Business Economics

Economists have a concept called perfect competition but as a business owner it won’t sound perfect to you.

What is Perfect Competition?

Perfect competition is a world where markets are in equilibrium and none of the firms who are competing make a profit, they just cover their cost of capital.

This is the enemy to an entrepreneur where the goal is to reap super profits from innovating and taking risks.

The Attributes of Perfect Competition

Perfect competition is a world where there are many competitors. New competitors are free to move into the industry if companies start to make profit and to move out quickly if returns fall below the cost of capital.

Perfect competition is a world where there is no product differentiation. Everyone knows how to make the same product or service to the same standard and in the same time periods.

In perfect competition there are many buyers of similar sizes and they all have perfect information of their buying options. Information is free and there aren’t any transactions costs which make it easier or cheaper to deal with one supplier than another.

Opportunities For Profit Exist When Perfect The Competition Assumptions Don’t Apply

This is the important point – it is when these assumptions are broken that create the opportunity for sustained profit or loss within an industry:

• When there are few buyers
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• When there are few suppliers
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• When products and services are different from one firm to another
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• When new competitors find it difficult to enter an industry
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• When existing competitors find it difficult to leave
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• When information isn’t freely available to customers about the best prices and deals
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• When information isn’t available to competitors about the best methods to market, sell and supply their products
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• When there are transactions costs which create a connection between particular buyers and sellers and a disincentive to trade with others.

Strategy professor Michael Porter took the insights from industrial economics to create possibly the most famous strategic planning model, the Five Competitive Forces.

Markets Continue To Move & Transform

When those factors change in your favour, then the market offers profitable opportunities.

But the factors can move against you.

Big customers are strong negotiators and demand low prices combined with expensive service arrangements when they see a range of suppliers offering a product that they consider to be a commodity. And to put you under pressure, they’ll tell you that it’s a commodity.

They can force you close to your marginal costs and even though you’re busy, you could be losing money.

Even worse, there may be exit barriers which make it difficult for the loss making business to get out quickly. Being able to exit is a key feature that keeps the perfect competition model in equilibrium and doesn’t create situations where supply is greater than demand.

But in industries where there are exit barriers – physical, contractual or emotional – loss making businesses linger and even worse, in their desperation to improve their situation, they mess it up for everyone else.

This is why differentiation is so important.

Differentiation Creates Your Own Little Market

As soon as your product or service is different, it stops being a commodity in the general market and instead has its own little special market where you’re able to control supply. You create your own little monopoly situation – what economists call monopolistic competition.

There are close substitutes so you don’t have absolute pricing power but you can charge more than cost and therefore make a profit.

And that profit rewards entrepreneurs for taking risk, innovating and finding ways to give customers extra value.

If you learn economics, one of the first things you’ll be taught is the law of supply and demand.

It’s like a great big X on a graph of prices and volumes.

The demand curve slopes downwards with the basic rule that as price decreases, then demand increases. Or vice -versa – as prices increases, demand decreases.

Why is that?

Because we only buy things that we believe will give us value equal to or preferably more than the price.

At a high price, few people believe they will get value.

But as the price reduce, more people see the opportunity to gain and earn a “consumer surplus”. This is the difference between the value they receive and the price they pay.

Demand then is a function of price and perceived value.

The supply curve slopes upwards. As market price increases, then more firms are willing to step in and supply the market.

This is because no business will knowingly supply below cost. There are a few provisos here for loss-leader strategies where the business intends to profit from other items bought at the same time or later in the relationship.

Just think about it.

If you could buy apples for 20 pence each and someone comes to you and says…

“I’ll buy every apply you can get for 50p each”

then you’re going to be eager to take them up on it. You stand to make 30p profit on each apple you sell.

But if they say…

“I’ll buy every apple you can get for 18p each”

then you’re not interested.

Each apple you sell will cause you to lose 2p. And the more apples you sell, the more money you lose.

However if you could find a way to buy apples for 10p, then you’re interested in the deal.

Supply is a function of market price and cost.

As the price increases. more firms have the ability to supply at a profit and are willing to do so.

Market prices are set where the demand curve and the supply curve meet – the middle of the X.

This may be a simple lesson on the basics of supply and demand but in a world then seems to get increasingly complicated, it’s good to get back down to basics occasionally.

Supply and demand reminds you that value, market prices and costs are critical factors in your business.

The more value you create compared to the price, the better your chances are to win business.

The lower your costs are, the more you are able to supply at a profit.

It’s no wonder that value (in terms of differentiation) and low costs are the two generic competitive advantages identified by Professor Michael Porter.

It’s now time for the difficult questions.

