TUTOR 2 U.

NET ECONOMICS NOTES GOVERNMENT INTERVENTION AND MARKET FAILURE

Market Failure- Introduction An introduction to the idea of market failure, drawing on concepts first introduced at AS level. What is market failure? Market failure occurs when freely-functioning markets, fail to deliver an efficient allocation of resources. The result is a loss of economic and social welfare. Market failure exists when the competitive outcome of markets is not efficient from the point of view of society as a whole. This is usually because the benefits that the free-market confers on individuals or businesses carrying out a particular activity diverge from the benefits to society as a whole.

There are many instances when the free market fails to deliver an efficient allocation of resources. Markets can fail because of: 1. Negative externalities (e.g. the effects of environmental pollution) causing the social cost of production to exceed the private cost. 2. Positive (or beneficial) externalities (e.g. the provision of education and health care) causing the social benefit of consumption to exceed the private benefit 3. Imperfect information means merit goods are under-produced while demerit goods are overproduced or over-consumed 4. The private sector in a free-markets cannot profitably supply to consumers pure public goods and quasi-public goods that are needed to meet peoples needs and wants 5. Market dominance by monopolies can lead to under-production and higher prices than would exist under conditions of competition 6. Factor immobility causes unemployment hence productive inefficiency 7. Equity (fairness) issues. Markets can generate an unacceptable distribution of income and consequent social exclusion which the government may choose to change Market failure results in Productive inefficiency: Businesses are not maximising output from given factor inputs. This is a problem because the lost output from inefficient production could have been used to satisfy more wants and needs Allocative inefficiency: Resources are misallocated and producing goods and services not wanted by consumers. This is a problem because resources can be put to a better use making products that consumers value more highly Options for government intervention in markets There are many ways in which intervention can take place some examples are given below

Government Legislation and Regulation Parliament can pass laws that for example prohibit the sale of cigarettes to children, or ban smoking in the workplace. The laws of competition policy act against examples of price-fixing cartels or other forms of anti-competitive behaviour by firms within markets. Employment laws may offer some legal protection for workers by setting maximum working hours or by providing a price-floor in the labour market through the setting of a minimum wage. The economy operates with a huge amount of regulation. The government appointed regulators who can impose price controls in most of the main utilities such as telecommunications, electricity, gas and rail transport. Regulation may be used to introduce fresh competition into a market for example breaking up the existing monopoly power of a service provider. A good example of this is the attempt to introduce more competition for British Telecom and also for the postal service industry. This is known as market liberalisation. Direct State Provision of Goods and Services Because of privatization, the state-owned sector of the economy is now much smaller than it was twenty years ago. The main state-owned businesses in the UK are the Royal Mail which is still subject to direct price controls and Network Rail. State funding can be used to provide merit goods and services and public goods directly to the population e.g. the government pays private sector health firms to carry out operations for NHS patients to reduce waiting lists or it pays private businesses to operate prisons and maintain our road network. Fiscal Policy Intervention Fiscal policy can be used to alter the level of demand for different products and also the pattern of demand within the economy. 1. Indirect taxes such as changes in VAT and excise duties can be used to raise the price of demerit goods and products with negative externalities designed to increase the opportunity cost of consumption and thereby reduce consumer demand towards a socially optimal level. 2. Subsidies to consumers will lower the price of merit goods such as grants to students to reduce the internal costs of staying on in full-time education and subsidies to businesses employing unemployed workers on the New Deal programme. They are designed to boost consumption and output of products with positive externalities a subsidy causes an increase in market supply and leads to a lower equilibrium price (see the separate revision focus article on producer subsidies). 3. Tax relief: The government may offer financial assistance such as tax credits for business investment in research and development. Or a reduction in corporation tax designed to promote investment and employment. 4. Changes to taxation and welfare payments can be used to influence the distribution of income and wealth for example higher direct taxes on rich households or an increase in the value of welfare benefits for the poor to make the tax and benefit system more progressive. Intervention designed to close the information gap Often market failure results from consumers suffering from a lack of information about the costs and benefits of the products available in the market place. Government action can have a role in improving information to help consumers and producers value the true cost and/or benefit of a good or service. Examples might include: 1. Compulsory labelling on cigarette packages with health warnings to reduce smoking. 2. Improved nutritional information on high-fat foods to counter the risks of growing obesity. 3. Anti-speeding television and cinema advertising to reduce road accidents. 4. Advertising health-screening programmes / information campaigns on the dangers of drug and alcohol addiction. These programmes are really designed to change the perceived costs and benefits of consumption for the consumer. They dont have any direct effect on market prices, but they seek to influence

demand and therefore the level of final output and consumption. The effects of government intervention

Decisions on our future energy sources government policy intervention can have huge effects on both the short term and the long term allocation of resources in the future One important point to bear in mind is that the effects of different forms of government intervention in markets are never neutral since financial support given to one set of producers rather than another will always create winners and losers. Taxing one product more than another will similarly have different effects on different groups of consumers. Judging the effects of intervention a useful check list To help your evaluation of government intervention it may be helpful to consider these questions: 1. Efficiency of a policy: i.e. does a particular intervention lead to a better use of scarce resources among competing ends? E.g. does it improve allocative, productive and dynamic efficiency? For example - would introducing indirect taxes on high fat foods be an efficient way of reducing some of the external costs linked to the growing problem of obesity? 2. Effectiveness of a policy: i.e. which government policy is most likely to meet a specific economic or social objective? For example which policies are likely to be most effective in reducing the scale of the UK road congestion problem? Which forms of intervention are most effective in improving the incentives of consumers to actively search for work in the labour market? Which policies are more effective in preventing firms from exploiting their monopoly power and damaging consumer welfare? Evaluation can also consider which policies are likely to have an impact in the short term when a quick response from consumers and producers is desired. And which policies are likely to prove most cost-effective in the longer term? For example, how best to encourage recycling in the long run and also provide incentives to increase the supply of energy in the long run that comes from renewable sources such as wind power. 3. Equity effects of intervention: i.e. is a policy thought of as fair or does one group in society gain more than another? For example it is equitable for the government to offer educational maintenance allowances for 16-18 year olds in low income households to stay on in education after GCSEs? Would it be equitable for the government to increase the top rate of income tax to 50 per cent in a bid to make the distribution of income more equal? 4. Sustainability of a policy: i.e. does a policy reduce the ability of future generations to engage in economic activity? Inter-generational equity is an important issue in many current policy

topics for example decisions on which sources of energy we choose to rely on in future years Government Failure Government intervention can sometimes fail to meet the desired outcomes, or can make existing policy problems worse. In this note we look at the idea of government failure. The idea of government failure Even with the best of intentions governments seldom get their policy application correct. They can tax, control and regulate but the eventual outcome may actually be a deepening of the market failure or even worse a new failure may arise which requires corrective action. Government failure may range from the trivial, when intervention is merely ineffective, but where harm is restricted to the cost of resources used up and wasted by the intervention, to cases where intervention produces new and more serious problems that did not exist before. The consequences of this can take many years to reverse. Over the last fifty or sixty years, Western governments have intervened to try to improve the social and economic life of their countries on a scale unimaginable to previous generations. Yet social and economic problems persist. Policies fail. Adapted from Why Most Things Fail, Paul Ormerod Government failure in a non-market economy The collapse of the Soviet Union in the late 1980s and early 1990s marked, for many people, the final failure of command or planned economies as a means of allocating resources among competing uses. The essence of a command economy was that the state-operated planning mechanism would decide what to produce and how to produce it and for whom to produce. Government failure occurred when the central planners supplied products that were simply not wanted by consumers showing a loss of allocative efficiency, since there was no price mechanism to signal changes in consumer preferences and demand. John Kays book The Truth about Markets has excellent sections on the basic fault-lines in the planning process. Another fundamental failing of the pure command economy was that there was little incentive for workers to raise productivity; few incentives to prevent poor quality control; and little innovation by firms as no profit motive existed. Command economies also suffered environmental de-gradation because they did not posses structures for valuing the environment and giving consumers and producers the right incentives to protect their environmental heritage. All of these economies are now moving towards the western mixed economy, though at varying speeds and with varying success. Eight former eastern Bloc countries joined the European Union in May 2004, some of them former state-run economies in the Eastern Bloc. Countries such as Hungary, the Czech Republic and Poland are all moving towards a market based system for the allocation of resources for example through programmes of privatisation and market liberalisation. Many of them have enjoyed fast rates of economic growth and a rise in relative living standards both before and since their accession to become members of the European Union. Possible Causes of Government Failure Government intervention can prove to be ineffective, inequitable and misplaced. There is a growing body of research in the economics literature on this topic some of which uses highly mathematical techniques to analyse public policy-making. We will focus instead on the underlying reasons and consider some topical examples along the way. (a) Political self-interest The pursuit of self-interest amongst politicians and civil servants can often lead to a misallocation of scarce resources. For example decisions about where to build new roads, by-passes, schools and hospitals may be decided with at least one eye to the political consequences. The pressures of a looming election or the influence exerted by special interest groups can create an environment in which inappropriate government spending and tax decisions are made. - e.g. boosting the level of welfare spending in the run up to an election, or bringing forward major items of capital spending on infrastructural projects without the projects being subjected to a full and proper costbenefit analysis to determine the likely social costs and benefits. Critics of current government policy towards tobacco taxation and advertising, and the controversial issue of genetically modified foods

argue that government departments are too sensitive to political lobbying from the major corporations. (b) Policy myopia Critics of government intervention in the economy argue that politicians have an in-built tendency to look for short term solutions or quick fixes to difficult economic problems rather than making considered analysis of long term considerations. The risk is that myopic decision-making will only provide short term relief to particular problems but does little to address structural economic difficulties. Consider for example the long term problems facing the UKs transport network. To what extent has transport suffered from a lack of long-term planning and joined up thinking about how to create a properly integrated transport network which can provide proper solutions to the issues of traffic congestion and the environmental consequences of rising transport use. Critics of government subsidies to particular industries also claim that they distort the proper functioning of markets and lead to deeper inefficiencies in the economy. (c) Regulatory capture. This is when the industries under the control of a regulatory body (i.e. a government agency) appear to operate in favour of the vested interests of producers rather than consumers. Some economists argue that regulators can prevent the ability of the market to operate freely.

Olive growing in Spain has the CAP encouraged over-production, a waste of resources and caused damage to the economies of many developing countries? For example, to what extent has the European Unions Common Agricultural Policy operated mainly in the interests of farmers? Has the CAP worked against the long-term interest of consumers, the environment and developing countries who claim that they are being unfairly treated in world markets by the effects of import tariffs on food and export subsidies to loss-making European farmers? The CAP is widely criticised as a classic example of government failure and there are many who claim that the current reform process does not go far enough. (d) Government intervention and disincentive effects Free market economists who fear government failure at every turn argue that attempts by the government to reduce income and wealth inequalities can actually worsen incentives and productivity in the economy. They would argue against the National Minimum Wage because they believe that it can lead to real-wage unemployment. They would also argue against raising the higher rates of income tax because it is deemed to have a negative effect on the incentives of wealth-creators in the economy and generally acts as a disincentive to work longer hours or take a better paid job. They are critical of the government focusing welfare benefits on the poorest using means-tested benefits because they might damage the incentive to find work.

