Connecting Business and Economics

Business and economics are highly interrelated. At the end of the day one would not exist without the other. The success of any business depends on a variety of economic aspects and at the same time businesses essentially make up the economy.

However despite this unquestionable connection, we often only hear about business or economics. In particular, many people fail to notice that in order to be successful in business it is  essential to have at least a basic level of economic understanding. Therefore we will look at how business and economics can be connected.

Business economics

Business economics is a branch of economics that specifically deals with the challenges faced by corporations. In that sense it is similar to microeconomics with the exception that it has a strict focus on corporations. Business economics may include topics like financing, business organization, strategy, or basically anything a corporation would have to deal with. 

Like most other economic branches, business economics emphasizes the use of quantitative methods to analyze issues and takes a positive approach. That means it deliberately restricts itself to describing the world without any judgmental component. In that sense business economics may help us to assess the effects of a certain decision but it does not tell us whether these effects are actually desirable for stakeholders or not. 

Hence, in order to enable people to take the right decisions and benefit all stakeholders we have to shift our focus more towards the business side. The economic consequences of any decision should not only be analyzed and described in hindsight, but should actively influence the decision itself. Therefore we have to move one step further and include such considerations into a more comprehensive framework.

Econ-founded business studies

A good way for business executives and entrepreneurs to connect business and economics in order to take better decisions is what we call econ-founded business studies. The basic idea behind this is pretty similar to business economics, since we also look at the challenges faced by corporations (and entrepreneurs). However, the major difference is that we shift our focus from the economics side more towards the business side. Which has some significant effects.

In particular, by looking at the issues from a business perspective we take more of an inside-out view. Business economics on the other hand takes a descriptive outside-in view. Rather than just analyzing and describing the relevant decision making processes from outside, we want to contribute and actively influence the process by taking into account various economic (and non-economic) aspects in advance to provide a more well-founded basis for the decision. 

As a result, econ-founded business studies go beyond the scope of business economics, because other branches of economics (e.g. macroeconomics, microeconomics) have to be taken into account as well. To take well-informed decisions it is important for executives and entrepreneurs to have a comprehensive understanding of basic economic principles and processes. Focusing on one branch does not provide enough information in that regard, since it does not take systemic interdependencies into consideration.

Ultimately, the goal of econ-founded business studies is to provide a comprehensive framework of economic and business knowledge that enables executives and entrepreneurs and guides decision-making processes in any business-related environment for the benefit of all stakeholders. By the way, that is also our guiding principle for selecting the topics of our posts (in case you wondered).

In a Nutshell

Business and economics are highly interrelated. At the end of the day one would not exist without the other. Therefore it is important to connect the two from an academic point of view. A possible approach to do this is business economics, a branch of economics that analyzes and describes the challenges faced by corporations. A more comprehensive way that originates from the business side, is the concept of econ-founded business studies. The idea behind this is to provide a comprehensive framework of economic and business knowledge that enables executives and entrepreneurs and guides decision-making processes in any business-related environment for the benefit of all stakeholders.

Flying high?

Robert Litan, the Brookings economist who last year published Trillion Dollar Economists: how economists and their ideas have transformed business, has written a short article in the latest McKinsey Quarterly based on ideas in the book. It's called 'Economists: Don't leave home without one'.

One of the examples he gives of economic thinking having an enormous impact is transport deregulation, which started with deregulation of airlines in the US in the late 1970s. Not only have consumers benefitted wildly, but so have businesses. As he points out, the whole clicks and mortar world of e-commerce would likely not have got off the ground:

Had the transportation industry not been deregulated in the 1970s and early 1980s, and had the much more efficient and flexible systems built by companies such as UPS not emerged in response to competition, it is difficult to see how Internet retailers like Amazon, which came along roughly two decades later, would have been able to get started or succeed. Amazon would have had to begin with its own fleet of trucks or even planes to escape the strictures of the pre-1980 regulatory regime, a barrier to entry that almost certainly would have been impossible for new retailers to overcome.

