Retail rip-off – what the milk market should teach us about regulating the marketplace

Dairy farmers are back in the news; the processors who buy their production to sell on to supermarkets and food manufacturers want to push through a substantial price reduction that will see most farmers getting paid well below their cost of production.   Clearly this is not sustainable; if the processors succeed many farmers will be forced out of business, inter alia increasing our trade deficit in dairy products despite our having one of the world’s best climates for it.

To the extent that imports are involved I would bet a substantial amount that they are driven by lower welfare standards overseas and/or devious transfer pricing schemes whereby most of the profit ‘just happens’ (/sarc) to arise in subsidiary companies based in tax havens that provide a ‘service’ but never actually handle the milk at all.   Clearly, this is enormously beneficial to those involved but, equally clearly, it’s not in the public interest.

The problem is not that milk is ‘too cheap’.  Rather it is because well over 100% of the profit in the industry that should be equitably spread through the supply chain has been appropriated by the buyers.  (It’s over 100% since the farmers’ loss adds to the buyers’ profits).   They are able to do this because the supermarkets at the top of the food chain have the power to dictate terms so forming an effective oligopsony as described in an earlier post.   This has enabled them to pump up gross margins year by year; they rip off consumers while pretending to be their friend.

On the figures provided by the BBC adjusted to a single litre (and which are consistent with the time series included in my earlier post – see above link) supermarket make a gross profit of around 15 pence/litre which is nearly 30% of the selling price.   The BBC lamely ducks the issue of how much of this makes it to the bottom line as net profit but we can make a reasonable guess.  Logistics, store overheads etc. will all be minimal as it’s handled in bulk and sales are predictable.  Also we know (earlier post) that in the mid 1990s supermarkets got by on gross margins of only 1 or 2 pence.  So we can be very sure that the vast majority of the gross profit translates into net profit meaning that the supermarkets are achieving a ‘economic rent’ (roughly the excess profit above what they would get in a genuinely free market) of at least 12 pence per litre or around 25% of the selling price.

That is HUGE; if the margins on other goods are broadly similar (and I think many are) then this is a big part of the cost of living – especially for those on limited incomes.

So what is to be done?  If you are a plutocrat then nothing; for everyone else reducing prices raised by oligopoly is an even bigger prize than increasing personal allowances for the low paid.   Getting retail right also has a very direct bearing on other issues including Clone Towns and Mary Portas’ Review of the future of high streets.  But what can be done?

Any solution must start from the fact that the core issue is an imbalance of power.  So, for instance, suggestions that producers should differentiate their product miss the point – some limited differentiation around the edges may be possible but milk is fundamentally a commodity product.  Ditto an ombudsman or Food Market Regulator: having someone looking over the supermarkets shoulder, so to speak, may lead to limited interventions but it leaves the bad dynamics in place.

The first thing to say is that size is a problem in itself.  Retailing is a complex and demanding business but not exactly rocket science.  Nor does it require global companies with the resources required to design a new jetliner or get a new drug to market.   But it does benefit from economies of scale – largely (though not entirely) because the bigger you are the easier it is to bully producers – which means that the big get bigger and the small go extinct unless they can hang on in some niche.   Therefore left to its own devices a retail sector will evolve into an oligopoly where a small handful of large firms, all with similar cost structures, dominates the market.  In effect, regulation of the marketplace becomes privatised for the benefit of the biggest participants and freedom to evolve without limit in response to the market’s internal dynamics eventually ends in a market that is neither free nor fair.

So, the first conclusion is that the size of retailers should be limited.  This could be done in several ways, for instance by legislating that retailers must divest operations above a market share of, say, 20% in any one local authority area or 5% nationally.

The other way that retailing has traditionally been regulated is by mandating an equal price at either the wholesale level (US practice) or the retail level (UK practice).