The opposite point of view is that a lack of effective government policies to reduce the scale of income and wealth inequality is also a cause of government failure since inequality can, over the longer term; create many deep-rooted problems for society once social cohesion starts to break down. (e) Government intervention and evasion A decision by the government to raise taxes on de-merit goods (such as cigarettes) might lead to an increase in attempted tax avoidance, tax evasion, smuggling and the development of grey markets where trade takes place between consumers and suppliers without paying tax. Equally a decision to legalize and then tax some drugs might lead to a rapid expansion of the supply of drugs and a substantial loss of social welfare arising from over consumption. (f) Policy decisions based on imperfect information How does the government establish what citizens want it to do in their name? Can the government ever really know the true revealed preferences of so many people? Our current electoral system is not an ideal way to discover this! Turnout in every type of election, (local, national, European etc) is falling, there is general disinterest in the political process. Furthermore, people rarely vote purely out of their own self-interest or on the basis of a well informed and rational assessment of the costs and benefits of different government policies. Proponents of government failure argue that the free market mechanism is, in the long-run, the best way of finding out (a) What consumer preferences are and (b) Aggregating these preferences based on the number of people that are willing and able to pay for particular goods and services. Often a government will choose to go ahead with a project or policy without having the full amount of information required for a proper cost-benefit analysis. The result can be misguided policies and damaging long-term consequences. How does the government know how many extra houses need to be built in the UK over the next twenty years? Is building thousands of extra homes in an already congested South-east the right option? Are there better solutions? There have been plenty of instances of government housing policy having failed in previous decades! (g) The Law of Unintended Consequences! This law lies at the heart of many of the possible causes of government failure in markets! The law of unintended consequences says that a government policy will always lead to at least one reaction from either consumers or producers that are unanticipated or unintended. Economic agents do not always act in the way that the economics textbooks would predict this is of course the essence of a social, behavioural science we do not live our lives in sanitised laboratories where all of the conditions can be controlled. The law of unintended consequences is often used to criticise the effects of government legislation, taxation and regulation. People find ways to circumvent laws; shadow markets develop to undermine an official policy; people act in unexpected ways either because or ignorance and / or error. Unintended consequences can add hugely to the financial costs of some government programmes so that they make them extremely expensive when set against their original goals and objectives. (h) Costs of administration and enforcement Government intervention can prove costly to administer and enforce. The estimated social benefits of a particular policy might be largely swamped by the administrative costs of introducing it. A summary of the arguments Free market economists are naturally distrustful of government intervention in the economy They believe that the signalling, incentive and rationing functions of the price mechanism should be given more freedom to operate They believe that government failure can occur at a microeconomic level (e.g. introducing minimum prices in markets, rent controls, producer subsidies etc) and at a macroeconomic level (pursuing inappropriate exchange rate, tax or interest rate policies etc) When government failure exists, the result can be a deepening of an existing market failure The result is a further loss of allocative and productive efficiency because of the waste of scarce resources leading to a reduction in consumer and producer welfare

Often we can accuse the government of policy failure only with the benefit of hindsight Limited information - no government has the resources and information available to it to make fully-informed, objective judgements. That is the nature of politics. Government failure is most likely to occur when decisions are made in the vested interest of special interest groups, at the expense of other groups (the result is a loss of equity) But government failure is rarely total. Policies may be ineffective, expensive and inefficient but providing that policies are flexible and adaptable, (i.e. lessons are learned) then intervention can often work in the interests of the majority Advances in our understanding of how consumers and businesses behave and respond to changing incentives are helping government policies to evolve. For example the growing interest in auctions and traded permits as a means of controlling pollution and other forms of environmental damage Externalities Overview We now consider in more detail than at AS level, the economics of externalities and policy approaches to controlling and correcting for market failure caused by the existence of externalities. Environmental economics is now a huge area of the subject. The economic importance of the environment The environment plays an absolutely essential role in shaping our economic and social welfare. The environment Provides services to consumers in the form of living and recreational spaces and the opportunity to enjoy utility from experiencing natural landscapes and habitats It provides us with the natural resources necessary to sustain production and consumption including the basis for renewable and non-renewable sources of energy It is a dumping ground for the waste products of our society - be it waste from producers in different industries or from households and consumers The link between economic activity and our environment is fundamental. We hear constantly about the need for sustainable economic welfare, for growth to take into account the direct and indirect effects on our resources. And increasingly we, as producers and consumers, are affected by many government policies and strategies designed to promote environmental protection and improvement. What is the commonly accepted definition of sustainability? Development which meets the needs of the present without compromising the ability of future generations to meet their own needs World Commission on Environment and Development Our Common Future (1987) Externalities and the environment the basics For environmental economics, one of the most important market failures is caused by negative externalities arising from either production or consumption of goods and services. A negative externality occurs where a transaction imposes external costs on a third party (not the buyer or seller) who is not compensated by the market. The result is a loss of allocative efficiency and shown by a reduction in economic welfare Environmental externalities generally arise for three reasons: Common resources (not privately owned - e.g. ocean fisheries) commonly owned resources may lack the protection of property rights and are susceptible to over-exploitation because the marginal cost of extracting the resource for a private economic agent is close to zero. This is known as the tragedy of the commons Public goods (indivisible common resources - e.g. the air) Future generations (sources of externality including carbon emissions greenhouse effects contributions to global warming which threatens future sustainability)

Dead fish on a polluted beach the external costs of pollution but who should pay? In these cases, the private equilibrium of supply and demand is not the same as the social equilibrium which includes all costs. In a completely free market, a producer will have no incentive to control pollution because it is external i.e. the producer only considers his/her own private costs and benefits. The market failure arising from negative externalities is shown in the diagram below.

Economists argue that market failures provide a rationale for policy intervention to improve economic efficiency. But since market failures are pervasive, intervention is only justified if the benefits exceed

the costs The Tragedy of the Commons The contribution of each economic agent is minute, but summed over all agents, these actions degrade the resource and may cause severe long term damage The tragedy of the commons is a metaphor used to illustrate the potential conflict between individual self-interests of producers and consumers and the common or public good. In the original version of the term, the example is used of a stock of common grazing land used by all livestock farmers in a small village. Each farmer keeps adding more livestock to graze on the Commons, because the marginal cost of doing so is zero. But because the commonly-owned resource is then over-exploited, the result is a depletion of the soil and a fall in the value of the resource for all users. The resource may become irretrievably damaged, an example of a public bad. The root cause of any tragedy of the commons is that when individuals use a public good, they do not bear the entire social cost of their actions. If each seeks to maximize individual benefit, he or she ignores the external costs borne by others. The absence of well defined and legally protected property rights lies at the heart of the problem. A tragedy of the commons can occur even without complete and permanent destruction of a resource the term can be used to describe any situation where what was perceived as a renewable resource becomes less valuable because of over-exploitation. Good examples of the tragedy of the commons: Burning of fossil fuels carbon emissions contributing to global warming Pollution of waterways - creating other externalities for users of waterways further downstream Logging of forests e.g. the long-term impact on the Brazilian rain forest and the effects of illegal logging see http://news.bbc.co.uk/1/hi/business/4842808.stm Over-fishing of the oceans e.g. the current crisis in the EU fishing industry see http://news.bbc.co.uk/1/hi/sci/tech/4996268.stm Fly-tipping of waste products on public land perhaps a response to the landfill tax? E-mail spamming on the internet! Game theory and the tragedy of the commons The tragedy of the commons can be linked to the prisoner's dilemma that is a core part of game theory. Individuals within a group have two options: cooperate with the group or defect from the group. Cooperation happens when individuals agree to protect a common resource. Defection happens when an individual decides to use more than his share of a public resource. Cooperation has the potential to maximize every individual's benefit in the long run (i.e. the 'tragedy' does not happen, the commons are preserved and can be used indefinitely), while defection maximizes an individual's benefit in the short run at the expense of destroying it in the long run. Thus in the case of fish stocks, suppliers need to cooperate over a period of time so that fish stocks can start to rise again. This is the essence of attempts to reform the European Union Common Fisheries Policy. An alternative to regulation by government is to create a market in property rights in order to control the impact of economic activity on the environment for example establishing a carbon trading emissions scheme or introduction tradable fishing permits for the EU fishing industry. The Economics of Waste The UK government wants more waste being disposed of through incineration rather than dumped in landfill sites. It has restated its strategy and at the top of the waste hierarchy is the desire to reduce the amount of waste created in the first place from the production and consumption of goods and services. The main aim is for the volume of waste to grow less quickly than GDP in other words to , achieve a de-coupling of waste generation from rising economic activity. Because waste is normally regarded as a de-merit good creating external costs, there is justification for some form of government intervention in the market to change market prices, alter incentives and, hopefully, cause a change in the behaviour of consumers and producers. Over two million tonnes of edible food is dumped by retailers in Britain each year, usually into landfill

sites According to data released by DEFRA, less waste in the UK is being land-filled down from 82% to 72% for municipal waste between 1999 and 2004 and from 50% to 44% for industrial and commercial waste between 1999 and 2003. A successful waste strategy will bring about sizeable increases in waste recycling and composting. Some local authorities have a superb record in raising awareness and interest in recycling products. But in other areas of the UK, recycling rates are abysmally low and well below the levels needed to meet UK and European Union targets. Government policy needs to be more effective in enhancing the incentives for individuals and businesses to recycle more of their waste products.

The vast majority of UK household and industrial waste is disposed of in landfill sites Hierarchy of principles of waste management: o Prevention of waste - reduce the amount of waste created in the first place o Reuse the product o Recycle or compost the product o Recover the energy by incinerating o Disposal of the product using landfill

What are the best incentives for households and businesses to reduce the amount of waste created?

Externalities - Government Policy Options Government intervention to reduce market failure from negative externalities Traditionally, government policy towards the environment has concentrated in two main areas Intervention in the price mechanism for example through environmental taxes Command and control measures for example direct regulation and legislation These policies are designed to: o Achieve a more efficient use of resources o Promote substitution between resources (e.g. abundant for scarce, renewable for nonrenewable) o Provide incentives for a reduction of pollution emissions or change from harmful to benign Environmental taxation An environmental tax is a tax on a good or service which is judged to be detrimental to the environment. It may also be a tax on a factor input used to produce (supply) that final product. The main aim of environmental taxation is to: Increase the private cost of producing goods and services so that the producer / consumer is paying for some of the negative externalities that their actions are creating (i.e. the externality is internalised) this promotes allocative efficiency In this way, the government is providing a continuous incentive for the producer / consumer to take the externalities into account, thereby correcting a failure of the signalling function of the price mechanism Raise the price of the product so that the level of demand contracts (there is normally a direct link between the level of output / consumption and the total pollution created) Reduce output levels towards the estimated social optimum level of production which contributes to a more sustainable economy in the long term Well designed environmental taxes may encourage innovation and the development of new technology which reduces the dependency of an economy on pollution inefficient forms of energy. This can help to promote dynamic efficiency

Revenue derived from these taxes can be earmarked for lower taxes elsewhere in the economy (e.g. a reduction in employers national insurance contributions) or to fund increased government spending on environmental projects / an expansion of provision of public and merit goods. Well designed environmental taxes can provide a source of revenue while correcting an economic distortion Inter-generational equity justification: Consider what might happen if the government refuses to introduce some environmental taxes so that current producers and consumers do not pay directly for some of the external costs they create. A refusal to impose tax displaces the environmental costs to future generations (implying a lack of intergenerational equity)

