Efficiency is a mirage

In my previous articles I’ve been critical of the domination of markets by very large companies. Your response might well be, “so what? The fact is these big companies are more efficient and that’s good for us as consumers isn’t it?” Possibly, but not for us as taxpayers.

As ever, language matters, so let’s start with what we mean when we say ‘efficiency’. Just as supermarkets have ‘value’ ranges because it sounds better than calling them ‘cheap’, so when economists talk about ‘greater efficiency’ usually what they really mean is ‘lower cost’. And that’s important, because if you’re a small company it doesn’t matter how efficient you are, there are reasons why you won’t be able to compete with major corporations on price.

Some of those reasons are linked to why mergers and acquisitions take place; things like creating economies of scale by producing more widgets at a lower price per widget. Others don’t quite make it into the economics textbooks — or at least at nowhere near the level of detail required — such as base erosion and profit-shifting. This is the practice of moving profits around multinational companies to exploit lower tax jurisdictions. The OECD reckons this costs taxpayers $240bn globally per year and it is only one of the tax ‘efficiency’ measures open to these companies.

When I was in my mid-20’s I went to stay with an old school friend while away with work. I was impressed by the flat he’d bought himself at a time when I was still renting (and when it was possible to be in your mid-20’s and actually aspire to own property — yes that’s how old I am!). What did he do, I wondered. Over a curry he told me all about it. He worked for a major multinational and his entire job was to massage chunks of money around inside the guts of the company to ensure it paid the lowest possible tax when it plopped out the other end. He spent his weekends in the UK and commuted to Moscow each week as part of this role. He was young, making great money, living an exciting lifestyle and he enjoyed it. Don’t judge him too harshly; he’s a nice guy and most of us make compromises in our working life. I would instead suggest you direct the energy from your righteous anger towards reading ‘Treasure Islands: Tax Havens and the Men Who Stole the World’ by Nicholas Shaxson.

Anyway, there’s another aspect to efficiency that I want to explore and it’s this; what is the price of achieving it? Other than $240bn per year of course. Efficient systems are focused on the here and now, but what if the situation changes? What if, oh I don’t know, a global pandemic killing hundreds of thousands of people suddenly occurs? Or a major terrorist attack? High impact, low probability events like these can have dramatic consequences for systems that are not resilient.

Let’s think about supermarkets. Why? Well, here’s what the UK Competition and Markets Authority says:

“UK groceries retailing is an important industry which was estimated to be worth around £190 billion in 2018. It is an industry that touches every household in the country. Food and non-alcoholic drinks represents around 11% of typical household expenditure, increasing to over 14% for those on lower incomes. It has been estimated that groceries account for just over half of all retail sales in the UK.”

In the UK, as of July 2020, the big four (Tesco, Sainsbury’s, Asda and Morrisons) supplied two thirds of the entire grocery market; Tesco alone supplies over ¼. What would happen if one of those companies went bust? Unlikely? Of course. But not impossible.

In 2004, Sainsbury’s was forced to write off £¼billion in investment in complex supply chain IT systems. The disastrous performance led to a pre-tax loss of £39million in the first half of 2004, which was the worst the company had recorded in its 139 year history. Sainsbury’s turned things around but it’s not the only supermarket to have had a close shave with disaster. In 2014, Tesco announced that it had over-inflated its profits by £¼billion, which led to £2billion being wiped off its share value. Again, the company recovered, but think through the scenario in which one of the four major supermarkets suddenly announces that it cannot afford to pay its suppliers.

If consumers are told that a reasonably large percentage of the UK’s grocery outlets are now shut then they will simply decide to use a different chain. But their next thought will be, ‘hang on, everyone else is thinking the same thing and there won’t be enough to go round.’ The result will be panic buying. A huge number of the affected supermarket’s suppliers would suffer cashflow problems because they would not be paid for products they had already delivered. There would be competition concerns over one of its rivals buying the ailing chain whole, but in any case there would be too little time to organise that before the real world impacts set in. The Government would in all likelihood have to step in as a lender of last resort.