If value, price and costs are so important, then

• How well do you understand your value (which is a key factor in demand)?
• How do you set prices? Guess? Copy competitors?
• How well do you understand and control your costs? In particular, how do you know that you should be supplying that product which you’ve just cut the costs on to clinch that big deal? Are you sure that you’re not selling 20p apples for 18p each?

I’ll be going into these ideas much deeper in the strategy articles but sometimes it is useful to go back to basics and remind yourself of what’s important and why.

It’s so easy to get caught up in implementing the latest fashionable tactics (social media still looks to me like the hot topic) but if you don’t have your strategy right, then you’re in trouble.

In the UK the Chancellor made his Autumn Statement yesterday updating Parliament and the electorate on the economic woes.

Things don’t look good and it’s hard to see how the UK can keep its AAA credit rating that keeps government interest rates down.

The basic message is that government spending is high while tax receipts are low. This means the annual public spending deficit will stay with us for many years to come

All the time the accumulated national debt is increasing and will create a huge burden when interest rates are forced up in the international money markets.

The unfriendly squeeze on lower government spending and higher tax rates is going to keep any feel good factor away for years.

The current coalition government between the Conservatives and Liberal Democrats and the next Labour government will be forced to do the opposite to what they want to do.

Perhaps I’m being unduly pessimistic but there seems to be an automatic assumption that the economy will return to the average growth rates of the past — about 2.5 % per annum.

The Underlying Causes Of Economic Growth

Economic growth is usually defined as the annual percentage change in gross domestic product (GDP) after adjusting for the increase in monetary values caused by inflation.

This is an assessment of how much the country has produced of value in a year.

It’s quite a hard concept to think about beyond the abstract level.

Does a nurse looking after sick patients add to GDP? Yes she gets paid although the NHS is funded by the taxpayers. But what about a relative who acts as an unpaid carer for an ageing parent?

Fundamentally there are only two ways to increase GDP

1. To have more people in the country contributing to the economy.
2. For those who are working to increase productivity.

Demographic information tells us that as the baby-boomer generation retires and life expectancies increase, there will be an increasing proportion of people who are retired. While they will create demand for goods and services, they won’t directly contribute to GDP.

In fact this generation bulge will increase the pressure on state spending on health, pensions and long term care.

Productivity of those who are working needs to increase quickly for the economy to stand still.

But there’s a fairness issue. If you work harder you want to share in the increased wealth. That’s only natural.

This increases the need for even more productivity gains.

And that means change.

But change is usually resisted. It’s scary.
It’s hard in the private sector but the balance of power between the business owners and the employees usually means that it happens. Perhaps not as much or as quickly as the business owners want but it happens.

It’s even more difficult in the public sector where union power is high and moral pressure for good causes is intense.

In 2012 the public sector represents about 38% of the economy by tax take and 45% by spending if I’ve understood the statistics correctly.

To close the annual deficit those numbers need to come together. To pay back some national debt tax needs to be higher than spending.

Can the public sector increase productivity fast enough to create economic growth? Can the private sector grow even faster to compensate?

I’m not convinced they can.

I struggle to see how we can live up to past rates of economic growth.

The Misery Index is a term which is gaining popularity in the press as economic problems and social unrest increase in 2011.

What is The Misery Index?

The misery index is a composite measure made up of two important measures of economic activity:

• The unemployment rate
• The inflation rate

The misery index was created by economist Arthur Okun in the 1970s. Harvard economist Robert Barro created the Barro Misery Index also in the 1970s which also included GDP and the bank rate.

When I first studied economics in the mid-seventies, it was thought that there was a trade-off between unemployment and inflation. As one increased, the other was supposed to reduce according to the Phillips curve suggesting a fairly constant misery index.

While it was a nice theory connected to supply and demand

• if demand exceeded supply, then prices would increase but unemployment should reduce as the incentives to increase supply improved; and
• if supply exceeded demand, then prices would fall but unemployment would increase as actions were taken to reduce supply

a look at the economic data showed that the link wasn’t strong and the misery index raises and falls.

The Misery Index Across The World

MoneyWeek magazine (28 October) reported the misery index across the world’s leading nations.

The Countries With the Lowest Misery Index

• Switzerland 3.50
• Japan 4.80
• Norway 4.90
• Mexico 8.37
• Australia 8.80

The Countries With The Highest Misery Index

• South Africa 28.90
• Spain 23.99
• Greece 19.23
• India 18.39
• Argentina 17.20

The UK has a rating of 13.30 and the United States 13.00.