The Durham congestion charge a means of reducing traffic congestion Examples of environmental taxes include: petrol duty, vehicle excise duty, the landfill tax, the new carbon tax and the London Congestion Charge. The Irish Government also introduced a tax on plastic bags in a bid to reduce consumption and encourage recycling. The main aim of an environmental tax is to increase the firms private marginal cost (PMC) until it equates with the social marginal cost curve (SMC). Evaluation problems with environmental taxation There is a growing body of economists who argue that reliance on environmental taxation is an ineffective way of promoting environmental improvement, indeed that some taxes are prone to government failure. And, that the focus should now switch to alternatives ways of changing the incentives of producers and consumers through the market mechanism. The main criticisms of environmental taxes are discussed below: Valuing the environment: There are fundamental problems in setting taxes so that marginal private costs will equate with the marginal social costs. The government cannot accurately value the private benefits and cost of firms let alone put a monetary value on externalities such as the cost to natural habitat, the long-term effects of resource depletion and the value of human life. Frequent adjustments of tax levels may be required and this involves substantial organisational costs Consumer welfare effects: Taxes reduce output and raise prices, and this might have an adverse effect on consumer welfare. Producers may be able to pass on the tax to the consumers if the demand for the good is inelastic and, as result, the tax may only have a marginal effect in reducing demand and final output Achieving a target quantity of pollution reduction: Taxes do not lend themselves to the

government achieving an accurate reduction in total pollution. This is because no government can ever predict how consumers and or producers will respond to higher costs and prices. The elasticity of demand may vary over time. Income distribution: Taxes on some de-merit goods (for example cigarettes) may have a regressive effect on low-income consumers and lead to greater inequalities in the distribution of income. Having said this, it should be possible for authorities to develop smart tariffs or taxes where account is taken of the impact of pollution taxes on vulnerable households such as low low-income consumers. The current Labour government has reduced the rate of VAT on domestic fuel to the EU minimum rate of 5%, but the government has no plans to introduce a domestic energy tax (which would be an explicit environmental tax) because of the huge numbers of low-income households that currently live in fuel poverty. In the UK, the poorest 10% of households spends 13.2% of income on energy whereas the richest spends 3.5%. Employment and investment consequences: If pollution taxes are raised in one country, producers may shift production to countries with lower taxes. This will not reduce global pollution, and may create problems such as structural unemployment and a loss of international competitiveness. Similarly, higher taxation might lead to a decline in profits and a fall in the volume of investment projects that in the long term might have beneficial spill-over effects in reducing the energy intensity of an industry or might lead to innovation which enhance the environment More efficient alternatives? It might be more cost effective for governments to switch away from pollution taxation to direct subsidies to encourage greater innovation in designing cleaner production technologies. Eco-tax reformers often argue that pollution taxes should be revenue neutral so for example, an increase in environmental taxation might be accompanied by reductions in employment taxes such as National Insurance Contributions so that the employment consequences of higher taxation are minimised. The impact of green taxes depends crucially on what is done with the revenues. If they are balanced by reducing other taxes through revenue re-cycling, research suggests that green taxes could result in an overall economic improvement Alternatives to environmental taxes An effective use of environmental taxation Most power stations are surrounded by coal tips or pipes carrying gas. But round the plant that powers the Swedish town of Enkping, some 70 kilometres west of Stockholm, there is willow coppice stretching as far as the eye can see. Enkping is probably the only town in Europe that is powered by bio-fuels. The plant's director, Eddie Johansson, says willow is as economic as coal or gas because Sweden levies a tax on carbon emissions from most power plants. Under the government's rules, he does not have to pay the tax because for every tonne of carbon dioxide that disappears up the stack, the plant's willow trees soak up a tonne from the air as they grow. Hundreds of willow-powered plants could operate across Europe, he says if power companies had similar incentives to cut carbon emissions. Source: Business Week, September 2005 Carbon Emissions Trading Emission trading is regarded by many as the future of environmental protection and improvement in the UK, European and international economy. Carbon trading is another form of pollution control that uses the market mechanism to change relative prices and the incentives of producers and consumers. There is also growing interest in the idea of personal carbon trading, the UK government is currently looking at the issue . Carbon allowances for consumers! The environment minister, David Milliband has unveiled a radical plan to cut greenhouse gas emissions by charging individuals for the amount of carbon they use. Under the proposals, consumers would carry bank cards that record their personal carbon usage. Those who use more energy - with big cars and foreign holidays - would have to buy more carbon points, while those who consume less - those without cars, or people with solar power - would be able to sell their carbon points. Under the scheme, all UK citizens would be allocated an identical annual carbon

allowance, stored as points on an electronic card similar to Air Miles or supermarket loyalty cards. Points would be deducted at point of sale for every purchase of non-renewable energy. People who did not use their full allocation, such as families who do not own a car, would be able to sell their surplus carbon points into a central bank. High energy users could then buy them - motorists who had used their allocation would still be able to buy petrol, with the carbon points drawn from the bank and the cost added to their fuel bills. To reduce total UK emissions, the overall number of points would shrink each year. Source: Adapted from the Guardian, July 2006 The basics of cap and trade - emissions trading A fixed number of emission permits is allocated each year to polluting factories Usual denomination: 1 permit = 1 tonne (e.g. of CO2 emissions) Total number of permits is the limit on pollution the cap Annual emissions of each factory must be less than or equal to permit holdings Permits can be traded i.e. cap and trade Factories which can reduce (abate) pollution for less than the price of a permit can sell spare ones for a profit Factories which find it more expensive to reduce pollution can buy extra permits instead Gradually the supply of permits is reduced the market price rises. This gives firms who find it expensive to cut pollution, more of an incentive to seek new technologies / process that will reduce their pollution emissions A marketable pollution permit gives a business the right to emit a given volume of waste or pollution into the environment. Ideally, the number of permits that are issued corresponds with the total level of pollution that is admissible at the social optimum level of output i.e. where the MSB = MSC. Once this has been determined the permits are issued by auction and firms that pollute the environment can bid for them and then buy and sell them amongst themselves. Pollution permits should, in theory, give firms an incentive to control pollution emissions for less than it would cost to buy permits, and there is evidence from cap and trade pollution permit schemes in the UK and the United States that the costs of monitoring pollution reduction and administration of the permits system is smaller than when an industry is subject to direct regulation. In the United States cap and trade scheme, it was found that many high-polluting businesses invested in fitting new pollution control equipment (e.g. Flue Gas Desulphurisation) and other polluters switched from high to low sulphur coal. Consequently the use of marketable permits allows the cost of pollution control to be minimised. Another advantage is that the revenue from a traded pollution permits scheme can be re-cycled into other schemes for environmental improvement. Incentives matter create a market in the right to pollute - The basic idea behind traded pollution permits is to through the incentive to cut pollution directly to the producers themselves. Companies can then make their own decisions about the costs and benefits to them of particular routes to emission reductions. In other words, market forces are brought to bear on the issue of pollution and potential market failure. Emission trading is likely to be most effective when: There is an easily measurable pollutant The government sets a clearly defined and stable emissions target There are a large number of participant firms, with companies sufficiently sophisticated to deal with the technicalities of trading at auction Wide variation in costs of reducing pollution so that trading of surplus permits can take place The transactions costs of trading permits are low and there is clear pollution data availability at the start and during trading Strict enforcement of permits (i.e. a high compliance rate among participating businesses) Kyoto Emission trading was a key feature of the Kyoto Protocol as a strategy to address some of the

threats posed by climate change in 1997. Kyoto allows trading of permits for carbon dioxide between industrialised countries but the United States withdrew from the agreement in 2001 and since the USA represents 32% of emissions amongst developed countries with emission targets, the absence of the USA from an embryonic trading system will seriously reduce demand for permits and therefore drive down their price and effectiveness. Pollution regulation Instead of relying on intervention in the market mechanism by using taxation, subsidies or pollution permits, the government and its appointed agencies can regulate the level of output and pollution in a market. In theory, the government could set a quota so that output is set at the social optimum. More frequently, minimum or environmental / emission standards are widespread in many industries. This requires regulatory bodies to monitor (inspect) and fine firms that do not meet the standards set for water and air quality. The 1989 Environmental Protection Act for example set standards on emissions for firms that carried out chemical processes, waste incineration and oil refining. There will be a ban on smoking on public places in England from the summer of 2007. A ban came into force in Scotland in March 2006. Compliance with environmental regulations can be very costly to enforce and it may be impossible to monitor all firms accurately because of imperfect information. Regulation also does not bring in any direct tax revenue flows that can be used to fund environmental improvement schemes or compensate those who have been negatively affected by pollution. Suggestions for further reading on carbon emissions trading o Carbon trading, what price a pollution solution? (Green Biz) o Carbon tradings real colours (BBC) o Power tool (Guardian) o Questions are raised over carbon trading (Guardian) o Scale of industrys impact on the environment (Guardian) Airlines and environmental policy Over the past 20 years, there has been huge growth in the airline industry. The number of passenger kilometres has risen from 125 billion worldwide in 1990 to 260 billion in 2000, while air freight grew even faster, at 9% per year. In 1970, British airports were used by 32 million people. In 2004, the figure was 216 million. In 2030, according to government forecasts, it will be around 500 million. Several factors have contributed to rising demand for airline travel The emergence of low-cost flying, such as EasyJet and Ryanair which have brought prices down allowing lower-income families to fly and creating a new effective demand for flying New technologies have also made long-haul flights with flagship-carriers, such as BA, cheaper and more enjoyable Increased demand for business air travel Aviation creates external costs. The main external cost of flying is the damage to the environment. It is estimated that one return flight to Florida produces as much carbon dioxide as a years motoring, while a return flight to Australia the same amount as 3 cars in one year. And flying from London to Edinburgh produces 8 times as much carbon dioxide as taking the train. Aviation currently contributes 5% to the UKs carbon dioxide emissions. With air travel growing at 3-5%, it is expected that planes will contribute 15% to the UKs carbon dioxide emissions in the next ten years For some time, there has been a debate over the merits and de-merits of introducing an aviation tax on airlines. Is this the best way of controlling the environmental damage created by the rapid expansion of the UK and European airline industry? Or will it simply create more problems and damage the competitiveness of the European airline sector? Are there better more effective ways of reducing pollution? For example bringing the airlines into the newly established EU carbon emissions trading scheme?

Public Goods When the market fails to provide certain goods and services, there is a clear case for government intervention. The nature of public goods Public goods are services which must be provided collectively for two main reasons: Non-excludability - the goods cannot be confined to those who have paid for it Non-rivalry in consumption - the consumption of one individual does not reduce the availability of goods to others Examples of pure public goods include flood control systems, street lighting and national defence. A flood control system, such as the Thames Barrier, cannot be confined to those who have paid for the service. Also, the consumption of the service by one household will not reduce its availability to others. If left to the free market mechanism, no public goods would be provided and, as a result, there would be a clear market failure. No individual consumer would pay for a product that could be consumed for free if another household decided to purchase it.