The US Robinson-Patman Act  (and see also here) prohibited price discrimination by, in simple terms, requiring that the same price and other terms be given to all purchasers of goods for resale except insofar as the cost of supply is genuinely different.  The effect is to put all retailers on a level playing field with respect to their purchases.   The most obvious consequence is that large and small retailers can coexist which means that they are all kept honest by competitive pressure; many corner stores would think themselves in heaven to get ADSA’s margins and would gladly undercut them to increase sales – provided they could buy competitively!  A less obvious consequence is that producers who depend in large part on selling to retailers are not under the bully pressure that has characterised the UK in recent years; there is no particular advantage for a strong retailer to beat them into the ground as the retailer gets no advantage from so doing – any lower cost they negotiate has to be given equally to other retailers.  Another result is that it helps maintain a reservoir of small firms – and small firms are almost always the most innovative.

One of Reagan’s first actions on becoming President was to eviscerate enforcement of antitrust (i.e. anti monopoly) legislation to allow brute force to rule in the marketplace.   The fallout from this has been one of the biggest drivers in the subsequent growth of inequality.

In the UK regulation was accomplished by Retail Price Maintenance (RPM) until the 1964 Resale Prices Act which made most such agreements illegal.  (Libertarians ought to – but mostly don’t as far as I know – object to the RPA’s  flouting of privity of contract.)   RPM put the onus on producers to set competitive prices vis-a-vis their rivals while helping preserve a diverse retail scene but large retailers can still get better terms.  Absent RPM producers have no control over price which compromises their marketing and puts most on the back foot.   Interestingly, RPM survived for books until 1995 since when its demise has helped drive a huge concentration in retailing matched by a corresponding defensive concentration in publishing despite which most publishers are over a barrel, held to ransom by the few surviving retailers.

So, we face a stark choice; if we want a competitive market in goods we have to legislate to create and maintain a competitive marketplace.  If we don’t restore effective competition in the marketplace we can’t have a properly functioning market in goods.

 

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Clegg’s bicycle shed

An apocryphal story (attributed to C. Northcote Parkinson) tells of a board of directors who had only two items on the agenda of their monthly meeting.  The first was a proposed £100 million investment in a new plant that would be a make or break investment for the company; the second what colour to paint the bicycle shed at head office.  The first was disposed of in two minutes, but agreeing the best colour for the bicycle shed took the rest of the afternoon.

However daft this may sound it’s pretty much the ranking of priorities Nick Clegg has chosen.   For many liberals reforming the House of Lords is a spot that must be scratched.  Fair enough – but how important is it in the scheme of things?   I have seen no compelling evidence that its existing form is a serious impediment to good government nor that the proposed changes would improve decision-making in Westminster.   Such evidence may exist but, if so, advocates of the bill have failed to make the case.  If anything the evidence is to the contrary;  there have been several occasions in recent years when I have been delighted that the Lords has, in effect, asked the Commons to reconsider some point and  I remain to be convinced that a reformed HoL would have done as well.  If composed largely of Westminster Village insiders (who else would stand?) it would be at great risk of succumbing to the waves of groupthink that periodically sweep the Commons.   Hence it is no surprise that the comments on this LDV post suggest widespread reservations about the bill’s specific proposals even among liberals.   In short, HoL reform remains firmly in the bicycle shed category.

In contrast the evolving financial mess and associated banking criminality are an existential crisis for Britain and moreover one that exposes the complete bankruptcy of Conservative thinking – not to mention how compromised some of their leading characters are.   And where is Clegg?   AWOL as far as I can tell.

Can we please focus on the things that really matter; things where we should be offering leadership.

 

 

 

 

 

Babel index

The inauguration in London of the Shard, for now Britain and Europe’s tallest skyscraper, reminds me that some time ago Barclays compiled a ‘skyscraper index’ (pfd) which shows, as they put it, “an unhealthy correlation between construction of the next’s world’s tallest building and an impending financial crisis: New York 1930; Chicago 1974; Kuala Lumpar 1997 and Dubai 2010“.

They trace the phenomenon back to the world’s first skyscraper the modest (by modern standards) 142 foot eight story Equitable Life Building built in 1873 New York but I suspect it goes back millenia.  Could it be that the account in Genesis 11:1-9 of the Tower of Babel records the catastrophic aftermath of an early debt crisis?   The scribes who wrote down the story long after the actual event would have been working from a verbal tradition that remembered the moral lesson but not the design flaws or debt crisis (as the case might have been).  Even today most of the Great and the Good of the world of economics cannot agree on what is at the root of the problem and therefore what to do about it.  Babel (which apparently sounds rather like ‘confused’ in Hebrew would seem to cover their situation perfectly.

