July 20th, Sabre
bought Lastminute.com, Britain's best-known travel website, for £577m ($1.1 billion).
Orbitz, the third giant, based in Chicago, was put together in early 2000 by a group of
airlines as a way to sell directly to consumers. It was sold for $1.25 billion in 2004 to
Cendant, a property and travel group based in New York. Cendant's other businesses
include Galileo, a rival to Sabre's global distribution system; the Avis and Budget car-
rental operations; and hotel chains such as Ramada and Days Inn. Earlier this year,
Cendant also bought ebookers, a British online agent.
"The barriers to entry are a lot bigger than people thought in the beginning," says
Brent Hoberman, a co-founder of Lastminute and now chief executive of the
combined European operations of Travelocity. Lastminute is a poster child of
Britain's dotcom boom. Although it survived the 2001 bursting of the technology
bubble, won millions of customers and ploughed some £25m a year into better
technology and service improvements, it never made an annual net profit.
Mr Hoberman spoke to a number of potential suitors, but he says Travelocity
impressed him because it is trying to get away from selling travel as a commodity. As
well as travel, Lastminute provides restaurant bookings, gifts and tickets to events. Its
website allows customers to do lots more than just arrange a trip.
That is a tactic others are trying. Creating a sense of community is an important way
in which online travel agents will compete in the future, reckons Expedia's Mr
Khosrowshahi. "So much of the travel experience depends on the hotel you stay in,"
he adds. This is why his firm is providing a lot more information than just the ability
to look at hotel amenities. Expedia allows users to rate hotels, write reviews and read
the comments of other travellers.
Of course, the network effect also favours the big websites: the deeper the inventory
and the greater the number of users, the more information a website will contain.
Expedia is also trying to expand beyond the basics of travel and offer more
destination services, such as a scuba-diving course or a sunset cruise.
As the online agents become travel cornucopias, more of those visiting their websites
are planning and dreaming about trips and vacations, rather than dashing to buy a
flight. A study by Nielsen//NetRatings of online-booking behaviour in America in
April confirms this. Whereas the three biggest online travel agencies attracted up to
twice as many website visitors as the three most popular airline websites, the airlines
were able to convert a far higher proportion of visitors into sales (see chart 2). Many
of the airlines' websites, of course, are visited by regular flyers who already know
where they want to go and what flight they intend to catch.
Websites have already become the most important shop window for many airlines,
hotels and car-rental companies. An example is ba.com. "It has transformed the way
we sell our tickets and the way we stay in touch with our passengers," says BA's Mr
Parks-Smith. Because the internet has made it easier to compare deals, BA realised
that users wanted to start by finding the lowest fare. "There was no point kidding
ourselves about that," adds Mr Parks-Smith. So people booking online are now
presented with a range of fares to choose from, with the busiest flights commanding
the highest premiums. Customers are shrewd enough to understand the laws of
supply and demand, BA concluded.
The airline is now making its website easier to use. The ability to check in and
choose your own seat online has proved extremely popular, so a new facility to print
your own boarding card at home is also likely to be a hit. Services such as booking
rental cars, hotels and even guided tours at destinations will be added.
In this way, some travel suppliers' websites will come to resemble those of online
travel agents. But how successful will airlines be at also taking hotel and car-rental
bookings? Some airlines have long offered deals with so-called travel "partners", so
the idea is not completely new. However, in the past these deals have not always
been the cheapest options.
If the prices of additional services offered by airlines are competitive, many travellers
might prefer the convenience of a "one-stop" travel shop. But the choice of services
offered by online agents may well be greater. And airlines and online agents will both
be restricted in what they offer--they will not necessarily have distribution agreements
with all the travel firms that operate in certain markets. This is particularly the case
with some of the lowest-cost operators.
Ryanair, for instance, is Europe's biggest low-cost carrier. It no longer pays any
commissions to travel agencies and now takes almost all its bookings directly, either
via its own website or by telephone.
It is hard to imagine hotels and car-rental firms being successful at trying to sell
flights, so their websites will probably remain specialised. But like airlines, these
companies can also rely on various loyalty schemes to pull in online business. These
schemes offer incentives to travellers to stay loyal to a particular brand, even if the
price is a bit higher. When it comes to business travel, where the employer rather than
the individual is paying, these incentives often succeed--making a booking via an
online agent does not preclude a traveller from earning frequent-flyer points or other
rewards, for example. However, the websites of airlines or hotels are likely to prove
more popular with frequent travellers than those of online agents because the former
can also be used to check up on rewards, cash them in and to find special offers, such
as upgrades.
Another weapon many travel providers are likely to deploy are lowest-price
guarantees. These are designed to persuade people that it is not worth looking any
further for a better online deal. InterContinental, one of the world's biggest hotel
chains and the owner of Crowne Plaza and Holiday Inn, claims to be the first hotel
company to have introduced a price guarantee for every room booked through its own
websites: if a lower rate can be found on the internet for the same accommodation on
the same date, it will honour the lower rate and also give a 10% discount.
Big hotel groups are most able to flex their muscles this way, especially in America
where the majority of hotel rooms are booked via chains. But in Europe smaller hotel
groups and independent operators still dominate. These firms will be much more
reliant on online agencies to bring them business.
The online agents also have an advantage with overseas visitors who may not know
anything about the travel firms that operate in a country they intend to visit. The
consumer reviews offered by online agents could become trusted guides. After all,
you are unlikely to find anything damning written about the standard of service on
the websites of travel providers.