I got to wondering if the deregulation of airlines could be seen in the prices we pay for international air travel, and the answer is, yes it can. Statistics NZ has prices series for air travel that, by happy coincidence, go back to March 1981, a little after the first US push to deregulate prices and the industry more generally. You can see them for yourself if you go to Stats' Infoshare and find your way via the Economic Indicators option to the 'CPI - Level 3 Classes for New Zealand'.

What you'll also find there is the price series for domestic air travel, and the comparison between the international and domestic air transport prices raises, for me, some disquieting thoughts.  Here's the graphical picture: I've rebased everything to 100 in March '81, and added what's happened to prices generally since then, as well as what has happened to the prices of some tradable goods (I've used footwear and new cars. I couldn't find a series for 'all tradables' that went back to 1981, so they'll have to stand proxy for what's happened to tradables more generally). For those who prefer numbers to pictures, there's also a table, where I've shown the average annual rate of price increase over the whole 1981-2015 period, and also, since the high inflation of the 1980s isn't so relevant anymore, over the period since the Reserve Bank Act went into effect (from March '90 onwards).

Some of these patterns were exactly what I'd have expected. Inflation in general has dropped since we - and the rest of the developed world - got our monetary policy act together. And I had expected international air travel prices to show only modest price increases over this period - we've had deregulation, increased competition, the rise of the budget airlines, and technological innovations in both aircraft (larger, more fuel-efficient) and airlines' own administrative systems (computerisation). International air transport prices have indeed risen very slowly over the whole period since 1981, and have actually been falling on average over the past 25 years. Other tradables - cars, shoes - show a similar pattern, where outsourcing to cheaper places in the developing world has played a large part, but international air prices have fallen even faster, and you'd have to think that the deregulatory process was one of the more important moving parts. Litan was spot on.

But then you come to domestic air transport prices, which show - to me at least - a disturbingly persistent pattern . Over the entire period, prices have risen a little faster than inflation as a whole, and over the lower-inflation post-Reserve-Bank-Act period have been rising considerably faster.

And that's rather odd, because some of the reasons that non-tradables inflation tends to be higher than tradables inflation don't apply to domestic air transport. True, you can't easily substitute an overseas product for a domestic one, just as you can't easily outsource your doctor's visit or your kids' secondary school to Vietnam or the Philippines: an ultra cheap fare between Dublin and Nice is no good when you want to go to Dunedin. On the other hand, another big reason why non-tradables tend to rise in price relative to non-tradables - it's harder to achieve the productivity gains you get in (say) manufacturing computer equipment because you can't suddenly make brain operations happen in a quarter of the time - doesn't apply. You'd think a good deal of the increases in aircraft and airline system productivity should have fed through to more modest rises in transport prices than we've seen.

So why didn't they? Much of the answer must lie in the smaller degree of competitive pressure that non-tradables like domestic air transport must face. In saying that, I recognise that there is some degree of domestic competition in air transport. Like everyone else I'm pleased to have snapped up some very low prices from time to time: on occasions, the cost of flying from Auckland to Wellington has been less than the cost of a return taxi between the North Shore and Auckland Airport. On average, however, the cheapies have not compensated for progressively higher airfares overall: in real terms, relative to the overall CPI, domestic prices are slightly higher than they were in 1981. International air travel prices, in real terms, are hugely lower. The numbers wobble around a bit, but you're paying a quarter or a third of what you would have paid back in 1981.

And I suppose there may be some good operational reasons, other than competition playing too weak a disciplinary role, why the domestic airlines haven't been able to match the falling international prices. They don't, for example, have the access to cheap secondary airports that the budget European and American carriers do: perhaps their fares have to reflect the market power of the airports. Or perhaps they've been lumbered with higher regulatory costs than your typical overseas operator. 

But you're still left with the feeling that competition isn't restraining local air prices as well as it might. It might be a coincidence, but the only time that domestic air price inflation lagged behind CPI price inflation as a whole, as you can see on the graph, was in the late '80s and through most of the '90s - precisely the period when Ansett New Zealand was most active.