What is certainly unchanged over the millenia is human nature, in this case a collective hubris.  As the saying has it, ‘pride comes before a fall’.

 

Potemkin regulation

Regulation in Britain has become a latter day Potemkin village – an impressive facade behind which lurks absolutely no substance.  The Libor (or Lie-bor as the wags have it) affair is a perfect illustration of everything that’s wrong with it.

On Question Time last night, in addition to the evasions and non-answers that are standard fare for politicians, Justine Greening for the Conservatives was attempting to sell the line that unfortunately the FSA had not been given powers by the last government to impose criminal sanctions (cue crocodile tears).  Earlier in the evening Faisal Islam had been saying much the same on Channel 4 News but looking, to my mind, very uncomfortable as he said it.  I suspect he had been fed this line by someone and could smell a large and particularly dirty rat but hadn’t yet had time to work out which cupboard it was hiding out in.

This has become pretty standard spin; ‘they’ (the last lot) got it wrong and of course ‘we’ will introduce new legislation but unfortunately in this particular case the horse has fled.   From a practical point of view this has the advantage of letting everyone involved off scot free with perhaps just a minor wrist slap for appearances’ sake.   The alternative – actually enforcing perfectly good existing legislation – would change the ground rules and that would never do in the brave new deregulated world.

So are we stuck with the FSA’s limited powers or are there alternatives?   Perhaps I can suggest a couple.

Offences under the Theft Act 1968 included “obtaining pecuniary advantage by deception”.  The Theft Act has since been replaced by the Fraud Act 2006 which lacks the resonant language but is equally clear.   At section 2 it states that:

A person is in breach of this section if he—

(a) dishonestly makes a false representation, and

(b) intends, by making the representation

(i) to make a gain for himself or another, or

(ii) to cause loss to another or to expose another to a risk of loss.

It goes on to talk of fraud by abuse of position (even when the conduct concerned consisted of an omission rather than an act).  Penalties include ample goal time for miscreants to consider the error of their ways.

Then there is competition law.  The penalty for anti-competitive behaviour is a fine of up to 10% of the worldwide turnover of the firms concerned and criminal sanctions are also available.  If it is proved that a small group of banks abused their position for competitive advantage I would have thought they would be very exposed.

Trillions of dollars of deals are tied in some way to Libor so even the smallest misrepresentation of its true rate is going to cost someone a fortune – and make someone else’s fortune.  I imagine that that such mind-boggling sums would naturally tend to attract spivs and scammers although only the courts can say if that has actually happened in this case.

For Britain what is at stake goes far beyond the money involved – behaviour like this poses a dangerous reputational risk to our largest industry.  Several recent financial scandals – most notably the AIG debacle – have tracked back to London, enabled by the regulatory race to the bottom which has been a feature of Conservative thinking in recent years; they have constructed a house of cards and mistaken it for something worthwhile; it is actually immensely fragile.

We need the banks but we need them to be good citizens.  In the circumstances huge fines are not the answer – they would only make the banks even more fragile than they already are and would ultimately come out of the pockets of the public.

What can be done, however, is ensure that individuals – and I mean especially captains, not foot soldiers – who have broken the law are prosecuted.  If a criminal standard of proof is impossible in some cases they should still be given lifetime bans from any involvement in financial services.

Politically the Conservatives too are very exposed.   They are traditionally hot on the deterrent effect of the law (which is regulation by another name) when it comes to blue collar crime (or the aftermath of the London riots) but when it comes to City they have been pushing the opposite position vigorously since at least Thatcher’s time.  Expect some nifty political footwork as they try to sidestep any responsibility for the resulting mess.

Zombie theory stalks the railways

Justine Greening, Secretary of State for Transport, has announced that the government plans to accept many of the recommendations of Sir Roy McNulty’s report on the railways and that she wants to see efficiency savings of £3.5 billion per annum.   Much of the media coverage has been dominated by the proposed introduction of smart card ticketing and job cuts.  Unions fear that 12,000 jobs may go.