In the middle are the specialist search websites that do not sell anything directly, but
put consumers in touch with both online agents and travel firms. Cheapflights.com,
for instance, asks travel firms to pay whenever a potential customer clicks through to
an advertiser's website or clicks to obtain their telephone number. "There is still an
awful lot of travel that can only be sold on the telephone," says David Soskin,
Cheapflights's chief executive. This could be because it involves complicated or
special arrangements. Whereas Mr Soskin is convinced that the internet has
persuaded people to travel more often, he also thinks the death of the traditional highstreet travel agent has been greatly overstated.
Indeed, the more costly the trip, the more likely a traveller is to use a traditional
travel agent. In America, according to Forrester, a research company, long-haul
travellers spend 58% more than domestic leisure travellers, but are more than twice as
likely to use an offline agent to book their trip. Henry Harteveldt, Forrester's online
travel analyst, points out that even wealthy long-haul travellers are just as tantalised
by low prices and many use the internet to research and plan their journeys, even
though they may end up booking offline.
Will the contest between online agents and the websites of travel providers remain a
draw, as it is now in America? There has always been commercial rivalry between
travel agents and travel providers. But whereas it was initially the agents who
developed the online market, the travel providers have caught up fast and are still
beefing up their sites. With the ability to offer lowest-price guarantees and exclusive
online services, such as picking your own seat in an aircraft, the travel providers may
well move into the lead. And that could fuel yet more consolidation among online
travel agents.
Nevertheless, the gap may not widen greatly. Both sides will still need each other,
especially if the industry hits trouble in future as a result of economic slowdown or
further terrorism. The online agents may then find their services are desperately
required by travel firms scrambling to fill aircraft seats, hotels and unused rental cars.
There is no doubt that the internet will become the standard way most people plan
and book travel. But when it comes to making reservations, there is still plenty to play
for. The ensuing competition will be great for consumers who want to hunt down
travel bargains.
Economist work-out 5.10
Solutions
1. Lower opportunity cost of purchasing air travel tickets will increase demand.
(Where you think of the ‘price’ of air travel as the price of the ticket, this means that a
decrease in other components of opportunity cost will cause a shift in the demand
curve.)
Suppose that the market for retail supply of air flights is initially in long-run
equilibrium. Then the increase in demand will have the following effects:
Short-run: An increase in demand causes excess demand at the initial equilibrium
price. Hence price will increase. The supply curve does not shift as the number of
suppliers is fixed. Instead the increase in price causes an upward movement along the
supply curve as existing firms are willing to increase the quantities they supply.
Existing firms will make positive economic profits.
Long-run: New firms will be attracted into the market by the opportunity to earn
positive economic profits. This will cause an increase in supply (outward shift of
supply curve). With the increase in supply, price will begin to decrease. We would
expect this process to continue until all firms are earning zero economic profits.
Where firms’ costs are not changed by the entry of new firms, then this would occur
once supply had increased sufficiently to restore the original equilibrium price.
Alternatively, where firms’ costs increase with the entry of new firms, then the new
equilibrium price (where all firms earn zero economic profits) will be at a higher price
than the original equilibrium price. In the new long run equilibrium there will be a
larger number of firms, and the market quantity supplied will be greater than in the
original equilibrium.
2. Selling tickets on-line (compared to retailing through physical outlets) is likely to
involve a higher level of fixed cost, and lower marginal cost. Hence average total
cost is likely to reach a minimum at a higher level of output. This is shown in
diagrams 1 and 2 below. With the capacity to achieve lower average cost at higher
levels of output, it becomes more important for firms to be supplying a larger number
of customers – This is the sense in which it can be said that “…size begins to
matter…”.
$ MC1 $ MC2 ATC1 ATC2 q Diagram 1 Diagram 2 q The decrease in marginal cost will cause an increase in short-run market supply. (In
the short-run the number of firms is fixed. Since the short-run market supply curve is
the aggregation of marginal cost curves for firms, and marginal cost has decreased for
each firm, therefore short-run market supply increases.) The increase in supply will
cause a decrease in price. At this new price it would generally be expected that
existing firms would make positive economic profits (since the decrease in price will
be less than the downward shift in MC and ATC). This is represented in diagram 3
below in the shift in equilibrium price from P1* to P2* , the shift in quantity supplied by
each firm from q1* to q*2 , and increase in market supply from S1 to S2. Where firms
are making positive economic profits, in the long-run this will attract new firms into
the market. Where the entry of new firms does not affect costs, then firms would
continue to enter until market supply has increased sufficiently that price decreases to
a level where each firm is making zero profits. This new long-run equilibrium occurs
at price P3* , where each firm supplies q*3 , and the market quantity traded is Q*3 . In
summary, the new long-run equilibrium involves a decrease in equilibrium price and
increase in equilibrium quantity traded, and an increase in the number of firms and
quantity supplied by each firm. The increase in quantity traded explains why ‘this
year’s travel season…has been busier than ever.’
$ S1 $ ATC1 S2 ATC2 S3 P11**
MC1 MC2 1 MR
P1*
P2* MR2 MR3 P3*
D1 Q1* Q2* Q3*
market q Diagram 3 q1*
firm q3*
q2*
q Economist work-out 5.11
Read the attached articles ‘The price of powder’ (The Economist, November 27 2004,
pages 65-66) and ‘Sniffy customers’ (The Economist, March 7 2009, pages 28-29).
The articles describe wholesale and retail markets for the supply of cocaine in the
United Kingdom.
Some questions to consider
1. In what regards do you think it is possible to think of the wholesale market for
cocaine as monopolistically competitive?