The benefits of the Thames Barrier cannot be confined only to those people who have paid for it Quasi-public goods: These are products that are essentially public in nature, but do not exhibit fully the features of non-excludability and non-rivalry. The road network in the UK is currently available to all, but could be made excludable via a system of electronic road pricing. There is also non-rivalry in consumption, but only up to an extent. Once the road becomes congested there is rivalry in consumption. Environmental public goods: An example of an environmental public good is public open space, which nobody would provide on their own, even though everybody benefits from it being available. Street lighting is another example of a public good. The Air-Waves a Quasi Public Good The airwaves are essentially owned by the government of a particular country. Do they count as a pure public good? Normally the answer would be yes. One persons use of the airwaves rarely reduces the extent to which other people can benefit from utilising them. But when demand for mobile phone services is high at peak times, the airwaves become crowded and access to the networks provided by the main mobile phone companies can become slow. In this sense the airwaves can be treated a crowded non-pure public good.

The government controls the issue of licences needed to operate mobile phone services using the airwaves in the UK. In 2000, they auctioned off five licences for 3rd generation mobile phone services and raised 22 billion in doing so. The government was using the auction process to ration the airwaves through a licence system. Although the government has monopoly control in the sense that it controls the issue of licences, it did not set the market price. This was determined by the auction process, and the fact that at the end of a bidding war, the major mobile phone companies were prepared to pay such a high price for a licence to allow them to operate in the market, is evidence of the private benefit (or anticipated future profit) that the companies expected to make from selling 3rd generation contracts to customers. The fact that these telecoms companies may have greatly misjudged the actual market demand for third generation mobile phone services is not the result of the auction process itself. The government decided that the income from the sale of these licences would be used to repay a slice of the national debt, providing a bonus for current and future generations in terms of reducing the annual interest payments on government debt.

An example of a quasi public good - the air-waves can become congested Finding an Equilibrium Allocation of Public Goods that Maximises Social Welfare Finding the socially efficient level provision of public goods is a hugely difficult process. First we must seek a valuation of the willingness and ability of consumers to pay for public goods which involves estimating the individual demand curves for each consumer and then aggregating to find the market demand curve a reflection of the social marginal benefit (or valuation) that consumers place on each extra unit of a public good that is made available. In the diagram below we consider a non-pure public good whose marginal cost of supply does rise gently as output is increased. If the market fails to provide a sufficient quantity of a public good, then there is a loss of economic (social) welfare.

Case Study: The BBC as a public good Broadcasting is a good example of a public good. Let us remind ourselves of the three main characteristics of a public good. Firstly it is non-rival, meaning that the consumption of a public good or service by one individual does not preclude consumption by another individual. Secondly, consumption is non-excludable. This means that consumption by one individual makes it impossible to exclude any other individual from having the opportunity to consume. Effectively the marginal cost of providing a pure public good to an extra user is zero, and this implies that, in order to achieve allocative efficiency, the charge for the product should be zero. Of course, in this situation, private sector businesses are unlikely to consider providing pure public goods because they will not be able to make any profit at a zero price, and many consumers can take a free ride on such goods because of non-excludability. The provision of pure public goods is therefore a cause of market failure. Left to the free market, public goods are under-provided and under-consumed leading to a loss of social welfare. Traditional analogue broadcasting differs from encrypted digital broadcasting in the sense that digital broadcasters can now exclude non-payers using set-top boxes. But even when Britain moves fully to digital when the analogue signal is turned off in a few years, the broadcasting services will continue to be completely non-rival and it is this that really matters in the context of the services that the BBC provides. One extra person consuming programmes on BBC1 or BBC2 has no effect at all on the ability of people to consume other services provided by the BBC. Paying for a public good - the licence fee debate At the moment, around 23 million households in Britain pay an annual licence fee. All of these people are stakeholders in the debate about the future funding of the BBC and the vast majority use one or

more BBC services at least once a week. The fee is a means of providing collective payment for a public good. We know that there are fee-dodgers who try to take a free-ride by avoiding payment, but there are well established although costly means to enforce the licence fee and take non-payers to court. According to research undertaken by the BBC as part of the Charter Review, on rough estimates, about 17 million households value BBC television, radio and internet services at more than the current licence fee of 122. These are gainers from the existence of the BBC. In contrast, the study finds that 6 million people value the BBC at less than the current licence fee. These are losers they are paying more than the utility that they get and many such people may resent having to pay the licence fee when they have paid for their BSkyB subscription and have already deserted the BBC for other digital or commercial channels. The BBC study estimates that the net consumer surplus created by the BBC is well over 2bn/year, or % of GDP. The most likely groups to think the licence fee represents good value for money for their household are those aged over 60 and those in the higher AB social groups. Groups more likely to think the fee represents poor value for money are those with multi-channel television access, people aged 31-45, people in the C2DEs social groups and younger people of Black or Asian origin. People in C2DE social groups are far more likely to have an income below the median, and therefore the question of raising the licence fee becomes important because a sharp rise in its level would affect peoples ability to pay.
Television BBC 1 BBC 2 BBC 3 BBC 4 Cbeebies CBBC BBC News 24 BBC Parliament Radio Radio 1 Radio 2 Radio 3 Radio 4 Radio Five Live Five Live Extra 1Xtra 6 Music BBC 7 Asian Network 6 Nations services 40 local and regional services Other BBC Online World Service BBC Scotland BBC Northern Ireland BBC Wales BBC English Regions

For millions of people, the value that they derive from the BBCs output does exceed the price they currently have to pay via the licence fee. Would they be happy to pay a significantly higher fee in the future? Much would depend on the quality and range of broadcasting that the BBC is able to deliver. Assuming a constant range, reliability and quality of services, a large rise in the BBC licence fee would reduce total consumer surplus. The BBC study estimates that if the fee was raised by forty per cent from 122 to 170, up to four million people would no longer value BBC services as much as the higher compulsory fee, consumer surplus would be reduced and the BBCs services might end up being underconsumed. This, in a nutshell, is the argument against the introduction of a subscription-based system for funding the BBC. It would exclude several million people from consuming their services and would probably result in a net loss of social welfare.

What is the best way to finance broadcasting? Should the licence fee remain compulsory? Criticisms of the licence fee Opponents of the licence fee argue that 1. It is a regressive form of taxation everyone pays the same flat charge, regardless of their disposable income, the number of televisions they own or the extent to which they watch television in general and BBC services in particular 2. As fewer people watch the BBC, the case for a licence fee diminishes. Indeed as technology develops, it become even harder to sustain a compulsory licence fee when people have moved predominantly to alternative sources of information through the internet, digital channels, broadband and their mobile phones 3. The costs of collection and evasion are high including 150 million per year chasing licencefee evaders What are the alternatives for funding the BBC? Moving to a subscription base system (technology may allow this in the future). Allowing advertising and sponsorship of programmes similar to the ITV model. Greater emphasis on selling BBC programmes overseas through BBC Worldwide and sales of DVDs to generate increased revenue for the BBC. Funding the BBC entirely through direct taxation and scrapping the licence fee. A tax on the revenues of other commercial broadcasters to part-fund the BBCs services reflecting the public service nature of much of the BBCs output. Of these alternatives, introducing advertising is least preferred among people surveyed. A sizeable majority of viewers (over sixty per cent according to a recent MORI poll) regard advertising as an intrusion to their enjoyment of programmes, and few think that the BBC should move to this form of finance. And there are worries that the total size of the TV advertising market is not large enough to absorb the entry of the BBC as a supplier of advertising slots. It might well damage the financial viability of ITV for example. In any case, advancing technology now allows viewers to skip advertising when they have pre-recorded programmes. On the whole, there is a preference for keeping the licence fee (a system of funding used in many other countries) although there are concerns among older groups about their ability to pay for it. But without a sizeable increase in its value, there is little doubt that BBC revenues will soon be overtaken

permanently by Sky and this will damage the BBCs ability to bid for live television events including the rights for sports such as soccer, cricket and golf. Public Goods and the Free Rider Problem Consumers have an incentive to not reveal their willingness and ability to pay for public goods if they believe that they will be expected or required to contribute to financing the public good accordingly by the government. After all, if the public good is supplied, it will be available to them just as it would be to anyone else because pure public goods are non-excludable. This is the essence of the free rider problem: the incentive which consumers have to avoid contributing to financing public goods in proportion to their valuation of such good. Good examples to use include TV licence dodgers and people who choose to evade the Council Tax but who still receive local authority services. Another example might be a group of residents in a block of flats who all stand to benefit from the refurbishment of an adjacent playground or better lighting and security systems, but who individually might try to avoid payment and benefit once the improved amenities are in place. Given the nature of the free rider problem, public goods are often financed through some form of enforcement, notably the compulsory nature of the TV licence fee, management fees for residents living in blocks of accommodation or the signing of international treaties on the environment. .

Market Failure Universities and Tuition Fees The introduction of tuition fees for students in England and Wales has been controversial. It raises important issues about the economics of higher education some of these issues are raised and evaluated in this note. Market failure in education Market failure occurs when markets operating without government intervention, fail to deliver an efficient or optimal allocation of resources - Therefore - economic and social welfare may not be maximised leading to a loss of allocative and productive efficiency (i.e. welfare losses for society). Market failure exists when the outcome of markets is not efficient from the point of view of the economy. This is usually because the benefits that the market confers on individuals or firms carrying out a particular activity diverge from the benefits to society as a whole (i.e. there are externalities not taken into account within the market). This is particularly relevant to the concept of education as a merit good

An aerial view of Oxford should higher education be regarded as a merit good which the government should subsidise directly for students? The idea of positive educational externalities is that the benefits of individually acquired education may not be restricted to the individual but might spill over to others as well, meaning that there will be macroeconomic advantages from a higher level of education spending and attainment. For example, there is compelling evidence that human capital increases productivity and thereby increases an economys trend rate of growth and international competitiveness. Education is found to yield additional indirect benefits to growth for example by stimulating physical capital investments and technological development and adoption across many different industries (creating the potential for gains in dynamic efficiency) The free spill-over effects of improved educational provision can be said to take education away from being purely as a merit good and more towards meeting the characteristics of a public good. The social returns to increasing the average length of time that people spend in education depend in part on the stage of economic development recent studies suggest that an expansion of tertiary/higher education is the most important for growth in countries such as the UK. Imperfect information Markets can also fail when the individual or firm does not have sufficient information to recognise the future returns from undertaking an action again this is relevant to decisions that individuals take as to how much education they should consume or purchase at different stages of their life. Many young people are myopic when making university and degree course decisions. Or they may be averse to taking on debts even though it might be in their long-term financial interest to do so. In this case, there might be an economic case for the government to adopt a paternalistic view on what is best or for younger people. Equity Markets can generate what is perceived to be an unacceptable distribution of income and too high a level of social exclusion where people on low incomes are denied access to essential goods and opportunities considered normal by a society. Education comes into this category not least on the issue of whether students should make a financial contribution to the cost of their own tuition when they are in higher education. Merit Goods and Market Failure A merit good is a product that the government believes consumers undervalue and under-consume because of imperfect information. A merit good is deemed to be socially desirable and also better

for a consumer than the consumer realises a value judgement is involved whenever we talk of merit goods.

How can a monetary value be placed on the additional social value of education overlooked by consumers suffering from information failure? Is it simply the present value of higher income? How can the value to society of a well educated and more skilled and productive work force be estimated both in the short term and the long run? The Private and Social Benefits of Education
Private Benefits of Education The fun and enjoyment of learning (personal satisfaction and fulfilment) Social Benefits of Education More literate and intelligent society lower crime rates?