There is clearly a problem.  As McNulty puts it in the forward to the report,

“However, there is widespread recognition that the industry has problems in terms of efficiency and costs.  Unit costs per passenger kilometer have not improved since the mid 1990s.”

Hmmm.  The ‘mid 1990s’ was when the railways were privatised (progressively between 1994 and 1997 in fact).   Yet a business with a high but fixed cost base should see efficiency soar when passenger numbers increase.  And passenger numbers have gone through the roof as long-suffering travellers know – up by about two-thirds over the same period according to the report.  Clearly something has gone badly wrong.

McNulty goes on to list some of the causes,

“The causes of GB rail’s excessively high costs are many and complex.  The Study was asked to examine “barriers to efficiency” and we have identified that among the principal barriers are fragmentation of structures and interfaces, the ways in which the role of Government and industry have evolved , ineffective and misaligned incentives, a franchising system that does not encourage cost reductions sufficiently, management approaches that fall short of best-practice in a number of areas that are key cost drivers, and a railway culture which is not conductive to the partnership and continuous improvement approaches required for effective cost reduction”.

In other words its structure too fragmented and byzantine to work properly.  Someone forgot the KISS rule.

On R4’s Today Sir Roy said that British passengers are paying about 30% more than their counterparts in other countries.  John Humphrys suggested that the ‘big opportunity’ is to reunite the fragmented parts and rail expert Christian Wolmar agreed adding that since privatisation public subsidies have increased from about £1.5 billion to £4 billion in real terms – i.e. over and above inflation.  Elsewhere, Bob Crow of RMT contributed the fascinating factoid that Network rail has 300 solicitors who spend their time suing the Train Operating Companies (TOCs) and the TOCs have another 300 who spend their time responding.  It’s a hell of a way to run a railway.

So, the government’s solution is to ignore the elephant in the room – that the structure of the railways is all wrong – and go for a combination of fare increases (disguised as smart ticketing) and substantial job cuts (even allowing that the unions may be a scaremongering a little).  Why would Ms Greening do that?  She could just blame it all on Labour as usual.

The answer is that too many in government still believe the neoliberal nonsense that markets have god-like powers and magically always deliver optimal solutions despite massive evidence to the contrary and a theoretical base that can’t stand up to scrutiny.  They are locked into a failed paradigm by bad theory and cemented in for good measure by the vested interests that are doing very nicely from the arrangement.  That 30% excess of costs is someone’s income and is quite big enough for some to be spared for a generous contribution to party funds.

As for hopes that a re-structuring of incentives and the like within the existing structure will solve the railway’s problems – forget it.  These are features of the system, not mere bugs.  Like all centrally mandated targets they will always be gamed by the industry players for their own advantage; if the incentives are changed the game will simply continue under the new rules.

 

The Ministry of Justice courts trouble with translations

The military would describe the UK’s current governance as a ‘target-rich environment’ with screw-ups following each other at a positively dizzying rate.   A recent Channel 4 News report on the Court Translation Service was a doozy.  Seeking to save around £18 million per year the Ministry of Justice has given a £300 million contract to provide all translation services for England and Wales to the tiny £7 million company of a failed Dragon’s Den entrepreneur with no apparent evidence that the firm could handle the demand.  And, surprise, surprise, it turns out that they can’t – leaving cases delayed, courts in chaos and costs mounting rapidly.

The way this has traditionally worked is that when a court needs an interpreter they would find one through the National Register of Public Service interpreters which currently has around 2,300 properly qualified interpreters on its list.  And it’s a system that works very well.  As it happens a good friend of ours did regular stints of court work until she moved overseas a couple of years ago and she had told us that middlemen were attempting to move in, sign ‘exclusive’ deals and, in return, help themselves to a juicy cut of the fees for little effort on their part but at the expense of the translators who, naturally enough, are not thrilled.  Most are refusing to work with the new system and ALS, the company involved, is accused of providing unqualified interpreters.