2. From the article what would you describe as the main sources of market power for
wholesale dealers of cocaine?
3. The average wholesale and retail prices of cocaine decreased steadily during the
1990s. How could this have occurred in a monopolistically competitive market?
This article (‘The price of powder’, The Economist, November 27 2004, pages 65-66)
is reproduced with kind permission of The Economist for use only for teaching
purposes (www.economist.com).
The price of powder
FOLLOWING a quiet spell, Britain's war on drugs seems to be heating up. This week,
the Home Office unveiled legislation that will create a Serious Organised Crime
Agency (SOCA), which, it is promised, will conduct "a specialist and relentless
attack" on racketeers. Suspected traffickers will be compelled to produce documents
and drug kingpins encouraged to inform on one another. Other legislation will force
more addicts into treatment.
Hopes are high, which is surprising given the failure of previous efforts. Street prices
of Class A drugs have fallen steadily in recent years (see chart) and the number of
users has risen. Drug traffickers are running slicker businesses. "We dealt with a team
a while ago that had a director of operations and a director of finance, and they
actually called them that," says Bill Hughes, the appointed director-general of SOCA.
More importantly, they are running a different kind of business.
The drugs trade used to be dominated by stable, vertically integrated outfits
resembling mini-Mafia families. That was a response to the risks of doing business.
Drug buyers may be undercover police officers; promises to pay may be broken (these
are criminals, after all); trusted contacts may be jailed and rivals get shopped. Stable
partnerships reduced these risks, as did recruitment from a shallow ethnic pool. But
market forces have gradually pushed these cumbersome organisations out of business.
Competition in the cocaine trade has cut margins to minuscule levels, considering the
risks involved. Powder cocaine from central America is sold in multiple-kilogram
loads for £15,000-30,000 ($28,000-56,000). But the price for a single kilogram,
£18,000-32,000, is barely higher, and the retail price not much more than that. Last
year, the National Criminal Intelligence Service estimated that cocaine was selling for
£56 per gram (equivalent to £56,000 per kilo) but the current London price is said to
be around £40 per gram.
The falling price of powder is especially striking considering the supply problems of
recent years. The United Nations Office of Drug Control (UNODC) estimates that
global coca leaf production has fallen every year since 1999, from 353,000 to 236,000
tonnes. And, unlike heroin, cocaine is perishable, which means it cannot be stockpiled
against lean times.
Margins are fatter in the heroin trade. Importers, many of them London-based Turks,
sell multi-kilo loads to white British middlemen at £16,000-22,000 per kilo. The
middlemen, who rarely deal in any other product, sell on to retailers at prices up to
£33,000 for a single kilo, enhancing profits further by adulterating the drug. Heroin is
then cut again before being sold on the street for the equivalent of £60,000 per kilo.
The reason why the cocaine price has fallen so much is that the market is opening
up. Dave King, a drugs specialist at the National Crime Squad, says that the Londonbased Colombian importers who traditionally controlled the import and wholesale
trades now contract freely with British entrepreneurs. A recent trend is for Britons
living in Spain to deal directly with Central American suppliers before selling on to
Colombians in London or directly to an army of middlemen.
New importation routes open frequently, sometimes as a result of police activity.
Operation Airbridge, a co-operative Jamaican and British venture, proved so
successful that traders have explored other routes through the Caribbean.
Improvements in Spanish policing have encouraged traffickers to ship cocaine
through Africa, where it can be bundled with other drugs likely to interest the same
consumer. One of the biggest domestic seizures this year came from a warehouse in
west London. Among a shipment of pineapples and vegetables from Ghana were ten
kilos each of cocaine and marijuana.
By contrast, the heroin trade is more closed and less innovative. Mr King believes
that is partly because demand for heroin is more inflexible than demand for other
drugs. Reliability of supply is more important than price, which means there is less
shopping around at any stage of the supply chain. Another barrier to greater
competition is linguistic. To move cocaine from producer to market, English and
Spanish are essential; to move Ecstasy, it helps to speak Dutch. But as many as 120
languages, from Italian to Pashto, are spoken by those involved in the heroin trade.
That makes it tricky to seek out new sources or new routes.
Heroin traffickers do not constitute a cartel, though. They behave more like members
of an oligopoly, with a mixture of competition and co-operation at the highest levels
of the trade. Paul Evans, chief investigation officer at Customs and Excise, says that
this can extend to emergency relief: "if your shipment hasn't arrived, someone else
will loan you stuff to tide you over."
Such cosy arrangements are likely to break down as new players enter. Turkish
importers have already lost business to Kurds and Albanians--both groups now
scattered across Europe, thanks to instability at home and higher immigration into rich
countries. British-based Colombians squeezed out of the cocaine trade are dabbling in
the more profitable opiates. The dissolving of ethnic and family bonds is likely to
mean still freer trade.
Competition in the drug market is good for the consumer, which means it is bad for
anyone trying to reduce or eliminate drug taking. Against Mafia-style cartels, the
police might have succeeded. They are less likely to prevail against the invisible hand
of the market.
This article (‘Sniffy customers’, The Economist, March 7 2009, pages 28-29) is
reproduced with kind permission of The Economist for use only for teaching purposes
(www.economist.com).
Sniffy customers
OUTNUMBERED and outgunned, the sailors raised their hands. About 300km off
the west coast of Ireland, the yacht Dances With Waves was within hours of
delivering a half-billion-euro payload of cocaine to Cork in time for Christmas. The
vessel had been under surveillance since setting off from Trinidad and Tobago a
month earlier. Inside, Irish police found almost 1.9 tonnes of cocaine. Three British
men are now awaiting trial.