Accumulation of human capital (qualifications and Contributes to international competitiveness of economy experience) that will reduce the risk of unemployment and importance of high-knowledge sectors in international trade allow people to hurdle over entry barriers to certain continues to grow expansion of scientific research etc occupations Higher expected earnings in work a university degree is a Higher tax revenues in the long run can be used to fund signalling mechanism for employers e.g. in promoting fast- other socially beneficial government spending programmes track promotion Blundell (2000) estimated that the average return to Social benefits from having more doctors and teachers and completion of a first degree for a cohort of 33-year-olds in scientists increased provision of public and merit goods 1991 was around 17% for men and 37% for women compared with people with A levels as their highest qualification

There is no such thing as a free lunch. Higher education involves costs the main issue is really how best it should be funded. Clearly there are many normative judgements involved but we should also try to bring economic arguments into the discussion. A recent research piece by the Institute for Fiscal Studies made the situation clear: It is important to be clear that higher education is never free, whether the costs are met upfront by

students, later in life by graduates or in an ongoing way by taxpayers in general. Altering the system of HE finance changes the incidence and the timing of payments but does not change the fact that the cost of university education must be paid for in one way or another. Adapted from www.ifs.org.uk Summary of some of the arguments on tuition fees and the funding of universities
Arguments for introducing tuition fees The benefit-pay-principle A university education is a valuable and expensive privilege. Why should something that is so rewarding and costly be free? It is equitable for students to make a financial contribution to their degree teaching they stand to gain financially from a degree education is an investment and it is rational for students to borrow at this stage of their life-cycle to finance such investment. It is rational to forgo current earnings in return for higher future earnings Arguments against tuition fees A tax on learning? Equity issues Only 7% of children from families in the lowest social class currently go to university tuition fees will make it harder for relatively poor families to fund a degree. This will widen educational inequality and create a further widening of the two-tier education system Top up tuition fees or a graduate tax will raise extra revenue but they are not an alternative for a higher level of government funding designed to increase education spending as a share of GDP

Extra funding for facilities, teaching & research Student debt may deter Tuition fees will provide extra finance that will allow the government to fund an expansion poorer students of the number of students able to enter higher education promoting wider access to HE. Tuition fees will lead to a huge surge in student debt and hardship which in turn will have negative economic and social consequences in the long run Means-testing is costly to monitor and can create disincentive effects Means testing to protect access for poorer students Access to higher education to people from less privileged backgrounds can be protected. Tuition fees can be means-tested to offset the danger that fees will hit lower income students hardest. Maintenance grants can also be means-tested Social benefits (externalities) argument The benefits to participation in higher education accrue not only to the individual graduate but also to society at large. And seeking to expand higher education too much may work against the best interests of the economy the graduate market may become over-crowded Limits to the market tuition fees no answer A graduate tax exhibits no relationship between the cost of the course attended and the amount repaid by the student. It therefore introduces no `market-based'

Improvements in dynamic efficiency Fees will encourage students to be more selective in the courses they choose and will stimulate an improvement in teaching quality if universities are to keep student numbers high and remain viable - tuition fees make parents and students ask hard questions about the purposes of higher education

element into the higher education sector in terms of students choosing between courses and institutions based on the various prices of attending them Research and international competitiveness Extra funding is needed for universities to maintain high levels of research offering long term macroeconomic benefits for the economy Uncertain flow of tax revenue The amount that tuition fees will raise is uncertain because it depends on the future earnings of graduates once they enter employment and it will take years for the extra funding to come through Education as a basic economic and social right Belief that access to university should be available to all people who qualify independent of their ability to pay (a value judgement) i.e. education as a right not a commodity Is education fundamentally different from providing health care free at the point of need?

Progressive system of tuition fee repayment Repayment through the income tax system introduces a progressivity into the system higher income earners will repay their debt more quickly. Specifying that the loans need only be repaid when incomes rise above a certain level should help overcome students reluctance to borrow when they cannot be confident about their future earnings. It is a pay-roll deduction scheme rather than a tax

Fees are more equitable than general taxation Impact on demand for Funding tuition from general taxation is an expensive and poorly targeted way of certain degrees intervening in the market, because graduates, who are predominantly found towards the It is feared science and top of the income distribution, benefit at the expense of everyone else i.e. why should non- engineering - among the graduates pay for the degrees of graduates? most expensive courses to The argument that education should be provided free is much stronger for the case of run because of equipment primary and secondary education than for higher education. costs and specialist staff will see a fall in demand threatening long term damage to our manufacturing competitiveness

Competitition Policy Competition policy covers the different ways in which the competition authorities of national governments and also the European Union seeks to make markets work better and achieve a higher level of economic efficiency and economic welfare. The Main Aims of Competition Policy The aim of competition policy is promote competition; make markets work better and contribute towards increased efficiency and competitiveness of the UK economy within the European Union single market. Competition policy aims to ensure: Wider consumer choice in markets for goods and services. Technological innovation which promotes gains in dynamic efficiency. Effective price competition between suppliers. Investigating allegations of anti-competitive behaviour within markets which might have a negative effect on consumer welfare. There are four pillars of competition policy in the UK and in the European Union: Antitrust & cartels: This involves the elimination of agreements which seek to restrict competition (e.g. price-fixing agreements, or cartels) and of abuses by firms who hold a dominant position in a market. Market liberalisation: Liberalisation involves introducing fresh competition in previously monopolistic sectors e.g. energy supply, telecommunications, air transport and postal services together with new arrangements for car retailers inside the single market. State aid control: Competition policy analyses examples of state aid measures by Member State governments to ensure that such measures do not artificially distort competition in the Single Market (e.g. the prohibition of a state grant designed to keep a loss-making firm in business even though it has no prospect of long-term recovery). Merger control: This involves the investigation of mergers and take-overs between firms (e.g. a merger between two large groups which would result in their dominating the market). "Ronald Coase said he had gotten tired of anti-trust because when the prices went up the judges said it was monopoly, when the prices went down they said it was predatory pricing, and when they stayed the same they said it was tacit collusion." Source: William Landes, "The Fire of Truth: A Remembrance of Law and Econ at Chicago", JLE (1981) Anti-Trust Policy - Abuses of a Dominant Market Position A firm holds a dominant position if its economic power enables it to operate within the market without taking account of the reaction of its competitors or of intermediate or final consumers. In appraising a firm's economic power in the marketplace, the EU Commission considers its market share and other factors such as whether there are credible competitors, whether the firm has ownership and control of its own distribution network and whether it has favourable access to raw materials. Note here that market share is not the sole determinant of economic power in an industry Holding a dominant position is not wrong in itself if it is the result of the firm's own effectiveness and competitiveness against other businesses. But if the firm exploits this power to stifle competition, this is deemed to be an anti-competitive practice. A recent example of this has been the long investigation and legal battle by the EU Commission into the alleged abuse of market power by Microsoft. Microsoft was accused of continuing to abuse its monopoly in the software market. The investigators alleged that Microsoft bundled Media Player with Windows, unfairly damaging rival programs such as Real Networks RealPlayer and Apple Computers QuickTime. The investigation and fall-out has now lasted more than eight years. In March 2004 the EU fine Microsoft 497m levied in March 2004 for its alleged abuse of its dominant position in the operating software and server software market. In July 2006, a Guardian Unlimited Business | | EU fines Microsoft 280mfurther fine of 194m was imposed.

Anti-Competitive Practices: Anti-competitive practices are best defined as strategies designed deliberately to limit the degree of competition inside a market. Such actions can be taken by one firm in isolation or a number of firms engaged in explicit or implicit collusion. Since 1998 there have been numerous investigations in industries such as chemicals, banks, pharmaceuticals, airlines, beer, and paper, plasterboard, food preservatives and computer games! Examples of anti-competitive practices Predatory pricing financed through cross-subsidization (not all price discrimination is anti competitive though much of it is simply a genuine attempt to remain competitive in a market). An example of an allegation of predatory pricing came in 2005 when Wal-Mart was accused of using this strategy as it tried to break into the German food retail market. WalMart faced accusations that it was using short-term predatory pricing to put small shopkeepers out of business. In July 2006, it was announced that Wal-Mart was pulling out of Germany having sold its stores to another business. Vertical restraint in the market: o Exclusive dealing: This occurs when a retailer undertakes to sell only one manufacturer's product and not the output of a rival firm. These may be supported with long-term contracts that bind or lock-in a retailer to a supplier and can only be terminated by the retailer at high financial cost. Distribution agreements may seek to prevent instances of parallel trade between EU countries (e.g. from lowerpriced to higher priced countries) o Territorial exclusivity: This exists when a particular retailer is given the sole rights to sell the products of a manufacturer in a specified area o Quantity discounts: Where retailers receive progressively larger price discounts the more of a given manufacturer's product they sell - this gives them an incentive to push one manufacturer's products at the expense of another's in order to widen their own profit margins o A refusal to supply: Where a retailer is forced to stock the complete range of a manufacturer's products or else he receives none at all, or where supply may be delayed to the disadvantage of a retailer Creation of artificial barriers to entry: Through advertising and marketing and brand proliferation which increase the costs of a new firm successfully entering a market Collusive practices: These might include agreements on market sharing, price fixing and agreements on the types of goods to be produced. Price Fixing The Office of Fair Trading UK competition law now explicitly prohibits almost any attempt to fix prices - for example, you cannot: Agree prices with your competitors, e.g. you can't agree to work from a shared minimum price list Share markets or limit production to raise prices Impose minimum prices on different distributors such as shops Agree with your competitors what purchase price you will offer your suppliers Cut prices below cost in order to force a smaller or weaker competitor out of the market The law doesn't just cover formal agreements. It also includes other activities with a pricefixing effect. For example, you shouldn't discuss your pricing plans with your competitors. If you then all "happen" to raise your prices, you are fixing prices. Cartels and the law in the UK Cartels are a particularly damaging form of anti-competitive behaviour - taking action against them is one of the OFT's priorities. Under the Competition Act 1998 and Article 81 of the EC Treaty, cartels are prohibited. Any business found to be a member of a cartel could be fined up to 10 per cent of its worldwide turnover. In addition, the Enterprise Act 2002 makes it a criminal offence for individuals to dishonestly take part in the most serious types of cartels. Anyone convicted of the