The Impact Of The Misery Index On Business

The misery index affects confidence. As it increases, consumers and businesses as investors become less confident about the future, increasing the likelihood of delaying spending decisions and increasing saving. As people become less confident of the general economy, the natural inclination is to put about some rainy day money although doing it may become harder because incomes are squeezed.

Different parts of the economy are affected in different ways by increases in the misery index.

As the unemployment element increases, people who are unemployed find it more difficult to get a job and those in employment fear that they may lose their jobs. This aspect of the misery index won’t affect those who are already retired.

As inflation increases, consumers incomes will buy fewer goods and services unless their incomes rise in line or faster than inflation. If unemployment is high, bargaining power of employees to protect their standard of living is weak meaning those in work are likely to have their incomes squeezed and be forced to either cut back on consumption or to increase their personal debt to maintain lifestyles. Increasing debt when unemployment risks are high is risky.

Those retired may be protected against inflation if their pension plans are linked to an inflation index although there will be discrepancies between the index and pensioners’ own purchases. Many pensioners may have a fixed income without any link to inflation and even worse, those without annuities who rely on investment income are squeezed by the record low interest rates.

The misery index creates a feeling of helplessness. Consumers want and need more income to keep up with inflation but unemployment keeps the wage pressures suppressed and there are few opportunities to supplement income with overtime and secondary part-time jobs. Individuals who can afford to save are likely to build up a “worst case” reserve but while this makes sense for the individual consumer, it further weakens confidence in the economy as the reduced consumption causes businesses to cutback further on employment.

The Misery Index and Business Strategy

Both unemployment and inflation should be considered in the PEST Analysis. I believe the misery index is worth adding in as an extra measure to monitor since the statistic related to confidence.

Wikipedia has an interesting analysis of the misery index across the presidents in the USA. It shows how troubled the seventies were with Nixon, Ford and Carter. To some extent, there is a time lag between the actions which cause inflation and unemployment and it showing through in measurements. For example, unemployment is a lagging indicator of recessions.

As part of helping you to apply PEST Analysis for scenario planning I want to examine the impact of tax on business.

First a disclaimer. Although I’m a chartered accountant I know next to nothing about tax and this article in written from a UK perspective although I expect its lessons for strategy purposes will apply in many parts of the world.

Austerity Cuts & The Tax Debate

The impact of tax on business is an important issue at the moment because of the Austerity Cuts to reduce Annual Deficits.

One alternative to difficult spending cuts is to increase taxation since the annual deficit is the difference between tax revenues received and the public expenditure made.

The Main Taxes That Impact On Business

• Income taxes
• National insurance / employment taxes
• Corporation tax
• Capital gains tax
• Capital transfer tax / inheritance tax
• Value added tax / sales tax
• Excise duties on petrol, alcohol, cigarettes
• Import duties
• Property taxes and business rates
• Specialist taxes e.g. tax on North Sea oil exploration and the Bankers’ levy

The Controversy Of High Tax Rates

There are only three options for assessing tax:

1. The poor should pay most of the tax because they benefit most from the government spending
2. Everyone should pay a flat rate of tax e.g. 25% of income so the high earners pay more in cash terms but the same proportion
3. Tax should be levied on the ability to pay so the high earners and wealthy should pay more tax proportionately than the poor.

That last option is usually the one adopted because of the apparent fairness that tax should be linked to the ability to pay.

But there are two problems which leads to a third problem.

First, the wealthy benefit little from state spending so they’re paying for something that they wouldn’t do in a rational, free world. You don’t eat dinner in a restaurant, get the bill for £85 and say to the waiter, because I earn ten times the average income I’d like you to charge me £850 (or more if you follow the increased proportion logic).

Second, high tax rates have been proven to provide a disincentive to earn more and create wealth. That’s not good for the individual but terrible for the country which desperately needs growth and for businesses to create more employment.

These factors together therefore encourage high earners to look for ways to legally avoid paying tax.

They can do that through:

1. Moving their homes and businesses overseas – or if they are not in the UK, avoid coming in the first place, therefore creating a potential shortfall of top talent.
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2. Paying accountants and tax lawyers to look for every loophole and using artificial tax avoidance schemes which reduce their effective tax rate (tax paid as a proportion of income).

This creates an effect where increasing the tax rates can reduce the tax collected by the government and reducing the tax rate can increase the tax collected by government.

Into the logic of the numbers you then need to consider the political issues (cutting taxes is good, increasing public expenditure is good, increasing tax on the high earners is seen as good because of the apparent fairness) with the emotional reactions of the general tax payers and the people who have to pay the extra tax.