Such seizures are getting more common. European forces intercepted some 120
tonnes of cocaine in 2006, more than double the haul they managed in 2001 and
nearly six times as much as in 1995. But for every boat that is caught, more slip
through. Despite the seizures, the price of cocaine in Europe has been falling (see
chart), leading the UN to conclude that its availability has probably increased. At the
same time, the number of users has rocketed. In Britain, which recently overtook
Spain as Europe's most coke-hungry country, 7.6% of adults claim to have tried it; use
has doubled in the past decade. Most rich European countries report a similar picture,
especially among the young. Overall, Europe now accounts for 17% of global cocaine
seizures. In 1980 the figure was 3%.
Europe's cocaine market is served by an evolving network of trade routes. Shipments
commonly head for the Iberian Peninsula, either hidden in legitimate container vessels
or on board creaking old "motherships", which loiter out at sea while nimbler craft
bring the packages onshore. The traditional hotspot is the north Atlantic coast of
Spain, though in recent years traffickers have also targeted Barcelona and Valencia to
stay ahead of the police. Some three-quarters of European seizures take place in Spain
and Portugal, which also have some of the highest rates of consumption on the
continent.
Like any sensible business, drug-traffickers spread their risk: large shipments are
complemented with little-and-often supply lines, including parcel post and human
mules. That particular ruse has been upset by an advertising campaign run by the
police, warning potential mules of the severity of trafficking sentences. Some still risk
it, but they now command a fee of around $6,000, compared with the $2,000 they
used to do it for. That is enough to make the route unprofitable, police reckon.
But as one route closes, another opens up. In the past four years customs officers have
spotted a sharp rise in the amount of cocaine being smuggled into Europe via west
Africa. Of those seizures where the origin of the cocaine could be identified,
European forces reckon that in 2007 some 22% had been via Africa. As recently as
2004, just 5% had stopped off there. Seizures have risen sharply, too: before 2003,
officials had never intercepted more than a tonne of cocaine each year in Africa. In
2006, they nabbed 15 tonnes. Britain and America have beefed up their presence in
the region, but the traffickers may already have planned their next move: on February
19th the UN warned that a new supply route was emerging in the Balkans.
In Britain, Europe's biggest consumer of narcotics, the Home Office reckons that
drugs are brought in by about 300 major importers, who pass them to 30,000
wholesalers and then to 70,000 street dealers. Cocaine, meaning both the sniffable
powder and smokable "rocks" of crack cocaine (which can be made using a simple
microwave), accounts for about half the value of this industry, being less widely taken
than cannabis but much pricier.
Some rare light was shed on the business by a Home Office study in 2007, in which
222 drug-dealers were interviewed in prison by analysts from Matrix Knowledge
Group, a consultancy, and the London School of Economics. One dealing partnership,
based in London and Spain, bought cocaine from a Colombian importer in 10kg
bundles, which they sold to retailers using an employee whom they paid £500 ($703)
per transaction. A second employee, paid £250 a day, would collect money from the
buyers and pass it to a third member of staff, who would count it (processing up to
£220,000 each day). Other employees would pay the Colombians and smuggle the
rest of the cash, on their bodies, back to Spain.
Most drug businesses are forced to stay small and simple to evade the police. Only
one dealer claimed to be part of an organisation of more than 100 people, and a fifth
were classified by researchers as sole traders. Fear of being uncovered also hampers
recruitment: most dealers stuck to family and friends, and people from the same
ethnic group, when hiring associates. Just like other businessmen, they carried out
criminal-record background checks on potential employees--except that, in this case, a
record was a good thing.
Kevin Marsh, an economist at Matrix Knowledge, argues that most players in the
drug business have a poor knowledge of the market. "Shopping around for new
wholesale suppliers is risky, so many retailers stick to the same one and pay over the
odds," he says. Most of the dealers interviewed knew little about the purity of what
they were buying, and money laundering was usually fairly shambolic. Managing
cashflow is one of dealers' biggest weaknesses, according to one drug specialist at the
Serious Organised Crime Agency (SOCA): "Supply of powder is the most resilient
thing. To destroy the business, you have to go after the money." That, and extradite
foreign dealers, as America has long done. Britain is believed to be negotiating its
first-ever extradition of a Colombian, on drug charges, at the moment.
Times may at last be getting harder for cocaine-dealers. Shortly before Christmas, the
wholesale price in Britain shot up to £40,000 per kilo, the highest in years. Better
policing was one cause; another was the slump of sterling. European retailers' margins
have been chipped away. To protect their profits, dealers are diluting what they sell. A
decade ago, average street-level purity was about 60%; police say it is now nearer
30%. "People think there is a lot of cocaine around, but two thirds of it isn't cocaine at
all," says one SOCA officer.
That would be fine if the remainder were talcum powder. But in the past few years
dealers have turned to pharmaceutical cutting agents such as benzocaine, a topical
anaesthetic, which mimic the effects of cocaine and may be more harmful. Dealers
call such agents "magic" because of their effect on profits. "Grey traders", who
knowingly sell such chemicals to dealers, are starting to be convicted.
Educating drug-takers about what is getting up their noses may lower demand. But
cutting raises bigger questions for drug policy. "We may have to say at some stage
that taking heavily adulterated cocaine is more physically harmful to the user than
taking cocaine that's less adulterated," a senior SOCA official says. "That is not the
case at the moment. But we've got to keep asking the question. I'm aware that the
health equation could one day say: Stop trying to stop cocaine coming in."