offence could receive a maximum of five years imprisonment and/or an unlimited fine. Source: OFT web site There have been many examples of allegations of and investigations in price fixing and other forms of collusive behaviour in UK and European markets in recent years. They all provide interesting evidence of how the competition authorities both in the UK and in the European Union are using their enhanced powers under new competition laws to investigate possible instances of price fixing or anti-competitive behaviour. House of Fraser and Oakley price fixing for sunglasses The House of Fraser department store group is facing accusations that it colluded with Oakley to fix the price of its sunglasses, which sell for between 50 and 200 a pair. Following a two year investigation, the Office of Fair Trading (OFT) has published a provisional report claiming that both House of Fraser and Oakley have breached the 2002 Competition Act. Both companies now have the opportunity to make submissions to the OFT in defence of their position. The OFT believes that between November 2001 and March 2004, Oakley supplied House of Fraser with sunglasses on the condition that the department store sold them at no lower than the Oakley suggested minimum selling price. The investigation was instigated after complaints from rival retailers and complaints from some customers. If the findings are confirmed, the OFT has the power to fine a firm up to ten per cent of its turnover. Dual pricing Sony versus the internet retailers The UK Office of Fair Trading is investigating accusations of possible illegal price discrimination by the global electronics giant Sony. Some online retailers have complained that Sony is discriminating against them by offering cheaper (discounted) prices to established high street retailers and making the online retailers pay more for their supplies of many of Sony's top selling products. The complaint came from the Interactive Media in Retail Group (IMRG) and their claim was that dual pricing acts as an anti-competitive strategy which is damaging to consumer welfare. Dual Pricing is a mechanism recently introduced by electrical consumer goods manufacturers whereby their dealers pay more for goods if sold online. The IMRG claimed that there is no economic justification for dual pricing and that the defence that it costs more to run a "bricks and mortar" retail business compared to an online business is both irrelevant and open to dispute. In a press release they claim that Sony have been exposed in the newspapers as one of the manufacturers being looked at but others including Panasonic, Sharp, Phillips and Hitachi may also have their dual-pricing tactics considered. Price fixing in the dairy industry The Office of Fair Trading is investigating claims that some of the UK's top dairy processing businesses have been involved in a price fixing agreement. Dairy Crest and Robert Wiseman, two of the UK's top three dairy processors are under the microscope and Arla Foods may also be part of the broader scope of the investigation which centers on a decision by the dairy processors to jointly increase the price paid to milk farmers in the UK. But this investigation is coming under quite fierce criticism from supporters of the farming industry who believe that unless effective steps are taken to raise the prices and incomes flowing to milk producers, the industry itself may collapse with the loss of thousands of jobs. Suggestions for wider reading on price fixing and cartels Breach of competition law by 50 independent schools (November 2005) Chemical firms face price fixing probe: Competition Commission of the European Union Enquiry begins into the price of school uniforms (July 2006) EU smashes acrylic glass cartel (March 2006) Fine for European chemical companies involved in price fixing cartel (2006) OFT to refer grocery market to Competition Commission (June 2006) see also Inquiry spells trouble for the Big 4 retailers (Guardian) and Supermarkets in competition probe (BBC) OFT to study market structure of UK airports (June 2006) Samsung in price fixing admission Scottish roofing contractors fined for collusive bidding (June 2005) Wikipedia: http://en.wikipedia.org/wiki/Price_fixing

Some collusive behaviour is tolerated / encouraged Not all instances of collusive behaviour are deemed to be illegal by the European Union Competition Authorities. Practices are not prohibited if the respective agreements "contribute to improving the production or distribution of goods or to promoting technical progress in a market. Examples include: Development of improved industry standards /technical standards of production and safety which eventually benefit the consumer. Research joint-ventures and know-how agreements which seek to promote innovative and inventive behaviour in a market. Market Liberalization The main principle of EU Competition Policy is that consumer welfare is best served by introducing competition in markets where monopoly power exists. Frequently, these monopolies have been in network industries for example transport, energy and telecommunications. In these sectors, a distinction must be made between the infrastructure and the services provided directly to consumers using this infrastructure. While it is often difficult to establish a second, competing infrastructure, for reasons linked to investment costs and economic efficiency (i.e. the natural monopoly arguments linked to economies of scale and a high minimum efficient scale) it is possible and desirable to create competitive conditions in respect of the services provided. The European Commission has developed the concept of separating infrastructure from commercial activities. The infrastructure is thus the vehicle of competition. While the right to exclusive ownership may persist as regards the infrastructure (the telephone or electricity network for example or the supply of gas and electricity to the individual household and business), monopolists must grant access to companies wishing to compete with them as regards the services offered on their networks (good examples include the markets for telephone communications or electricity and gas supply). State Aid in Markets The argument for monitoring state aid given to private and state businesses by member Government is that by giving certain firms or products favoured treatment to the detriment of other firms or products, state aid disrupts normal competitive forces. According to the EU Competition Commission, neither the beneficiaries of state aid nor their competitors prosper in the long term. Often, all government subsidies achieve is to delay inevitable restructuring operations without helping the recipient actually to return to cost and non-price competitiveness. Unsubsidised firms who must compete with those receiving public support may ultimately run into difficulties, causing loss of competitiveness and endangering the jobs of their employees. Under the current European state aid rules, a company can be rescued once. However, any restructuring aid offered by a national government must be approved as being part of a feasible and coherent plan to restore the firms long-term viability. Government aid designed to boost research and development, regional economic development and the promotion of small businesses is normally permitted. Merger Policy in the UK and the European Union Corporate restructuring is a fact of life. There is a natural tendency for markets to consolidate over take through a process of horizontal and vertical integration. The main issue for competition policy is whether a proposed merger or takeover between two businesses is thought to lead to a substantial lessening of competitive pressures in the market and risks leading to a level of market concentration when collusive behaviour might become a reality. When companies combine via a merger, an acquisition or the creation of a joint venture, this generally has a positive impact on markets: firms usually become more efficient, competition intensifies and the final consumer will benefit from higher-quality goods at fairer prices. UK Competition Commission gives the green light for the takeover of Ottakars by HMV After an investigation into the possible effects on competition in the UK retail book market, the Competition Commission has announced that a takeover of the bookseller Ottakar's by HMV, which owns the larger Waterstone's book chain, would not harm the public interest and that the takeover has been given the green light. The takeover bid was launched in September 2005 and valued

Ottakar's at 96.4 million. But at a time of weakening demand for book sales in a faltering economy, HMV may be able to complete a successful takeover with a bid of perhaps one third less than its opening gambit. The decision goes against a wave of opinion in the book industry among authors and publishers that the creation of a much larger book retailing business could limit consumer choice and have a damaging effect on smaller independent booksellers. The book industry is growing, but there are enormous competitive pressures for smaller booksellers not least from the supermarkets and online retailers. The Competition Commission has concluded that the takeover will be unlikely to affect book prices, the range of titles offered or the quality of service. They believe that there will be sufficient competition between existing bricks and mortar retailers and the new entrants to the market so that HMV will not have any extra power to raise prices on top-selling books. The combined UK market share of Waterstones and Ottakars in 2005 were around 24 per cent of all books but overall market concentration has changed little during the past five years. The Commission estimates that the four largest retailers (WH Smith, Waterstones, Ottakars and Borders) have 45 per cent of the market.
Waterstones (HMV) Number of stores Square footage (m) Sales (m) year to April 05 Operating profit (m) Employees 194 1.3 440.0 26.1 4,231 Ottakars 131 0.6 173.2 8.2 2,023

There is intensive price and non-price competition especially at local level. Non-price competition tends to focus on the range of titles in stock and quality of in-store service including author book signings, book ordering facilities, opening hours and complementary facilities such as areas to browse books and the quality of advice from bookstore staff. However, mergers which create or strengthen a dominant market position can, after investigation, be prohibited in order to prevent ensuing abuses. Acquiring a dominant position by buying out competitors is in contravention of EU competition law. Companies are usually able to address the competition problems, normally by offering to divest (sell or off-load) part of their businesses. Evaluating the factors behind approving or rejecting a merger within the EU Often a merger is allowed to progress without any intervention by the competition authorities when the economic benefits of allowing the integration to take place are significantly greater than the potential costs. Here are some of the justifications for approving a merger between two businesses: (1) Efficiency arguments Static efficiency: Mergers may result in the exploitation of further internal economies of scale and therefore improved productive efficiency (cost savings) Dynamic efficiency: Increased profits can be used for R&D into new products and new production processes (innovation) creating long term dynamic efficiency; provides funds for capital investment (2) The role of the capital markets: Some economists argue that capital markets (stock markets) will sort out mergers which eventually fail to deliver the promised financial benefits. If unsuccessful mergers occur, corporate raiders are always ready to kick out the unsuccessful management who are not making enough profit for shareholders. The survival of the fittest ensures efficiency by keeping management on their toes (reducing X-inefficiencies). It is argued that this is a more effective mechanism than government intervention which will only make matters worse because of the potential for government failure. (3) Market contestability arguments: There has been a huge growth of interest in the concept of contestable markets and this tends to complement the free market approach to mergers. By concentrating on removing entry barriers to a marker, monopolies and mergers can only remain dominant by producing good products efficiently

(4) The capital investment argument: Lower costs and a bigger combined business may prompt higher levels of capital investment which is good news for the productive capacity of the EU economy (5) The globalisation argument Mergers and takeovers can reinforce and improve the competitive position of EU companies relative to non EU companies (a countervailing power to dominance of giant US firms) this is important in industries that are becoming truly globalized and where increasing returns to scale (falling LRAC) is an important ingredient of competitive advantage (6) Mergers and takeovers as a means of enhancing economic integration within the EU: Mergers and takeovers are an inevitable consequence of the creation of a single market perhaps the EU competition authorities should continue take a benign view of mergers if they have at their core, the aim of creating businesses large enough to provide goods and services to a community of nearly 500 million people. Economic arguments for not approving a merger: Under what circumstances might the EU Competition Authorities block a merger/takeover or insist on some form of redress before permitting it to proceed? (1) Monopoly power: Mergers and takeovers create market dominance; consumers are exploited and resources misallocated if there are entry barriers inhibiting competition leading to market failure and loss of economic welfare. In practice, there are always barriers to market contestability especially in industries where sunk costs are high. (2) Mixed evidence on benefits of mergers: The evidence is mixed as to whether mergers improve companies' performance, either in terms of profitability, or cost savings indeed many of the claims for increased efficiency and economies of scale made prior to a merger or a takeover prove to be exaggerated with the benefit of hindsight. (3) Imperfections in the capital markets: The market for corporate control does not work optimally. Unsuccessful managements in poorly performing businesses may remain in place for a long time. Shares are mainly held by financial institutions but whilst they are the owners, they do not run the companies on a day to day basis. This means there is a divorce of ownership and control with managers pursuing their own interests (salary and welfare) rather than maximising profits for the shareholders. (4) Employment effects Mergers and takeovers nearly always lead to rationalisation as part of a process of cost cutting but may be at the expense of jobs (possibility of structural unemployment) and fewer outlets / choice for consumers (an issue of equity) The vast majority of cases referred to the EU competition authorities are cleared

Privatisation & de-regulation Privatisation became one of the most significant microeconomic policies of the 1980s and 1990s. We look briefly at some of the issues involved in transferring assets from the public to the private sector of the economy. What is privatisation? Privatisation means the transfer of assets from the public (government) sector to the private sector. In the UK the process has led to a sizeable reduction in the size of the public sector of the economy. State-owned enterprises now contribute less than 2 per cent of GDP and less than 1.5% of total employment. Privatisation has become a common feature of microeconomic reforms throughout the world not least in the transition economies of Eastern Europe as they have made progress towards becoming fully-fledged market economies. Major privatisations The major privatisations in the UK over the last twenty five years have occurred with the following businesses (the year of privatisation is in parenthesis).