The shape of our competitive landscape

Every now and then there's a debate about our industrial structure. Some argue that as a small economy we've already got an issue with industries that are too concentrated, and so need to be unusually alert to collusive oligopolistic behaviour, while others argue that we're nowhere near concentrated enough, and that our fragmented industries need to bulk up so we've got companies at the fighting weight to be internationally competitive.

There's a lot of interest in the issues. The viewing stats for this blog are currently showing that my most read piece at the moment is the post that criticised the 'national champions' approach, not that it's easy to kill it off. There have been a number of recent moves in that direction, as I reported here.

In any event, it occurred to me that I didn't have too clear an idea of the actual concentration of New Zealand markets and the strength of competition within them. And then I remembered that Stats' Business Operations Survey (assorted links to commentary and data here) has a question about how many competitors respondents thought they had. I've played around with the data, and here are the key results, by size of business.

Is this benign or troubling? On the plus side, the typical situation faced by a New Zealand business is one of many competitors, with a core of several bigger ones (the "several dominant" phraseology comes from the survey questionnaire, and is a bit at odds with how competition folk would normally use "dominant", but it's pretty clear what the responses must mean). Add in the 20% or so of firms who face multiple competitors, with no especially big ones in the mix, and you find that 70% or so of businesses operate in what are likely to be reasonably competitive markets (I know, numbers of firms don't automatically align with intensity of competition, but it still looks the way to bet).

On the troubling side, close to one fifth of all businesses say they operate in a duopoly or triopoly, and another 5% say they've got a completely captive market with no competitors at all (and, I'd guess, some of those in the 5% of "Don't knows" might be in the same boat, but would probably not prefer to say so).

So after a first pass through the data, there's no knockout evidence either way: there's evidence for a mostly competitive economy, and there's evidence of potentially problematic concentration. If you feel like having a closer look yourself, you'll find the underlying data at NZ.Stat, in Module A of the Business Operations Tables.

Incidentally, if you were minded to take the radical step of asking a competition authority to account for whether it's making any difference or not, you could do worse than put "the proportion of businesses reporting a captive market or no effective competition" onto its shopping list.

How do supermarkets compete?

In the previous post I wrote up the results of the Electricity Authority's latest survey of competition in various industries: supermarkets came out tops in terms of people's assessment of whether they are getting a competitive deal from businesses they deal with. While it wasn't a full economy-wide survey, and maybe there are unsurveyed sectors that would have shown up better than the supermarkets, it was nonetheless very interesting that people feel they are getting a fair deal from supermarkets vying for their custom, and all the more so because there have been concerns about a potential duopolistic shakedown.

As it happens, I just came across another new survey which tells us in more detail what people value from supermarkets (it's Australian, but I'd suggest it's equally applicable here). It comes from Roy Morgan Research's 'Single Source' surveys, which are very large scale: this supermarket one had close to 16,000 respondents, all interviewed face to face. The press release is here (the full thing costs serious $, which is fair enough given the scale and value of the exercise).

Here's the core result, where we can see the various dimensions across which supermarkets compete, and which ones most press consumers' buttons.

Before seeing these results, I'd have guessed that some dimension of all-in-one convenience would have topped the list, supermarkets being (you'd think) the classic economies of scope/minimise transactions cost model, but I'd have been wrong. There are, to be sure, some convenience dimensions in the most valued characteristics of a supermarket. And there are some price/value dimensions, too, which you'd also expect to be high up the list. But the surprise packet - for me - was the very high ranking of quality, with 'high standards of food safety', 'hygienically prepared food', 'good quality' fruit and veg and 'clean and tidy' taking four of the top nine spots, including the top one itself.

Apart from its intrinsic interest, and the insight it gives into the real nature of the supermarkets' value proposition (and, I'd guess, a glimpse of their likely strategic thinking), it's a good reminder that competition is more than competition on price. Sure, most of us involved in thinking about competition have taken the idea on board, most of the time, and there's even an acronym SPQR (Service, Price, Quality, Range) that people sometimes deploy to make sure they've got all the potential bases of competitive rivalry covered. But it's nonetheless easy to lapse into using price as a proxy for everything. In some lines of business, and supermarkets are clearly one, that could lead you badly astray, and in several directions. You could easily assume there is less competition that there actually is. And, if rivalry diminished on one of those non-price dimensions, you could easily miss that, too.