Economist work-out 5.11
Solutions
1. In what regards do you think it is possible to think of the wholesale market for
cocaine as monopolistically competitive?
• Likely to be product differentiation between cocaine supplied by different
wholesalers – for example, in the region from which the cocaine is grown, and the
extent to which it is diluted prior to sale; as well, each individual retailer is likely to
have a different amount of knowledge about the trustworthiness of different
wholesalers, which means buying from each wholesaler would not be regarded as
identical.
• It appears that entry by new suppliers is relatively easy – for example, the article
‘Sniffy customers’ states (p.28) that ‘…as one route closes, another opens up’, and the
article ‘The price of powder’ states (p.65) that ‘New importation routes open up
frequently…’.
2. From the article what would you describe as the main sources of market power for
wholesale dealers of cocaine?
One source of market power appears to be that – because the activity of trading
cocaine is illegal – retailers prefer to buy from a wholesaler from whom they have
bought in the past and regard as trustworthy. In other words, a wholesaler could
increase the price it is charging for cocaine, and not lose all its customers since some
retailers will still prefer to buy from a source they regard as trustworthy, rather than
taking the risk of switching to a new wholesaler.
3. The average wholesale and retail prices of cocaine decreased steadily during the
1990s. How could this have occurred in a monopolistically competitive market?
The articles suggest that it new suppliers entering the market in response to the
perception of a high level of profits from the wholesale supply of cocaine that
accounts for falling prices. For example, the article ‘The price of powder’ states (p.65)
that ‘The reason why the cocaine price has fallen so much is that the market is
opening up…the London-based Colombian importers who traditionally controlled the
import and wholesale trades now contract freely with British entrepreneurs’.
Economist work-out 5.12
Read the attached article on ‘How the West got lost’ (The Economist, January 22
2005, page 53). This article describes competition amongst theatres in London.
a) The article describes a difference in demand for musicals and plays – How would
you represent this?
b) The article describes how subsidised theatres that show plays have higher
attendance and lower prices than unsubsidised theatres – Can you explain how this
would occur?
c) The article describes that ‘subsidised theatre [is] increasingly hard to distinguish
from commercial theatre’ – How would you represent the effect of this change in the
types of productions at subsidised theatres on demand for productions at commercial
theatres? What would you predict would be the long-run effect on the commercial
theatre market?
This article (‘How the West got lost’, The Economist, January 22 2005, page 53) is
reproduced with kind permission of The Economist for use only for teaching purposes
(www.economist.com).
How the west got lost
LONDON'S theatreland may suffer from cramped seating and be served by lousy
theatre bars, but it still excels at one thing: spreading rumours. So the news that
Andrew Lloyd Webber, its most commercially successful son, has been approached
by a bidder for all of his Really Useful Group, and by bidders for a handful of the
theatres it co-owns, has created a flurry of excitement. Since the theatres that,
according to backstage whispers, are the focus of serious interest are all smallish
playhouses rather than big theatres that tend to house musicals, it also prompts a
question: is it now impossible to make money by putting on plays in the West End?
"The West End has been written off before," says Peter Longman, director of The
Theatres Trust. Competition is always intense: London's theatregoers are so
capricious that of ten new shows, seven will close early, two will break even and one
makes money. Nevertheless, this time the prognosis doesn't look good. Six
productions closed within a month of opening last summer, an unusually speedy death.
And there is also evidence that two more fundamental shifts are luring away
audiences from London's commercial theatres.
First, tastes seem to be changing. Though audiences in the West End are not falling,
that's mostly thanks to the allure of musicals, not plays. The Society of London
Theatre's members ran at 65% capacity in 2003, the most recent year for which
figures are available. But this disguises a big difference between musicals and plays.
For the musicals, attendance averages 68% of capacity; for plays, attendance is
somewhat lower, at 56%. So if a show doesn't contain some warbling and plenty of
sequins, half the red velvet chairs are likely to stay folded up. And in a business in
which the costs are all fixed, a few punters more or less can make the difference.
Second, London's subsidised theatres are doing unusually well. Across the river at the
National Theatre, which receives around [pounds sterling]14m ($26m) in public
money every year, attendance has been running at over 90% of capacity for the past
20 months. That's partly thanks to a sponsorship deal with Travelex, a foreignexchange company, which allowed the National to sell 170,000 tickets for [pounds
sterling]10 over the quiet summer months; and partly to aggressive programming.
Hits like "Jerry Springer--the Opera", "His Dark Materials" and "The History Boys"
have provided a string of sell-outs. By the time plays transfer from the subsidised
sector to the commercial West End, they have often lost both their initial buzz and
their lead actors, already booked to star in something else.
That leaves the playhouses hoping to recover some glitz by casting well-known
American actors in movie adaptations. So far this has worked, but the formula is
likely to become tired quite soon, leaving producers scratching their heads again.
With subsidised theatre increasingly hard to distinguish from commercial theatre, the
West End thinks it should be subsidised too. The Theatres Trust has a plan that would
involve spending [pounds sterling]250m (half provided by the taxpayer) over 15 years
on sprucing up the West End's playhouses. Wisely, the government has not, so far
Economist work-out 5.12
Solution guide
1. Theatres and musicals can be thought of as differentiated products within the
market for musicals. The article suggests that demand for musicals is higher than for
plays – This could be represented as in Figure 1.
