Authors: David Smith
The Internet can provide something like perfect information. It has, in fact, spawned the growth of websites whose specific task is to check prices. These sites are not always comprehensive but they do provide something close to price transparency. It is possible in a few seconds to see who is offering the best deal on a product. Add in the fact that geography is far less important – even for people who confine their online shopping to UK sites there is usually no difference in shipping costs whether the supplier is a few miles or several hundred miles away – and the Internet does indeed start to look like the perfect competition of the textbooks.
So why is it not turning out that way? Online retailing may not yet have grown as rapidly as its most optimistic proponents hoped but its impact has been significant. Bricks and mortar retailers, apart from running their own e-tailing sites, have had to take account of the prices available online when setting their prices in the shops. The Internet has thus been a force for low inflation, and has helped bring about falling prices for many goods. It has not yet, however, resulted in perfect competition. Only a minority of online shoppers use price-checking sites (usually free to the customer) before deciding on a purchase. The information is there but most customers are not making use of it. Those who do not, and even some who do, are still heavily influenced by reputation. They will buy from online retailers they have heard of and who they trust not to make off with their credit card details. Simply setting up a website is unlikely to be enough to build a strong market position. A good reputation is also required. How do e-tailers go about building reputation? By spending a lot on advertising. Existing retailers start with an advantage in that their names are already known. Those seeking to sell online have to get their name across in another way. Think of the amount of advertising by Amazon, or in Britain a company like lastminute.com during the height of the dot.com boom, and you get the point. Amazon’s strategy was to erect a barrier to entry by convincing the public, through heavy advertising, that it was
the
books e-tailer. To a large extent it appears to have worked. In place of the barrier to entry of the cost of establishing a network of stores, a new one emerged – the need for advertising budgets stretching into tens of millions. Perhaps this will change again, and the growing sophistication of online shoppers will give us something like a perfect market. But it is not there yet.
What about companies that do not sell a product but a ‘weightless’ service? What about online businesses whose product is, say, music tracks or movies that can be downloaded over the Internet? This is an interesting area. Most of the above principles apply. Such services may be weightless but they are not costless. An online music provider, for example, has to invest in web capacity – the greater the demand the bigger the capacity – and in marketing and administration. The economies of scale can be considerable but there are still marginal costs and revenues. It does, however, mean that such markets can be truly global. Thinking of mail delivery times and reliability you might not want to buy CDs from a site based in Bombay, Shanghai or Sacramento. That does not apply if the product is simply downloaded.
Business games
The approach that firms took in the online market is an example of a business strategy. Economists in the twentieth century took an increasing interest in such strategies as real-world examples of ‘game theory’. The idea of game theory is simple. Whether you gain maximum advantage in a particular situation depends not just on what you do but on what others do. Amazon’s decision to spend so much promoting its name was influenced in part by its expectations of what others, including the existing book retailers, would do. Do I open a new supermarket in a particular part of town? Perhaps, but to determine how profitable it is likely to be I would also want to know whether others are planning to do so. Many students are introduced to game theory in the form of the prisoner’s dilemma, in which two suspects are questioned about an offence. The obvious strategy for each of them is to plead innocent but rat on the other one. If both do so, though, the authorities are likely to deem them both guilty and give them an extra sentence for dishonesty. Depending on what the other does, the optimum strategy for each individual could be to plead either guilty or innocent, but to know which is best he has to form a judgement on what the other will do. In a market of two firms, the best collusive strategy would be for them both to restrict output so as to keep prices high. But if one firm restricts its output while the other pumps out as much as it can, the first firm would be a loser. Guessing, or finding out, what your competitor is up to is all part of the game.
Game theory has attracted some eccentric economists. Paul Strathern called his book
Dr Strangelove’s Game
after John Von Neumann, who, together with his colleague Oskar Morgen-stern, effectively invented game theory and gave us the ‘zero-sum game’ – one player’s gain is another’s loss. It was the Hungarian-born Von Neumann, a man with an extraordinary sex drive, who, in the 1950s and by this time confined to a wheelchair, advised the American government on its Cold War strategy in relation to the Soviet Union, based on a game theory approach. In this case, while the best outcome for America might have been to blow up Moscow with no retaliation, ‘mutually assured destruction’ was the chosen alternative. John Nash, the brilliant American game theorist who developed the idea of the ‘Nash equilibrium’ – the optimum solution for all players in any game – became a shambling drop-out in the 1970s and 1980s after suffering bouts of schizophrenia but recovered sufficiently to be awarded the Nobel Prize for economics in 1994. Nash took game theory on by demonstrating the possibility of ‘win–win’ outcomes, in which all players could gain. He was the subject of an award-winning film in 2001,
A Beautiful Mind
, in which Russell Crowe narrowly missed out on an Oscar for his performance as Nash.
Governments have tried to use game theory in devising ways of allocating licences, for example for oil exploration, to businesses. One of the most interesting examples of the practical use of game theory in a business context came in Britain in 2000 when the government held an auction for third-generation (3G) mobile telephone licences. In designing the auction, the government called on the services of a team of economists specializing in game theory, led by Professor Ken Binmore of the University of London. The design they came up with was no ivory tower creation. For nearly two years, using research students as ‘players’, the team tried different approaches to determine how the bidders were likely to respond under various conditions. For the telecom firms bidding for licences, the best outcome would have been that each paid a small amount for the licences on offer but that depended on awareness of how the others would bid. In the event, this battle of the game theorists (the bidding companies also employed their own) turned into a comprehensive victory for the government side. Helped by timing, the stock market’s mobile telephone frenzy being at its height, the auction raised the extraordinary sum of £22.47 billion, enough to build 400 new hospitals and many times the sum expected at the start of the process. Within a few weeks, as the telecom bubble burst, the companies were asking for their money back. The fact was that the bidders misjudged their game theory very badly. Even the biggest firms would have done better to hold back when the bidding got out of hand. As Binmore later put it:
Nobody is forced to bid in an auction, and anybody who bids more for a licence than he thinks it is worth is just plain stupid. Claims that the complexity of the auction led the bidders astray do not stand up to serious scrutiny. In our auction, the optimal strategy was absurdly simple: just make the minimum bid for whichever licence would maximize your profit if you won it at that price.