Associated British Ports (1983) British Aerospace (1980) eventually merged with Marconi Electronic Systems British Airports Authority (1986) British Airways (1987) British Coal (1994) in 1994, UK Coals assets were merged with RJB Mining to form UK Coal plc British Gas (1986) - In 1997 British Gas plc de-merged Centrica plc and renamed itself BG plc (later BG Group plc). in Britain it is used by Centrica, while in the rest of the world it is used by BG Group British Petroleum - In August 1998, British Petroleum merged with the Amoco Corporation (Amoco), forming "BP Amoco." British Rail (privatised in stages between 1994 and 1997) British Steel (1988) British Steel merged with the Dutch steel producer Koninklijke Hoogovens to form Corus Group on 6 October 1999 British Telecom (1984) Cable and Wireless National Power and PowerGen (1990) - 1990 the Central Electricity Generating Board was split into three generating companies (Powergen, National Power and Nuclear Electric plc.) and electricity transmission company, National Grid Company. Regional water companies

The early examples of privatisation such as the sale of British Telecom to the private sector in 1984 represented a simple transfer of ownership as shares were offered for sale via the stockmarket. More recently the privatisation process has become more complex. The focus has switched to breaking up existing statutory monopoly power through a process of deregulation and liberalisation of markets basically designed to introduce competition where once monopoly power was well established. Market forces have been introduced in social services, the NHS and in higher education. What remains of the public sector? Privatisation has radically reduced the size of the public or government sector of the economy although since the current Labour government came to power, there has been a huge rise in total public sector employment, in part the result of a large rise in government spending on the national health services. The following businesses remain part of the public sector: British Nuclear Fuels plc - an international company, owned by the British government, concerned with nuclear power. See this company profile. Network Rail - Network Rail is a "not for dividend" company that owns the fixed assets of the UK railway system that formerly belonged to British Rail, the now-defunct British stateowned railway operator. Network Rail owns the infrastructure itself, railway tracks, signals, tunnels, bridges, level crossings and most stations, but not the rolling stock. Network Rail took over ownership by buying Railtrack plc, which was in "Railway Administration", for 500 million from Railtrack Group plc. The Royal Mail - Royal Mail has been a state-owned company since 1969 and remains a public limited company wholly owned by the UK government. The Royal Maul is regulated by PostComm which has the power to grant licences to new competitors entering the deregulated market for household and business mail services. The market was opened up to full competition in January 2006. The Royal Mail retains a universal service commitment. Delivering competition On 1st January 2006, the mail market opened to full competition. This means that organisations other than Royal Mail can now - if they have been licensed by Postcomm - act as postal operators

and collect, sort and distribute mail in the UK. Postcomm will protect the universal service, which is provided by Royal Mail. This means that everyone - no matter where they live - will continue to enjoy an affordable daily delivery. The universal service also includes the "one price goes anywhere" stamp, as well as collections and deliveries for every address in the country, each working day. Source: Adapted from the PostComm website The main economic arguments for privatisation and deregulation Supporters of privatisation believe that the private sector and the discipline of free market forces are a better incentive for businesses to be run efficiently and thereby achieve improvements in economic welfare. The argument is that extra competition in markets will lead to reductions in price levels for consumers and improvements over time in dynamic efficiency. Privatisation was also seen as a way of reducing trade union power and encouraging an increase in capital investment as businesses were now free to raise extra financial capital through the stock market. The main economic arguments against privatisation Opponents of privatisation argued that state owned enterprises had already faced competition when part of the public sector and that in several instances the transfer of ownership merely replaced a public sector monopoly with a private sector monopoly. There were criticisms that state assets were sold off by the government at too low a price and that the consequences of privatisation has been a decrease in investment and large scale reductions in employment as privatised businesses have sought to cut their operating costs. Deregulation of markets Another important policy in industries where welfare and efficiency might be affected by the dominant market power of some suppliers is to open up markets and encourage the entry of new suppliers a process called de-regulation of product markets. Examples of this in the UK include the opening up of markets for household energy supplies, the liberalisation of household mail services and financial deregulation affecting both banks and building societies. The expansion of the European Single Market has accelerated the process of market liberalisation. The Single Market seeks to promote four freedoms namely the free movement of goods, services, financial capital and labour. In the long term we can expect to see the microeconomic effects of the EU Single Market working their way through many British markets and the general expectation is that competitive pressures for all businesses working inside the European Union will continue to intensify. Product market liberalisation involves breaking down barriers to entry in industries and making them more contestable. The aim is to boost market supply, bring down prices for consumers, and encourage an increase in competition, investment and productivity leading to a rise in economic efficiency. In the long term, if product markets become more competitive and investment flows into these industries, there are macroeconomic implications for example an increase in an economys underlying trend rate of economic growth which might contribute to an improvement in average standards of living

Has rail privatisation been successful? Utility regulators Utility regulators oversee the activities of companies privatised over the last two decades. These former state-owned utilities are regulated to ensure that they do not exploit their monopoly position. The main aims of the regulators have been to create and simulating the disciplines that companies would experience inside a competitive market. In the long run, the thrust of regulation has been to encourage competition by easing the entry of new suppliers and making markets more contestable. Ofwat (water services regulation authority) Ofwat is the body responsible for economic regulation of the privatised water and sewerage industry in England and Wales. Key issues for Ofwat at the moment include the threats of water shortages, the problems of leaks and rising water bills. Ofcom - The Office of Communications is the UK's communications regulator Ofgem - The Office of Gas and Electricity Markets is the government regulator for the electricity and downstream natural gas markets in Great Britain. Its primary duty is to promote choice and value for all gas and electricity customers". Office of the Rail Regulator ORR is the UK government's agency for regulation of the country's railway network. The roles of an industry regulator the case of Ofgem Ofgem seeks to protect consumers by promoting effective competition, wherever appropriate, and regulating effectively the monopoly companies which run the gas pipes and the electricity wires Ofgem seeks to help secure Britains energy supplies by promoting competitive gas and electricity markets - and regulating so that there is adequate investment in the networks A further role of Ofgem is to help and encourage the gas and electricity markets and industry achieve environmental improvements as efficiently as possible take account of the needs of vulnerable customers, particularly older people, those with disabilities and on low incomes Ofgem is funded by the energy companies who are licensed to run the gas and electricity infrastructure. Adapted from the Ofgem web site Price Capping for the Utilities Price capping has been a dominant feature of regulation in recent years although this is now being phased out as most utility markets become more competitive. Inn reality, setting a price cap, the industry regulator usually has in mind a satisfactory rate of return on capital employed for each

business. Basics of price capping Price-cap regulation is a form of intervention in the price mechanism which has been applied at various points in time to all of the privatised utility businesses in the UK. Price-capping is an alternative to rate-of-return regulation, in which utility businesses are allowed to achieve a given rate of return (or rate of profit) on capital. In the UK, price capping has been known as "RPI-X". This takes the rate of inflation, measured by the Consumer Price Index and subtracts expected efficiency savings X. In the water industry, the formula is "RPI - X + K", where K is based on capital investment requirements designed to improve water quality and meet EU water quality standards. This has meant increases in the real cost of water bills for millions of households in the UK. In practice, the distinction between price-cap and rate-of-return regulation may be lost, as regulators may end up making implicit decisions on the acceptable real rates of return on capital employed in order to arrive at price limit determinations. Source: Adapted from the Wikipedia web site Price capping has meant in most cases that average prices for consumers have fallen in real terms although this has not been the case for all privatised industries. The assumption is that productivity growth will help to accommodate the price caps. Profits for utilities can rise providing that efficiency levels improve (i.e. firms are able to bring down their unit labour costs) Arguments for and against price-capping for the utilities Advantages Capping is an appropriate way to curtail the monopoly power of natural monopolies. Cuts in the real price levels are good for household and industrial consumers (leading to an increase in consumer surplus and higher real living standards in the long run). Price capping helps to stimulate improvements in productive efficiency because lower costs are needed to increase a producers total profits. o The price capping system is a useful tool for controlling consumer price inflation in the UK. Disadvantages Price caps have led to large numbers of job losses in the utility industries. Setting different price capping regimes for each industry distorts the working of the price mechanism. Yell and price capping Price capping is still used in the market for telephone directories where Yell has a dominant position in the market. In June 2006 it was announced that Yell would still be subject to a price capping formula because of the relative absence of competition in the industry. According to the Competition Commission report, "Yell continues to hold a powerful position in this market and competition is not working effectively. Prices are capped at the moment and without this price cap, advertisers would pay more than in a well-functioning market. At present, Yell is subject to a yearly price cap of RPI less 6% - so at the moment, the real cost of advertising rates are falling year-on-year. PostComm approves a rise in the price of stamps Stamp prices rose in April 2006 under a compromise deal between regulator Postcomm and the Royal Mail. First class stamps would rose 2p to 32p and second class stamps by 1p to 22p, with the possibility of them rising to 36p and 25p respectively by 2010. The Royal Mail had wanted to push stamps up to 39p and 27p to help pay for capital investment and to plug a 4bn hole in its pension fund. Adapted from the BBC news website, November 2005 The rail industry was privatized between 1994 and 1997 and since then the average price of a rail fare has risen faster than inflation. Fare changes are announced by the Association of Train Operating Companies. Despite continuing high levels of government subsidy, the train operating businesses have increased those fares that are unregulated by more than inflation, partly because they have to high fees to Network Rail for access to the track and infrastructure and because they have been making a contribution towards improvements to rail safety.

Changing Role of the Utility Regulators Gradually the main utility regulators have withdrawn from price regulation because of the increased degree of competition in the market. The main focus of the regulatory authorities is now to provide improved price information for consumers to make prices of different suppliers more transparent to improve the flow of information in the market. The authorities also want to encourage free transfer for consumers between suppliers (by monitoring and enforcing the nature of supply contracts) and keeping a close eye on anticompetitive behaviour. In telecommunications, one key decision made eventually by Ofcom was to enforce unbundling of the local loop. Local loop unbundling is the process of allowing telecommunications operators to use the telephone connections from the telephone exchange's central office or exchange to the customer premises be it a household or a business location. In the UK this has meant opening up the telephone exchanges owned by British Telecom and allowing broadband businesses such as AOLUK and Tiscali to put in their own equipment and then supply broadband services in direct competition with BT to households. The vast majority of households are within one mile of their local telephone exchange. Although local look unbundling has taken time to become widespread, it has been one factor behind the rapid expansion of market supply in broadband which is revolutionising the UK telecommunications market. Unbundling the local loop allows rivals to take market share British Telecom has announced that it has lost half a million residential phone lines to competitors as broadband operators such as Talk Talk, from Carphone Warehouse, and Orange have increased their investment in local loop unbundling (LLU). LLU allows rival firms to place equipment in BT's exchanges and transfer customers to their networks. When 1.5m lines are unbundled, BT's wholesale unit can cut the price of wholesale broadband and its retail business will be better able to compete for customers. Source: Adapted from the Guardian web site, July 2006

One of the consequences of the greater level of competition in the telecommunications industry in the UK is that in July 2006, Ofcom withdrew all price capping controls on British Telecom. After 22 years of having its prices controlled directly by an industry regulator, this marked an important milestone in the privatisation and market liberalisation process. Summary comments on privatisation Privatisation has changed the face of the British economy over the last twenty five years. Over twenty businesses have been transferred from the public sector to the private sector and many remaining state sector enterprises are now subject to the disciplines of the market. The transfer of ownership from one part of the economy to another has been, in many cases, rather a superficial change. The more fundamental changes have occurred when monopoly powers have been broken down either because of regulators legislating to open up the market, or because of the effects of wider international changes such as the process of globalisation. The performance of the privatised companies has been patchy. Most of them have seen their monopoly powers eroded as their markets have become more contestable. Some privatisations have not worked, the most obvious example being the failure of rail privatization and the eventual collapse of Railtrack when it went into administration. There remain controversial issues about the size of the profits that some of the privatised utilities are making, the water industry is a good example of this. In most utility markets there is now genuinely more choice for consumers. And real price levels have come down over the longer term

Cost Benefit Analysis In a world of finite public and private resources, we need a standard for evaluating trade-offs, setting priorities, and finally making choices about how to allocate scarce resources among competing uses. Cost benefit analysis provides a way of doing this. What is cost benefit analysis? Cost benefit analysis (COBA) is a technique for assessing the monetary social costs and benefits of a capital investment project over a given time period. The principles of cost-benefit analysis (CBA) are simple: 1. Appraisal of a project: It is an economic technique for project appraisal, widely used in business as well as government spending projects (for example should a business invest in a new information system) 2. Incorporates externalities into the equation: It can, if required, include wider social/environmental impacts as well as private economic costs and benefits so that externalities are incorporated into the decision process. In this way, COBA can be used to estimate the social welfare effects of an investment 3. Time matters! COBA can take account of the economics of time known as discounting. This is important when looking at environmental impacts of a project in the years ahead Uses of COBA COBA has traditionally been applied to big public sector projects such as new motorways, bypasses, dams, tunnels, bridges, flood relief schemes and new power stations. Our example later considers some of the social costs and benefits of the new Terminal 5 for Heathrow airport. The basic principles of COBA can be applied to many other projects or programmes. For example, public health programmes (e.g. the mass immunization of children using new drugs), an investment in a new rail safety systems, or opening a new railway line. Another example might be to use COBA in assessing the costs and benefits of introducing congestion charges for motorists in London. Or the costs and benefits of the New Deal programme designed to reduce long-term unemployment. Cost benefit analysis was also used during the recent inquiry into genetically modified foods. Increasingly the principles of cost benefit analysis are being used to evaluate the returns from investment in environmental projects such as wind farms and the development of other sources of renewable energy, an area where the UK continues to lag behind.