2. The subsidy increases the MR that the theatre receives per extra person who attends
by the amount of the subsidy – that is, MR is now equal to the extra revenue from
ticket sales plus the per person subsidy). In Figure 2 this is depicted as upward shifts
of the demand and MR curves by the amount of the subsidy (from
D1 to D 2 , and MR1 to MR 2 ). The increase in MR per person attending means that
the theatre’s profit maximizing quantity to supply increases (from q* to q subsidy ), and
there is also an increase in the total amount received by the theatre per person
attending. Note that P* is greater than Pconsumer so that persons attending the theatre
pay a lower ticket price with the subsidy. However P* is less than Pproducer so that the
theatre receives a higher total amount per person attending after the introduction of
the subsidy. In other words, both persons attending the theatre, and the theatre
company, receive some benefit from the subsidy.
3. As productions at subsidised theatres become increasingly similar to at commercial
theatres, the degree of substitutability is increasing. Given the closer substitutability,
and the lower price at the subsidised theatres, we would expect demand for
productions at commercial theatres to decrease (see Figure 3a). This is likely to cause
some commercial theatres to become unprofitable (see Figure 3b), and in the long-run
we would expect these theatres to close down.
$ Demand for plays Demand for musicals
attndance Figure 1 $ Pproducer p* pconsumer amount of subsidy
.
.
. .
MC B A MR2(with subsidy) MR1 q* qsubsidy D2(with subsidy) D1 Attendance Figure 2 $ D2 D1 attendance Figure 3a $ negative economic profits ATC MC ATC Pr D2 MR2 r q
attendance Figure 3b Economist work-out 5.13
Read the attached article ‘Media’s two tribes: charging for content’, (The Economist,
July 3 2010, page 61).
Some questions to consider
1. The article raises the question: ‘Is it better to take a little money from a lot of
people, or a lot of money from a few?’ Explain how this question relates to the
tradeoff a firm faces where it can only choose a single price for its output. How does
price discrimination allow a firm to relax this tradeoff?
2. How does the issue of ‘...whether the studios should sell DVDs to cheap rental
services on the same day as they put them on sale to the public...’ relate to the
concepts of price discrimination and versioning? What must be Disney, Paramount
and Sony’s beliefs about consumers’ preferences for them to decide it is not worth
‘windowing’ films?
This article (‘Media’s two tribes: charging for content’, The Economist, July 3 2010,
page 61) is reproduced with kind permission of The Economist for use only for
teaching purposes (www.economist.com).
Media’s two tribes; charging for content
IS IT better to take a little money from a lot of people, or a lot of money from a few?
In Britain the Times and the Sunday Times newspapers are about to take the latter
course by asking people to pay for news online. It is a bold move: the Times, which is
owned by News Corporation, is a mainstream paper in a fiercely competitive national
market. And the paywall it is building is a mighty one that is impervious even to
Google's web crawlers.
Paywalls are rising across the media landscape as many firms conclude that revenue
from online advertising alone is not enough to make ends meet. The Tallahassee
Democrat, a newspaper owned by Gannett, starts charging from July 1st. Hulu, a free
video website that was launched in America in 2008, said this week that it would
begin selling subscriptions.
Yet there is a strong drift in the opposite direction, too. For every outfit that is trying
to build a premium subscription service, another is becoming more convinced of the
virtues of giving away free content.
Britain's Daily Mail newspaper, for example, is something of an anti-Times. Its
website, which is heavy on pictures and celebrity news, has grown rapidly in the past
two years, both at home and abroad. It had 42m unique monthly visitors in May,
according to the Audit Bureau of Circulations--more than any other British newspaper
website. Martin Clarke, who runs the Mail's website, reckons people simply will not
pay for general news on the web, and is happy to maximise viewers and advertising.
The model of giving away content is not broken, he says: "It's only broken if you are
not big enough."
This is not merely a difference of opinion over whether to charge for online content. It
is a divide between a strategy based on "up-selling" people to premium subscriptions,
and a strategy based on scale and market-share. More fundamentally, it reflects
different views about the extent to which consumers can be steered towards the most
profitable products.
This crack stretches all the way from newspapers to the film business. The hot issue in
Hollywood these days is whether the studios should sell DVDs to cheap rental
services on the same day they put them on sale to the public. Netflix, which sends
discs through the post, and Redbox, which rents them from kiosks for $1 a day, have
grown quickly. Fox, Time Warner and Universal believe such outfits undermine more
profitable DVD sales and video-on-demand rentals. They have "windowed" Redbox,
making it wait 28 days for popular films. Disney, Paramount and Sony disagree: a
person who wants to rent a film cannot be strong-armed into buying it.
Television is no closer to consensus. Hulu's decision to charge $9.99 a month for full
seasons of TV shows and access to the service from smartphones and games consoles
is a victory for the premium camp. News Corporation, a part-owner of Hulu, had
publicly argued that it should become a subscription service. But cheapskates can take
heart. In Britain, Channel 4 and Five have put their programmes on YouTube. Disney,
which also owns part of Hulu, now offers many of its broadcast TV shows free on the
iPad (Steve Jobs, Apple's boss, sits on Disney's board).
The big media firms are not wholly consistent. Although News Corporation
champions subscriptions, it is not yet erecting paywalls around its tabloid newspapers.
Disney makes its broadcast TV shows available free but does not do the same for
ESPN, its lucrative sports network. Other outfits are fence-sitters that believe they can
both take a little money from a lot of people and a lot of money from a few people.
But the drift is towards the extremes. Few believe the future lies in premium-ish
products and middling scale.