These companies are too big to fail. The low prices they achieve through the efficiency they have gained by buying up their competitors is illusory because it comes at the cost of lower resilience of the system as a whole. That is a real cost, albeit one that we will only discover if, or when, something goes catastrophically wrong.

But even if the cost is high, perhaps the likelihood that the system will come close to collapse is so small that the risk is minimal. If that sentence doesn’t make sense, think of it this way: risk = hazard multiplied by likelihood. The hazard might be, for example, a banking crisis that cost the UK Government £137bn (with ‘only’ £27bn of that still outstanding) and caused untold hardship as a result of the economic policies that followed it. But it was a “once in a lifetime crisis” according to the Deputy Governor of the Bank of England. The average lifetime of a person in the UK today is about 81 years. It’s really quite a long time and I’m only halfway through. Here’s a list of the events that the UK Office for National Statistics says have had a significant negative impact on UK GDP in my lifetime.

· 1979–81: high inflation, unemployment and Government debt caused partly by the 1970’s oil crises.

· 1984: The Miners’ Strike

· 1991: Recession linked to high interest rates, falling house prices and an overvalued exchange rate.

· 2001: 9/11 but mainly the Foot and Mouth Crisis

· 2008: The Global Financial Crisis

· 2020: The Covid pandemic

That’s six events in 40 years, or a likelihood of the shit hitting the fan once every seven years, if you’ll forgive me being so prosaic. And these are just the events that had a large enough impact for it to be seen across the entire UK economy. Many others deeply affected particular sectors: aviation for the Icelandic volcano eruption for example and agriculture for the wettest April to June on record in 2012.

So we are making a trade-off. Efficiency refers to low prices for consumers now, in exchange for some unknown cost in the future.

You might think this is crazy, leftfield economics, but actually it’s just the logical extension of the most fundamental neo-classical economic principles. Perfectly competitive markets are preferable because they give the greatest efficiency even though they are unachievable in reality. Monopolies are inefficient. But how close to a monopoly do you have to be before inefficiency creeps in? A market dominated by two companies? Three? Four? In the UK, the Competition and Markets Authority (the CMA) decides. But for all the impressive level of analysis that the CMA brings to bear on these matters, it doesn’t consider the implications of its decisions for system resilience, nor does it consider the impacts on suppliers.

As I pointed out in my last article, there’s also plenty of evidence of collusion in markets dominated by well-known large companies and yet there they remain; the fines resulting from being caught illegally inflating prices simply absorbed as a cost of doing business and passed on to us, the consumers.

So, is the domination of markets by a handful of huge companies really efficient?

References

CMA (2019) Anticipated merger between J Sainsbury PLC and Asda Group Ltd Final report. Downloaded from https://assets.publishing.service.gov.uk/media/5cc1ec1340f0b64031cfa6f0/Final_reportSA.pdf

Financial Times (2019) Former Tesco executive acquitted over £250m accounting scandal. Downloaded from https://www.ft.com/content/e470725e-1ef8-11e9-b126-46fc3ad87c65 (paywall).

Fullfact (2019) £1 trillion was not spent on bailing out banks during the financial crisis. Downloaded from https://fullfact.org/economy/1-trillion-not-spent-bailing-out-banks/

Kantar (2020) Great Britain: Grocery Market Share (12 weeks ending). Downloaded from https://www.kantarworldpanel.com/grocery-market-share/great-britain

OECD (2020) International collaboration to end tax avoidance. Downloaded from https://www.oecd.org/tax/beps/

Reuters (2008) Financial crisis may be worst in history — BoE’s Bean. Downloaded from https://www.reuters.com/article/britain-bank-bean/financial-crisis-may-be-worst-in-history-boes-bean-idUSLAC00300720081024

The WritePass Journal (2017) Analysis of the Warehouse Automation Failure at Sainsbury’s. Downloaded from https://writepass.com/journal/2017/02/analysis-of-the-warehouse-automation-failure-at-sainsburys/