Why firms invest
Bidding in a licence auction is one way in which firms invest, albeit an unusual one. It raises more general questions. Why do firms invest, and what determines the amount they invest? For decades, one of the supposed weaknesses of Britain’s economy was under-investment – spending a smaller proportion of GDP on investment than rival economies. Lately, the Treasury has produced figures suggesting that business investment, at about 15 percent of GDP, is similar to that of the other Group of Seven (America, Japan, Germany, Britain, France, Italy and Canada) industrial countries. The legacy of past under-investment remains, however, with the capital stock per worker (the amount of equipment available, for example) some 30 percent higher in America, 40 percent higher in France and 50 percent higher in Germany, than in Britain. Why is this important? Because, as the Treasury puts it:
A high quantity and quality of investment has two key influences. The first is that it increases the level of inputs into the economy – increasing the productivity and hence the earnings of workers in a very direct way. But it is also a vital channel for the introduction of new technology and processes. New investment does not just replace existing machinery, but moves forward production processes by embodying technical change.
Investment by businesses is not, of course, the only source of capital expenditure. Economists would argue that under-investment by government in the infrastructure – roads, railways, hospitals and schools – has been as serious as the legacy of business under-investment. Leaving that aside for later, it is clear that a vital ingredient in the long-term success of any economy is an adequate level of investment. It is also essential for the long-term health of any company. But what determines how much firms are prepared to invest? On the face of it, the reasons for company investment are as many and as complex as those that determine why we choose on a particular day to buy something in the shops. Managers might decide to invest to replace a noisy or worn-out piece of machinery or vehicle. They might, similarly, decide to replace all the firm’s personal computers because they are becoming obsolete. It could be that the firm has decided on a new product range and needs to invest in new equipment to produce it. Or, perhaps, the company has been doing well, is flush with cash, and decides to spend some of it.
In fact, while all these are subsidiary reasons why firms may decide to invest, there is one easy underlying explanation. Investment will occur when it is expected to generate a sufficient rate of return. A new piece of equipment, in other words, not only has to pay for itself in what it adds to revenue and profit, but it has to generate a return over and above this. How high does that return have to be? That depends on the alternatives. Suppose the level of interest rates is 10 percent and the cost of a new industrial plant is £10 million. If the firm already has cash of £10 million, it could invest it in the new plant, or it could simply leave the money in the bank, where it will generate a 10 percent return, equivalent to £1 million in the first year and more, if no money is withdrawn and the value of the deposit grows, in subsequent years. To make the investment worth making, its rate of return has to exceed 10 percent, probably by a comfortable margin. So the income of the firm as a result of the new investment will have to rise by more than £1 million in the first year, and so on. Economists call this alternative use the ‘opportunity cost’ of the investment – the return that would have been available if the cash invested had been put to its next best use. The same principle applies if the firm has to borrow the money from the bank. Again that borrowing will not be worth- while if the investment does not generate a return significantly higher than the cost of the funds.
This explains why high interest rates, and in particular high ‘real’ rates of interest (the interest rate after allowing for inflation – a 15 percent interest rate with 10 percent inflation is a 5 percent real interest rate) tend to discourage investment. Low and stable interest rates are likely to be more conducive to investment. Of course, when it comes to assessing the return on an investment, accountants may struggle to be as precise as economists would like. In the absence of a controlled experiment, could a firm possibly tell exactly what the rate of return is on an investment in ten £2,000 computers, and how it would differ if twelve had been bought? Probably not, but the same general point applies as with marginal cost and revenue, discussed above. Firms that ignore such rules will eventually get into trouble. Managers who invest willy-nilly, without regard for the rate of return, should not expect a very long career in business.
Should firms have a conscience?
One of the interesting developments in recent years has been the recognition by companies that there is much more to corporate life than money. Corporate social responsibility, the idea that it is ‘not just profit’, is not new in itself. Andrew Carnegie (1835–1919), the Scottish-born American industrialist, is famous for endowing a high proportion of the public libraries in Britain, as well as the Carnegie Institute of Technology, the Carnegie Institution and the Carnegie Hall in America. The Cadbury family in Birmingham was a notable early example of the enlightened company, both in the treatment of its workers – taking them from the slums of the city to work and live among the green fields, back then at least, of Bourneville. They were not the only ones. When religion and business mixed – the Cadburys were Quakers – greater attention to the social obligations of commerce was often the result.
Firms would say they have always taken such obligations seriously. Happy and healthy employees are likely to be more productive. Customers will be more likely to buy from firms that are regarded as good corporate citizens – not polluting the environment or exploiting Third World suppliers, for example. Money spent on community projects or charitable work has the useful side effect, perhaps even the main effect, of generating a warm image for the business. In recent years, however, such matters have climbed higher up the corporate agenda. Businessmen have become more fearful of the actions of pressure groups, whether they be anti-globalization protestors capable of disrupting business gatherings or annual general meetings, or environmental charities. When Greenpeace successfully lobbied Shell against the dumping of the Brent Spar oil platform in deep ocean waters, doing so by creating a consumer boycott of the company’s products, it was a watershed. The fact that Greenpeace was subsequently shown to have got its facts wrong over the environmental effects of Shell’s original plan seemed to matter less than the power it had demonstrated to exert influence over company actions.