The two camps are likely to grow further apart. Online advertising is picking up,
encouraging firms that have hitched their fortunes to it. As others erect paywalls, the
audiences for free sites will probably grow. The Times will surely lose online readers
when it begins charging. The mere act of asking people to register caused its market
share to drop by half, according to Hitwise, a market-research firm. In film, similarly,
the Redbox-friendly studios benefit from the reluctance of others to supply DVDs to
kiosks, argues Richard Greenfield, an analyst at BTIG Research.
Apple's iPad appears to be speeding the separation. The scale outfits have seized on
the iPad as a means of reaching more people and charging high rates to put
advertisements in front of them. Although the premium folks appreciate those ads,
they view the iPad mostly as an opportunity to sell more subscriptions. At some
magazine firms, such as Time Inc, building a paid iPad app is the first step towards
withholding some free content from the web.
This lack of consensus worries many in the media industry. Those who pursue scale
(and their many allies in the blogosphere) claim that premium strategies are doomed.
The other side retorts that the practice of giving stuff away undermines the value of
all content. But it is likely that winners will emerge on both sides. Some will find a
way of profiting from scale, while others will carve out dedicated audiences and
lucrative niches. There need not be a single right way to do things.
Economist work out 5.13
Solutions
1. The article raises the question: ‘Is it better to take a little money from a lot of
people, or a lot of money from a few?’ Explain how this related to the tradeoff a firm
faces where it can only choose a single price for its output. How does price
discrimination allow a firm to relax this tradeoff?
A firm that must charge a single price for all units it produces faces a tradeoff – If it
sets a higher price it can capture more of the willingness to pay of customers with a
high willingness to pay, but at the cost of not selling to some customers whose
willingness to pay is less than the high price. On the other hand, if it sets a lower
price it will capture some of the willingness to pay of many consumers, but at the cost
of charging customers with a high willingness to pay much less than the maximum
amount they would pay.
Price discrimination relaxes this trade-off. By charging different prices to different
consumers the firm can potentially target each price at the willingness to pay of the
consumers to whom it is selling at that price. For example, 1st degree price
discrimination allows a firm to charge a price to each consumer equal to that
consumer’s willingness to pay.
2. How does the issue of ‘...whether the studios should sell DVDs to cheap rental
services on the same day as they put them on sale to the public...’ relate to the
concepts of price discrimination and versioning? What must be Disney, Paramount
and Sony’s beliefs about consumers’ preferences for them to decide it is not worth
‘windowing’ films?
Versioning is the idea of selling different versions of a product to induce consumers to
pay an amount for a product that corresponds to their willingness to pay for the
product. Here the idea is that a DVD producer might initially release a DVD only for
sale, hoping to attract viewers with a high valuation who want to be able to watch it
immediately, and then release it for rental, hoping then to pick up customers with
lower willingness to pay who are willing to wait to watch the DVD. If the DVD is
made available for rental at the same time as it is made available for sale, this might
undo the scope for versioning to allow the DVD producer to price discriminate. If
both the low price (rental) version and high price (sale) version are made available at
the same time, customers with a high willingness to pay who might otherwise have
bought the high price (sale) version in order to have the DVD immediately, may
choose to buy the low price (rental) version. For Disney etc to be willing to release
both versions simultaneously, they must believe that customers for DVD sales regard
renting DVD of the same movie as such an imperfect substitute, that they would not
switch from buying to renting the DVD, even if they were able to rent at the same
time as the DVD becomes available for sale.
Economist work-out 5.14
Read the article ‘They’re watching you’ (The Economist, October 18 2003, page 79).
The article describes how businesses can use the internet to implement new pricing
practices, and some factors that may constrain the degree to which they can engage in
price discrimination.
1. Why does the article argue that internet trade will ‘…usher in an unprecedented
level of price discrimination’?
2. Why would universities want to adopt a pricing practice that charges different
prices to students with different levels of family income, but drug companies not want
to set different prices for AIDS drugs for buyers in countries with different income
levels?
3. How can ‘loyalty clubs’ be considered as a form of price discrimination?
4. In an environment where firms have a greater capacity to engage in price
discrimination, why might customers have an increased preference for ‘fixed price for
unlimited access’ deals?
This article (‘They’re watching you’, The Economist, October 18 2003, page 79) is
reproduced with kind permission of The Economist for use only for teaching purposes
(www.economist.com).
They’re watching you
The internet is eroding privacy. It also allows unprecedented price discrimination. Are
the two related?
"ON THE internet, nobody knows you're a dog," ran the caption of a cartoon in the
New Yorker in 1993, showing one grinning pooch at the keyboard and another
looking on. In fact, plenty of people know not only that you're a dog, but lots of other
things about you, including your favourite brand of dogfood. The internet and
associated technologies have had a devastating impact on privacy. The effect, argues
Andrew Odlyzko of the University of Minnesota in a new paper*, will be to usher in
an unprecedented level of price discrimination.
That is not what most people expect. Because the internet makes it easier to compare
prices, the consensus has been that sellers' ability to charge different amounts to
different buyers will be eroded. Not so, argues Mr Odlyzko. Thanks to the internet,
lots more opportunities for price discrimination are emerging. The most obvious
example is airlines. Airline websites now discriminate in extraordinarily refined ways,
setting fares that may vary not just by class but by the date of booking and the time of
the flight. Some manufacturers are starting to do the same: Dell Computer, Mr
Odlyzko notices, charges different prices for the same computer on its web pages,
depending on whether the buyer is a state or local government, or a small business.
And such discrimination is being extended to other parts of the economy. JSTOR, a
non-profit organisation that makes available online back numbers of scholarly
journals, analyses the electronic data it thus accumulates to charge libraries and
academic institutions different fees, depending on their use and circumstances.