Are we getting a competitive deal - 2015 version

The Electricity Authority has done everyone a service. It's just come out with its latest surveys of the state of competition in the electricity industry and - because it needs to know whether the level of competition in electricity is good, bad or indifferent compared to other industries - in a range of other sectors. It's got two surveys, one of the general public and, if you're into electricity, one of stakeholders in the electricity industry. These surveys are a great thing to do, especially as they are now beginning to develop a bit of history: when I first wrote about them, there were only two surveys' worth of data, but now there are four, and we can maybe start to see patterns over time.

Here's the key graph from the survey of the public, which shows people's responses to the question, "Using a 0-10 scale where 0 means not at all competitive, 5 means just adequate and 10 means extremely competitive, how competitive are the following businesses in terms of working to get your business and offering you the best deals? If you do not know enough, just say so".

It's hard to know which of these results is the most intriguing. The ranking of industries is interesting: for all the concerns expressed about our supermarket duopoly, consumers evidently feel that it's a competitive one, with the the two of them duking it out in the marketplace, and they rate the deal they're getting ahead from the supermarkets a little bit ahead of the others in the survey. The low ranking of online bookstores, by the way, is because there's an unusually high proportion of 'don't know' answers, which kind of surprises me as I'd have reckoned anyone buying a book these days must have given the offshore services  a go by now, but there you are. If you're interested in the minutiae of the poll results, I've out a detailed table at the end of this post, 'over the fold' as they say.

The most recent trend, admittedly on this short series, is a little bit of a worry: except for petrol stations, the trend over the past year has been for the degree of competition to ease off a bit. Perhaps in the currently strong economy, sellers don't feel they have to compete quite as hard to earn a crust? As for petrol stations, while I'd generally go on the assumption that people are perfectly capable of making good judgements about suppliers and the deals they're offering, I'm not sure in this particular case whether motorists have been able to separate out how much of lower prices is due to lower import costs and how much to any increased intensity of competition (you might be interested in my earlier post about what's happening at the petrol pump).

These are great surveys: full marks to the Electricity Authority for running with the idea. It does, naturally, raise the question why the Commerce Commission isn't doing the same across a wider range of sectors. As I've argued before, "I reckon it's time for the Commerce Commission to belly up to the bar and tell us what real differences [in levels of competition] are happening in our markets".

And if they don't, or can't, or won't, maybe we should pirate one of the recommendations of Australia's Harper review of competition policy (if you haven't caught up with its excellent work, start here or go to the thing itself). It argued (in Recommendations 43 through 47) for a new pro-competition advocacy body, an Australian Council for Competition Policy, that would among other things "develop an understanding of the state of competition across the Australian economy and report on it regularly" (p76). It's a good idea, and we should steal it.

Finally, for anyone who wants the more detailed responses, here they are.

The Price Elasticity of Supply

According to the law of supply and demand the quantity supplied of a good or service will generally decrease as its price falls. To see how strong this effect actually is, we can once again draw on the concept of elasticity. In particular, we use the price elasticity of supply.

The most relevant supply side elasticity is the price elasticity of supply. It describes to what extent the quantity supplied of a good is affected by a change in its price. Not surprisingly, there are various factors that influence the elasticity so it seems reasonable to look at the most relevant determinants first.

Determinants

The price elasticity of supply is determined by several factors that influence the production flexibility of a good or service. Being familiar with those determinants will be crucial for analyzing and comparing elasticities of various products.