Because financial resources are scarce, COBA allows different projects to be ranked according to those that provide the highest expected net gains in social welfare - this is particularly important given the limitations of government spending. The Main Stages in the Cost Benefit Analysis Approach At the heart of any investment appraisal decision is this basic question does a planned project lead to a net increase in social welfare? o Stage 1(a) Calculation of social costs & social benefits. This would include calculation of: o Tangible Benefits and Costs (i.e. direct costs and benefits) o Intangible Benefits and Costs (i.e. indirect costs and benefits externalities) o This process is very important it involves trying to identify all of the significant costs & benefits o Stage 1(b) - Sensitivity analysis of events occurring this relates to an important question - If you estimate that a possible benefit (or cost) is x million, how likely is that outcome? If you are reasonably sure that a benefit or cost will occur what is the scale of uncertainty about the actual values of the costs and benefits? o Stage 2: - Discounting the future value of benefits - costs and benefits accrue over time. Individuals normally prefer to enjoy the benefits now rather than later so the value of future benefits has to be discounted o Stage 3: - Comparing the costs and benefits to determine the net social rate of return o Stage 4: - Comparing net rate of return from different projects the government may have limited funds at its disposal and therefore faces a choice about which projects should be given the go-ahead Evaluation: Criticisms of COBA There are several objections to the use of CBA for environmental impact assessment: 1. Problems in attaching valuations to costs and benefits: Some costs are easy to value such as the running costs (e.g. staff costs) + capital costs (new equipment). Other costs are more difficult not least when a project has a significant impact on the environment. The value attached to the destruction of a habitat is to some priceless and to others worthless. Costs are also subject to change over time I.e. the construction costs of a new bridge over a river or the introduction of electronic road pricing 2. The CBA may not cover everyone affected (i.e. all third parties) inevitably with major construction projects such as a new airport or a new road, there are a huge number of potential stakeholders who stand to be affected (positively or negatively) by the decision. COBA cannot hope to include all stakeholders there is a risk that some groups might be left out of the decision process a. Future generations are they included in the analysis? b. What of non-human stakeholders? 1. Distributional consequences: Costs and benefits mean different things to different income groups - benefits to the poor are usually worth more (or are they?). Those receiving benefits and those burdened with the costs of a project may not be the same. Are the losers to be compensated? To many economists, the equity issue is as important as the efficiency argument. 2. Social welfare is not the same as individual welfare - What we want individually may not be what we want collectively. Do we attach a different value to those who feel passionately about something (for example the building of new housing on greenfield sites) contrasted with those who are more ambivalent? 3. Valuing the environment: How are we to place a value on public goods such as the environment where there is no market established for the valuation of property rights over environmental resources? How does one value nuisance and aesthetic values? 4. Valuing human life: Some measurements of benefits require the valuation of human life many people are intrinsically opposed to any attempt to do this. This objection can be partly overcome if we focus instead on the probability of a project reducing the risk of

death and there are insurance markets in existence which tell us something about how much people value their health and life when they take out insurance policies. 5. Attitudes to risk e.g. a cost benefit analysis of the effects of genetically modified foods a. Precautionary Principle: Assume toxicity until proven safe 1.1. If in doubt, then regulate b. Free Market Principle: Assume it is safe until a hazard is identified 1.1. If in doubt, do not regulate. Despite these problems, most economists argue that CBA is better than other ways of including the environment in project appraisal. Discounting the future Would you rather have 1000 of income today or 1000 of income in the future (say in 3 years?). The answer is probably now, because 1000 in three years time is unlikely to buy as many goods and services as it does now (because of inflation). And also because 1000 put into a savings account today will yield interest. Discounting is a widely used technique as part of cost benefit analysis. The technique of discounting reflects the following: The value of a cost or benefit now > the value of a cost or benefit in future years Discounting reflects this by reducing all future costs and benefits to express them as todays values. The key question is: How do you choose an interest rate for reducing future costs to give them a present value today? Setting a general discount rate for new projects has important implications for the environment: 1. A low discount rate is often favoured by economists since they argue that investing a high proportion of current income is a good way of providing for the future 2. A high discount rate may also be favoured since it discourages investment (and by implication environmental damage) in the present Most projects have lifetimes of 20-30 years with many of the big costs arising early in a project e.g. from construction whereas the stream of benefits from a project occur over a much longer period of time. But for many huge construction projects, some of the costs only become apparent in the long run. Consider the building of a new nuclear power station. Environmentalists would argue that there is a long list of costs from waste management and decommissioning which stretch over 100 years into the future whereas no social benefits exist to offset these costs beyond year 30 or 40 (where the nuclear power station might reasonably be expected to be ready for closure). The value of decommissioning costs over 100 years away is almost negligible no matter what discount rate we use. This makes discounting difficult to justify Revealed Preference Valuing the Benefits from a Project According to some economists, the valuation of benefits and costs used in COBA should reflect the preferences revealed by choices which have actually been made by individuals and businesses in different markets. Consider this example: 20 employees are given the chance of using a new car park close to work for 5 per day or parking further away from work for free but involving an extra 10 minutes walk. Their decisions reveal how much they value time. If they all choose to spend the 5 per day on car parking, this reveals that time is more important to them than 50p per minute. If only half take up the car parking option, this reveals that average value of time to them was 50p per minute. Hard choices made in markets are the best guide to private benefit. Information contained in the demand curve tells us much about how much people are willing and able to pay for something. This is important in revealed preference theory. When consumers make purchases at market prices they reveal that the things they buy are at least as beneficial to them as the money they relinquish. Cost benefit analysis in practice Heathrow Terminal 5 The debate over whether there should be a fifth terminal at Heathrow airport has fierce and longlasting! The official planning enquiry reported after 5 years and having cost many millions of

pounds. The rival arguments at the inquiry highlighted many examples of environmental impact (externalities) - noise, air quality, rivers etc. - but concluded that these were not enough to refuse planning permission and that the new terminal project should go ahead. The case for terminal 5 1. Economic growth: Demand for air travel in south-east England is forecast to double in the next 20 years, making expansion vital many thousands of jobs and businesses depend on Heathrow airport expanding to provide sufficient supply capacity to meet this growing demand. An increase in the capacity of Heathrow will make best use of airport's existing infrastructure and land (nearly 3,000 acres). 2. The economy and trade: The UK will lose airlines and foreign investment to European rivals if it does not meet demand. The benefits of a world-beating industry would be diminished many sectors of our aviation industry have a comparative advantage and add huge sums to our balance of payments 3. Jobs: The terminal 5 project will create or safeguard an estimated 16,500 jobs, as well as creating 6,000 construction jobs during the building phase this will have multiplier effects on the local / regional and national economy 4. Transport: The terminal will be the centre of a world-class transport interchange, with new Tube and rail links. Car traffic would rise only slightly the social costs of increased traffic congestion have been exaggerated by the environmentalists 5. Environment: The site earmarked for terminal 5 is currently a disused sludge works, and any displaced wildlife and plant life will be carefully relocated. The noise climate around Heathrow Airport has been improving for many years, even though the number of aircraft movements has increased considerably partly due to the phasing out of older, nosier aircraft 6. Noise and night flights: BAA promises no increase in overall noise levels or in night flying. The number of flights would rise only 8% Objections to Terminal 5 1. Growth: BAA forecasts are misleading and will lead to uncontrolled expansion, rather than targeting better solutions such as using existing space at other airports. 2. The economy: Heathrow already has the biggest capacity in Europe, and ambitions to extend its lead are merely "commercial prestige" rather than having long term macroeconomic benefits 3. Jobs: Only 6,000 jobs will be created - a tiny fraction of all the new jobs in the South East. Local studies say jobs will increase anyway even without a fifth terminal 4. Transport: There will be a significant increase in road-widening and car parks to cater for the tens of thousands of extra car journeys to the airport every year 5. Environment: Air pollution will increase significantly, and hundreds of acres of wildlife and Green Belt land will be lost forever. Plus the environmental costs of increased traffic congestion 6. Noise and night flights: More flights will mean more noise under the flight paths, and the pressure for controversial night flights and a third runway will increase the regulators will be captured by the airlines and airport authorities and will eventually be pressurized into giving way on allowing more night time flights These are just a few of the arguments raised for and against the Terminal 5 project. For more news on the project consult www.baa.com/main/airports/heathrow/terminal_5_frame.html Case study - A national smoking ban According to a cost benefit analysis performed for the Chief Medical officer's Annual Review of Public Health published in July 2004, a ban on smoking in public places would benefit the economy by between 2.3bn and 2.7bn a year. The COBA argued that a ban on smoking in pubs, restaurants and cafes would not reduce profits in the leisure, catering and hospitality industry. However critics of the new study responded by saying that the assumptions behind the economic model, remained unpublished.

Annual Benefits Health benefits (reduced absenteeism) Health benefits (reduced costs of healthcare) Health benefits (averted deaths from second-hand smoke amongst employees) Health benefits (reduced uptake, particularly new young employees) Health benefits (smoking cessation) Safety benefits (damage, deaths, injuries) Safety benefits (cost to fire services) Safety benefits (administration costs) Cost savings to NHS from smoking cessation Cleaning costs and damage to equipment avoided Production gains Total Annual Costs Production losses (smoking breaks) Losses to continuing smokers (loss of satisfaction) Losses to quitters (loss of satisfaction) Losses to the Treasury Total

million 70 140 4 21 550 1600 57 0.2 6.3 Not estimated 100 340 680 2700 - 3100 million 430 155 550 1145

To recap, cost benefit analysis is basically an appraisal technique that tries to place monetary values on all benefits arising from a project and then compares the total value with the project's total cost. It has numerous potential applications although there are inherent difficulties with the issue of valuation. Essentially the process of COBA is a comparative one, so that we can perhaps make judgements about which projects from a limited choice should be given the go ahead.