There is nothing to like about the MOJ’s bright idea of creating a supplier monopoly making its money by screwing the talent.  How many would finish up on income support of some sort offsetting any savings?   And do the MoJ really imagine that if a monopoly got established it wouldn’t turn round in a few years and demand higher fees to further fatten its bottom line?

All credit to Gavin Wheeldon, the entrepreneur concerned for being an excellent salesman and, in fairness also to the Dragons who agreed that he would do very well but baulked at the high price he was asking.  He eventually got his price by selling out to Capita.

Which raises the question of what should be done to fix the mess.

Well, Capita is a big company with deep pockets that has got rich by feeding at the outsourcing trough and they should not be allowed to run away with the idea that contracting with government is a one way bet where profits are taken and costs are walked away from.  In other words they should be on the hook for ALL the losses, both the costs of delays and the loss of promised savings.  Does the contract say that is what will happen – and if not why not?  I don’t know but Capita depends for a very large part of its revenues on government.  In such circumstances the customer is ALWAYS right irrespective of whatever the contract might say.

I’m not holding my breath but I live in hope.

 

Cameron’s 2% nuclear deal

The Prime Minister has just been to Paris to sign a deal with France to, as the BBC puts it, “strengthen co-operation in the development of civil nuclear energy” with much happy talk of, “our shared commitment to the future of civil nuclear power, setting out a shared long-term vision of safe, secure, sustainable and affordable energy, that supports growth and helps to deliver our emission reductions targets“.

Translation: we have agreed a deal to buy a number of nuclear reactors from the French nuclear company Areva.

And this is a BIG deal.  According to Radio 4’s Today, the first four reactors will cost a total of £20 billion and will create 1,500 UK jobs.

But enquire a little and it doesn’t start to look too clever.  Interviewed by Evan Davis on Today, the boss of ‘New Build’ for Areva in the UK, was gushing about the potential, “the UK is the most exciting new build opportunity in Europe; it’s one of the most exciting in the world….”   He explained (above link) that, “Rolls-Royce will become our prime manufacturing partner to supply some £100m of key critical components of the reactor for each EPR [next generation nuclear power plant] that’s constructed in the UK“.   Apparently Rolls Royce will build a factory in Rotherham to fill orders flowing from the deal and this will include supplying equipment for orders in other countries.

Uh!

Do the numbers.  Rolls Royce is to get £100 million out of £5 billion per reactor – that’s just 2%.  Other companies will be involved but the Rolls Royce deal alone accounts for 80% of the £500 million identified so far.  And, according to their website, Rolls Royce already supplies “safety-critical instrumentation and control systems to all 58 operating nuclear power facilities in France …”  so it’s not clear how much of this work is actually extra.

And yet we have it straight from Areva’s senior man that this is “the one of the most exciting [opportunities] in the world“.  With that much buying power 2%, is a truly pathetic result.  The percentage will inevitably rise during the construction phase but much of that will be the modern equivalent of navvies.   The strong implication is that most of the high-tech value-added bits are coming from France.

This looks very much like a replay of the trains affair where a £1.4 billion contract was awarded to Siemens with one crucial difference.   This time as a result of years of dithering and confusion in Whitehall there is no domestic competitor;  we built the world’s first commercial reactor but no longer have a fully capable civil nuclear supply industry because the UK simply doesn’t provide a suitable ‘habitat’ for complex, technology companies headquartered here (Rolls Royce is a very rare exception).

£20 billion (and that’s just for the first phase of a bigger programme) is enough to make a big difference to the economy as any Keynesians would point out – indeed that new energy investment would do just that has been the constant refrain from governments over many years (although they normally prefer to talk more of renewables than nuclear).   The trouble is that the economic boost in this case is going largely to France.

Politicians have been grandstanding about how the latest technology was going to ‘jump start the economy’ since Harold Wilson’s “white heat of technology” speech (and probably long before that) but we are slowly and steadily going backwards.   It’s a good idea in principle but they just don’t know how to do it.

And yet the how of it is perfectly discoverable; any number of Asian countries, starting with Japan and later South Korea, Taiwan and others have worked out how to do it.   We could too – I don’t even think it’s terribly difficult – but first we would have to start asking the right questions and as far as I can see no political party is yet doing that.  Why not?