Of course, not all products and services can be priced in such ways. Price
discrimination will be undermined if secondary markets develop in which people who
can buy at low prices resell to those who would otherwise have to pay higher prices.
In the case of airlines, that cannot happen: government security requires that a
passenger's name must match the one on the ticket. The result is that the ticket cannot
be sold to somebody who might otherwise have to pay more for it. It is harder to
discriminate in sophisticated ways among train passengers, say, because there are
fewer identity checks to prevent tickets being resold.
Generally speaking, goods are easier to sell on than services. That is why American
private universities are extremely good at charging students who can afford high fees
and giving rebates to those who can't; and also why drug companies have been so
unwilling to set prices for AIDS drugs that discriminate in favour of poor countries.
The electronic collection of data, which is the consequence (and cause) of the erosion
of privacy online, provides new ways to see who is likely to pay what and to monitor
whether secondary markets are developing.
Price discrimination, points out Mr Odlyzko, makes economic sense. Customers are
willing to pay different amounts for the same product or service, depending on how
well off they are and how much they need it. A company will maximise its revenues if
it can extract from each customer the maximum amount that person is willing to pay.
In primitive street markets, plenty of price discrimination goes on, through a mix of
haggling and local knowledge. But in supermarkets and restaurants, the goods
generally have a single, published price tag.
And that is how customers prefer it. People generally resent the idea that somebody
else should pay less than they have had to do. In the 19th century, railways charged
more for some freight routes than others. But customers bitterly resented that. In
America, they eventually won government intervention, in the form of the Interstate
Commerce Act of 1887--"the first serious federal regulation of private business," Mr
Odlyzko observes.
Today's customers will also hate the trend towards price discrimination on and
through internet-associated technology, even if some of them enjoy lower prices and
are better off as a result. Companies will therefore have to find increasingly clever
ways of hiding it. They already discriminate in the non-electronic world: petrol
stations, for example, charge more in some parts of town than in others. But two
techniques look likely to flourish: loyalty clubs, which extract additional information
from members and give them discounts; and "bundling", or the offering of packages
of services, partly in order to make it harder for consumers to compare the prices of
individual components.
The world of electronic communications is full of examples of bundling, such as the
charging arrangements offered by telecoms companies and by internet-service
providers. Curiously, individual customers turn out greatly to prefer paying a single
fee for, say, unlimited text-messaging or 90 hours of telephone talk-time, rather than
paying for each item, one at a time--even though that might be a cheaper option.
Many bundling arrangements take the form of site-licensing agreements, under which
companies or other organisations pay a single fee for unlimited online access to a
database, say, or a software package. A company may feel it has a bargain if it pays a
single fee that gives all its employees access--even though it might cost less to charge
only the employees who are likely to make use of the package. Mr Odlyzko's
explanation is that at least with such "bundles" both individuals and companies can be
sure of the total bill. With charging by item, they cannot.
Such devices offer the best way to square the circle. As electronic media elicit more
personal information, discrimination will increase. Most consumers are likely to
resent it. Only by disguising what is happening can sellers discriminate, yet keep
buyers happy.
* "Privacy, Economics and Price Discrimination on the Internet". Available online at
http://www.dtc.umn.edu/~odlyzko/doc/privacy.economics.pdf
Economist work-out 5.14
Solutions
1. Why does the article argue that internet trade will ‘…usher in an unprecedented
level of price discrimination’?
Price discrimination involves firms charging different prices for the same product to
different customers. Price discrimination increases a firm’s profits by allowing it to
better target prices at the willingness to pay of buyers. The internet could increase
scope for price discrimination by: a) providing more information about willingness to
pay of potential customers (for example, by being able to easily collect data on
previous on-line transactions by a customer); or b) increasing the scope to engage in
price discrimination (for example, making it easier to charge prices that differ on a
daily basis).
2. Why would universities want to adopt a pricing practice that charges different
prices to students with different levels of family income, but drug companies not want
to set different prices for AIDS drugs for buyers in countries with different income
levels?
For a firm to be able to effectively apply price discrimination it is important that
resale between customers should not be possible. Otherwise, customers who can buy
at a ‘low’ price will be able to resell what they have bought to customers who the firm
had intended should pay a ‘high’ price, thereby undercutting the scope for the firm to
charge any price higher than the low price. The article makes the point that it is not
possible for one student to re-sell entry to a University course to another student (so
that resale cannot undo a University charging prices to students that differ by their
income), but that it would potentially be possible for citizens in a country where a
drug was sold at a low price to re-sell that to buyers in another country where the drug
supplier had intended to sell at a higher price (so that resale could undo price
discrimination between countries).
3. How can ‘loyalty clubs’ be considered as a form of price discrimination?
Loyalty clubs (such as frequent flier schemes) generally provide discounted or free
products to customers who have purchased above a certain amount of the product
supplied by that firm. This effectively means that the average price of the product
varies with the quantity that the customer purchases. For example, where a customer
who travels more than 50,000 kilometres with an airline than receives 5,000
kilometres of free travel, this implies that the average price (per kilometre) of travel
will be lower for a customer who travels more than 50,000 kilometres than for a
customer who travels less than that distance.
4. In an environment where firms have a greater capacity to engage in price
discrimination, why might customers have an increased preference for ‘fixed price for
unlimited access’ deals?
Customers may be concerned that the scope for a firm to price discriminate as it
learns their willingness to pay introduces uncertainty about future prices or that price
will increase over time. Hence they may prefer to accept offers that involve a fixed
price for provision of a good or service over some future period.