• availability of raw materials: If the availability of raw material is limited, supply will be rather inelastic. In this case it is more difficult for producers to react to changes in price. Especially if the price decreases the availability of raw materials may limit the production of additional units which results in a more inelastic supply.
• complexity of product: The more complex the production of a good or service is, the more inelastic its supply will be. A more complex production process requires more specialized equipment. This makes it more difficult for producers to react quickly to price changes because the equipment cannot simply be used to produce different products. In addition to that, complex products usually take longer to produce which also contributes to more inelastic supply.
• inventories: If it is easy to keep inventories of a product, supply will be rather elastic. Keeping stocks allows producers to increase supply by selling part of the inventories even if production cannot be increased immediately. On the other hand it also reduces the financial risks of excess production, since at least part of the stock can still be sold at a later time.
• factor mobility: The more mobile the factors of production within an economy are, the more elastic supply will be. Producers can react more quickly to changes in price of a good or service if they can easily reallocate their factors of production (i.e. labor, capital, etc.) according to current demand.
• excess capacity: If suppliers have excess capacity, supply will be more elastic. As long as production is not working to capacity, it is easier to react to price changes because outputs can be changed more easily
• relevant time horizon: Generally speaking supply is more elastic in the long run as compared to the short run. Firms often cannot easily change the capacity of their production facilities in the short run (because of binding contracts, opportunity costs, etc.). Those costs are usually lower in the long run because contracts can be allowed to expire and new factories can be built or old ones can be shut down.

Now, please note that there may be additional determinants that are not mentioned here but are applicable in certain situations. This is not supposed to be a complete list. Basically every aspect that affects production flexibility in any way will have an effect on the elasticity of a good or service and can thus be considered a determinant of elasticity.

Types of Elasticity

There are different types of elasticity. Similar to the demand side, a supply curve can be elastic, unit elastic or inelastic. Please note that since elasticity is always measured at a certain point a single supply curve can have segments of all three types simultaneously. To see how this is possible, we will have to crunch the numbers and look at how elasticity is computed. The price elasticity of supply is defined as the percentage change in quantity supplied divided by the percentage change in the price of a good. This can be illustrated using the formula below.

To give an example, let's assume that an increase of 2% in the price of ice cream causes sellers to produce 4% more of it. According to our formula the elasticity in this case can be computed as 4% / 2% = 2. So the elasticity of supply equals 2. However right now this number does not really say much so we still need some sort of classification to actually work with it. With the help of the different types of elasticity mentioned above we can classify the supply curve and thus interpret the result.

• If the elasticity is greater than one, a supply curve is said to be elastic.  In this case suppliers respond strongly to price changes. As a result the quantity demanded changes proportionally more than the price.
• If the elasticity is equal to one, a supply curve is said to be unit elastic. In that case suppliers respond proportionally to price changes which means the quantity supplied will also change in the same proportion as the price.
• If the elasticity is less than one, a supply curve is said to be inelastic. In this case suppliers do not respond strongly to price changes. Therefore the quantity supplied changes proportionally less than the price.

Since elasticity in our example is equal to 2 we can conclude that supply of ice cream is elastic at this point. Once again please note that this elasticity may change as we move along the supply curve, so there may be other examples where the ice cream has different elasticities on the same curve. This is due to the fact that we use relative proportions to calculate elasticities.

In a Nutshell

The price elasticity of supply measures how the quantity supplied of a good or service changes as its price changes. It is determined by a number of factors, including the availability of raw materials, the complexity of the product, the possibility to hold inventories, the factor mobility within the economy, the amount of excess capacity, and the relevant time horizon. The supply curve of a good or service can be elastic (i.e. greater than 1), unit elastic (i.e. equal to 1), or inelastic (i.e. less than 1). It is possible to have different types of elasticities along the same curve.

Australia's got the competition gospel. Have we?

At the end of last month Australia's 'Harper Review', or more formally the Competition Policy Review, issued its final report (where there are links to the chapters, the full report, and, if life's too short, a series of cheat sheet infographics which will give you the guts of the thing). I'd loved its draft report when it came out last September: it was a breath of fresh air to find a review body that was systematically on the side of the benefits of competition and against the privileged interests created, for example, by restrictions on parallel imports. In particular I'd liked its proposed change to s46 of Australia's Competition and Consumer Act, which is the equivalent of s36 of our Commerce Act, the bit that deals with misuse of a substantial degree of market power, and I was very pleased with its forthright stance against creating "national champions" shielded from domestic competition.

