Case Study: Separation of Ownership and Control

Sometimes it is difficult to understand how some economics concepts can be used in the real world (although with economics, it should be easier to relate that other subjects..) so here is a perfect example of the principal/agent problem.

There seems to be a conflict between what shareholders want and what managers (executives) want at Barclays. At Barclays, £730m was paid out to shareholders last year in contrast to £2.15bn that was paid in bonuses.

Read more here:  http://www.thisismoney.co.uk/money/news/article-2132282/Barclays-boss-Bob-Diamond-lose-1-3m-bonuses-bank-attempts-douse-shareholder-rebellion-pay.html 

Read notes on the Principal Agent Problem here.

Oligopoly

·       A type of market structure where there are a small number of firms dominating the market, all selling similar goods

·       What’s your definition of ‘dominating’ the market? How do economists go about determining whether a market is dominated by a few firms or not? They measure the concentration ratio – the market share of the biggest firms in the market. For example, a four firm concentration ratio shows the percentage of output produced in the market by the four largest firms. Statistically, this method is okay to use, but at A-level (and GCSE), it is better that you know that the essence of understanding the oligopoly market is that firms in the market make decisions on price and output based on the decisions of rival firms. They attempt to predict what the other firms are doing, to compile their own strategy.

·       An example of an oligopoly market is supermarkets

·       Can compete on price (resulting in a price war, see here and here) or not, instead competing on other bases such as:

o   Loyalty schemes (Tesco Clubcard, Sainsbury’s Nectar points)

o   Advertising and marketing

o   Home delivery options (e.g. Asda and Tesco)

o   Discounted petrol  (e.g. Asda, Morrisons)

o   Extension of opening hours (e.g. Metro Bank open on Sundays)

o   Lateral growth in other industries (Asda opticians, Tesco banking and insurance)

·       There are barriers to entry in the market

Kinked Demand Curve Theory

The theory explains how a competitive oligopolist may be affected by rivals’ reactions to its price and output decisions.

 Look at the AR curve for now. The AR curve is relatively elastic from P* to P₁ and relatively inelastic P₁ onwards.

The oligopolist sets price to P₁ initially. When the curve is relatively elastic, if a firm in the market increases the price, other firms will not follow because the resulting fall in demand is greater than the proportionate change in price. The firm loses too much demand to attract other firms to follow.

When the curve is relatively inelastic, if a firm lowers the price, other firms will follow because they benefit from the resulting increase in demand. Even though the resulting increase in demand is lower than the fall in price, firms benefit because consumers ‘shop around’ for lower prices; if Tesco are selling a notebook for £1 and Asda are selling a notebook for 80p, provided that Asda is just as accessible as Tesco, the consumer may decide to shop at Asda instead. This is under the assumption that the oligopoly market compete on price. If this happens, a price war may result.

Now consider the MR and MC curves. The oligopolist sets price and output level to P₁ and Q₁. The profit maximising level of output is Q₁. The initial MC curve is MC₂, but if the MC curve was to shift to above MC₁ or below MC₃, the oligopolist would have to charge a different price to ensure profit maximisation (assuming AR = selling price). Price stability is achieved because the MC curve can be anywhere between MC₁ and MC₃.

Furthermore contributing to price stability, the oligopolist may decide to leave price and output at point X because of the uncertainty from rivals’ price and output decisions.

The Kinked Demand Curve is only a theory and an estimate of how demand changes when the oligopolist changes price because there is not perfect information in the market for olipogolists to know the exact position and shapes of their demand and revenue curves. The theory is useful because it illustrates how firms are interdependent on rivals, and affected by uncertainty.

Government Policies to Reduce Market Failure

If you've watched the news recently, you guys should know that the government are considering changing the packaging on cigarettes to discourage new smokers. Use this as a case study in your exam to demonstrate government policy to reduce market failure caused by demerit goods (See notes on Negative Externality and Market Failure. These notes specifically apply to negative externalities, but it is relevant because the consumption of demerit goods causes negative externalities, e.g. second hand smoke).

The new plain branding is being considered to deter youths from starting to smoke, but critics say that the branding will make no difference to those who are already in the habit of smoking. What is your view? Good idea? Tell the examiner!

Another Contribution to the Business Cycle

Read an interesting article on the BBC about the cost of bank holidays, according to research from The Centre for Economics and Business Research (CEBR).

Each bank holiday costs the economy £2.3m and that means the economy could gain an extra £19bn if bank holidays were scrapped. This can be a contribution to the business cycle (see here) because bank holidays reduce GDP. If the economy was suffering a downturn, the loss of GDP can cause the economy to worsen from a downturn to a recession. For the UK, especially at a time where we are not experiencing strong growth, forecasters are predicting the worst from the working days that are lost.

15% of the economy, which includes pubs, clubs, restaurants, cafes and visitor attractions, do well on bank holidays and 45% of the economy suffers, which includes offices, factories and building sites, where people do not go to work on the bank holiday. The areas that benefit do not balance out the loss of productivity from the services sector of the economy.

Do read the full article for more information.

Principal-Agent Problem

The divorce/separation of ownership and control helps explain the principal/agent problem.

Among large firms, the managers and the owners of the company tend to be separate. One who has the financial capacity to invest into a company (in extreme cases this can be through inheritance, lottery..) can do so without running it. This is the separation of ownership and control.

Because the owners are different to those who run the company (the managers), they may have different objectives. Managers want to benefit from perks (e.g. company car contribution, pension contribution, discounted gym membership) and bonuses. Owners want to maximise shareholder value. They also want to satisfice: achieve minimum targets that are acceptable and satisfactory to all member groups of the coalition that make up the firm. Satisficing helps resolve the conflict bought by the separation of ownership and control because in order to achieve ‘minimum’ targets, both parties must compromise. For more on satisficing, click here.

The principal-agent problem is the conflicting objectives of the owners and the shareholders of the company.

How does the principal-agent problem affect a firm?

The owner can never be sure that the employed managers are aiming to maximise profits or succumb to the temptation of maximising their own benefits, possibly leading to decreased profitability.

Quantitative Easing (QE)

QE causes a change in the money supply. Steps:

1. The Bank of England (BoE) purchases assets such as government bonds and corporate bonds
2. Pays for these assets by creating money electronically and crediting the accounts of the companies that it bought assets from
3. These accounts are called reserves. All banks hold reserves at the BoE and the essence of QE is that it builds up these reserves
4. QE is likely to lead to inflation because banks lend more and increases the money supply (see Quantity Theory of Money). Another reason for inflation is, holding everything else equal (ceteris paribus), more people have more money that they supposedly use for consumption, creating demand pull inflation

Explained by Stephanie Flanders

http://www.bbc.co.uk/news/business-16973560

Stephanie Flanders in the BBC’s economics editor, the link above provides a short video RSAnimate of QE. A summary of the video is as follows:

·         The Bank of England creates money and spends it so that there is “extra cash” flowing into the economy. They spend it by buying government bonds or IOU’s (formal definition: documentation confirming that the debt is owed) from financial institutions such as pension funds or insurance companies.

·         This puts more money into the economy (higher money supply) because these financial institutions that sold these bonds have more money to spend on new businesses or on housing for example.

·         Because of this, it is cheaper for the government to borrow as the BoE pushes up demand for the Treasury’s IOUs and supply of bonds has been reduced. Long term interest rates are lower than they should be making it cheaper for everyone else to borrow as well, because higher demand means more spending and this leads to faster growth.

The last point explains the theory WHY the government uses QE even with the risk of inflation, particularly during recessions. If demand rises, consumption may increase and the economy begins to recover.