And there was also a whole bunch of other worthwhile stuff dealing to impediments to competition, notably (I'm quoting from the relevant cheat sheet) removing regulations that inhibit competition in areas such as aviation, shipping and taxis, and dealing immediately to archaic anti-competitive arrangements by reforming retail trading hours, parallel importing, and pharmacies. Predictably the pharmacists have responded with the usual special pleading, but there was an excellent riposte by the University of Melbourne's Prof Philip Clarke which said among other things that "the lack of competition in the sector comes at a cost to the consumer, both in terms of the choice of where they can shop and in the prices that must be paid...a packet of aspirin, which may cost as little as $3 in [the] retail marketplace costs up to $12 when it is dispensed under the PBS [Australia's Pharmaceutical Benefits Scheme]".

The final report has a few changes from the draft version (the relevant cheat sheet is here), including a new and sensible recommendation (p51) that "Competition principles, particularly those promoting choice and a diversity of providers, should be incorporated into [government] procurement, commissioning, PPP [Public-Private Partnerships] and privatisation policies and practices" and the equally sensible recommendation that "Non-employment trading restrictions in awards and industrial agreements should be subject to competition laws".

On the misuse of market power, the Review was originally minded to allow a defence that

the prohibition would not apply if the conduct in question would be both:

• a rational business decision by a corporation that did not have a substantial degree of power in the market; and

• likely to have the effect of advancing the long-term interests of consumers

but as the Review notes (p342), "This proposed defence is generally not supported by submissions", including, incidentally, our own Commerce Commission's, and they dropped it. Their final position (Recommendation 30) is

The primary prohibition in section 46 of the CCA should be re-framed to prohibit a corporation that has a substantial degree of power in a market from engaging in conduct if the proposed conduct has the purpose, or would have or be likely to have the effect, of substantially lessening competition in that or any other market.

To mitigate concerns about inadvertently capturing pro-competitive conduct, the legislation should direct the court, when determining whether conduct has the purpose, effect or likely effect, of substantially lessening competition in a market, to have regard to:

• the extent to which the conduct has the purpose, effect or likely effect of increasing competition in the market, including by enhancing efficiency, innovation, product quality or price competitiveness; and

• the extent to which the conduct has the purpose, effect or likely effect of lessening competition in the market, including by preventing, restricting or deterring the potential for competitive conduct in the market or new entry into the market.

This for me is a good finishing point, and I'd like to see MBIE, who are looking at what to do about our s36, adopt it holus bolus and move smartly on.

I also liked the Review's recommendation that the net benefits of its proposals ought to be formally modelled (they suggest, by Australia's Productivity Commission). Yes, obviously, it's rather a heroic exercise, and you'll find a discussion of the issues involved in s30 of the report (from p492 onwards), but where we can, we should all be moving to policy that's based on at least some stab at reasonable numbers rather than on wishful thinking or ignorance. I'd suggest the net benefits of their overall package could be very large: the Review helpfully included (pp497-8) some existing estimates of specific reforms, and they're sizeable. Here are a couple of them:

In respect of parallel imports (see Recommendation 13), the PC [Productivity Commission] found that, in 2007-08, a selection of around 350 books sold in Australia were on average 35 per cent more expensive than like editions sold in the US. In many cases, the price difference was greater than 50 per cent.

In regard to planning and zoning (see Recommendation 9), in New South Wales, a recent study commissioned by the state government into the potential benefits of comprehensively reforming planning and zoning in that state showed net benefits ranging between $569 million and $1,482 million per annum, depending on the reform option considered.

So hats off to the Aussies. They haven't done the political hard yards to implement it yet, but at least they've come up with a terrific blueprint for advancing a more productive, more competitive economy and for dismantling the Olde Spanish Practices that have been rorting Australian consumers.

On the other hand I wish I could see a similar appetite for reform in New Zealand. As I've said before, when another Aussie review also came up with a hatful of competition and regulation reforms, you struggle to see the same issues being treated with the same degree of urgency here at home.