I’ve read that about 90% of the 30 million taxpayers are net takers rather than net contributors. That is they get more back from state expenditure than they pay in tax. That makes the 3 million net contributors very important to the economy and you can see how there’s a risk of “killing the golden goose.” Push too hard and they can decide that it’s not worth playing and that means trouble for the rest of us.

The Tax Controversy In The UK

The UK currently has a 50% tax rate on incomes introduced as one of the final acts by the last Labour Government. The Institute of Fiscal Studies suggests that the highest tax rate that won’t reduce tax revenue is below 50% and HM Revenue & Customs are reporting on the impact of the 50% tax rate in 2012.

For comparison purposes the top rates of income tax are:

• • Canada 29%
  • India 30%
  • United States 35%
  • European Union average 37.5%
  • France 41%
  • Germany 45%
  • Japan 50%
  • Netherlands 52%
  • Sweden 56.6%

Tax freedom day in 2011 (when you’ve worked long enough to pay the tax) was May 30, after that everything is yours to keep.

The top 1% of earners pay 24% of all income tax.

In a new survey of global competitiveness the UK is ranked 94th out of 142 countries for the extent and effect of taxation. In 1997 it was fifth.

Tax & Red Tape

The tax rules are incredibly complicated as politicians have tinkered with them. The problem is that the more complicated it gets, the more it opens up opportunities for loopholes.

The big advantage of the flat rate tax is its simplicity and how it stops exceptions.

The Impact of Tax On Business

The Impact Of Income Tax Changes On Business

We need to look at income tax from the perspective of customers and the entrepreneurs, managers and employees.

We can include in this any national insurance or social security, pension or healthcare tax that is paid by the employees as a proportion of income

A reduction in income tax will put money into the pockets of employees and since most people spend what they earn, will increase consumer expenditure and create a surge in demand.

Consumers will buy more if they wanted more or will trade up in price/quality. They will switch from low priced substitutes to higher priced substitutes (e.g. move from home cooking to takeaways to meals out at restaurants).

Tax breaks for the less well-off are more likely to create demand throughout the rest of the economy than for the better offer who may decide to save more.

An increase in taxes has the opposite effect as it reduces discretionary expenditure. Basic products and services – food, energy, accommodation – will be less affected than the treats we buy.

Higher tax rates for the entrepreneurs are likely to change their behaviours in terms of the risks they are prepared to take and could force some to review where they decide to live.

Higher tax rates for well paid employees – e.g. top footballers – act as a demotivating factor to come to this country which can only be offset by increasing pay rates to compensate. The same can happen with professional managers although boards need confidence that the extra value created will cover the increased costs.

The Impact Of National Insurance On Business

Employers have to pay a proportion of the employee’s gross salary to the government as national insurance. While it sounds like political rhetoric, this is literally a tax on jobs.

Along with the red tape of employment law, the minimum wage and the difficulty of finding employees who can make a positive contribution, it helps to explain why so many one-man-band businesses don’t have any intention of employing anyone else.

The Impact Of Corporation Tax On Business

Businesses pay corporation tax on taxable business profits.

Owner-managers of businesses are able to look across the income tax, national insurance, corporation tax and other tax schemes to find the best profit extraction policies that maximise the cash they bank personally compared to the cost to the business.

Shareholders receive their dividends from profits after tax so higher tax rates reduce the likely returns on equity investment and may make it tougher for small, entrepreneurial businesses to raise finance.

The Impact Of Capital Gains Tax on Business

Businesses can pay capital gains if they sell a capital asset (rather than a trading asset like stock) for a profit but the main capital gains issues arise when the business itself is sold.

Various reliefs are given to entrepreneurs who have sacrificed their short term rewards by leaving profits in the business to finance future growth. Often an entrepreneur will see their business as their pension, an asset to be sold to finance their retirement.

Increasing capital gain tax rates and cutting back on the entrepreneurs’ reliefs may provide a disincentive to grow the business. Personally I think income tax and corporation tax rates have more impact on incentives because of their “cash now” impact.

Impact Of Capital Transfer Taxes On Business

Apart from a few stamp duties on the transfer of particular assets, the big issue here is inheritance tax on family businesses. I have no idea how this works at the moment. If you’re in this situation, go and talk to a tax expert.

Impact Of VAT / Sales Taxes On Business

In the UK, very small businesses have a choice of whether to register for VAT or not (HMR&C guidelines).

A VAT unregistered business doesn’t charge VAT on their sales. This can give them a profit or pricing advantage for sales  to consumers compared with bigger competitors but they can’t reclaim the VAT they pay on their purchases. Increases in VAT rates therefore increase their costs but increase their pricing advantage as well.

For businesses that do register for VAT, an increase in the rate becomes an administrative burden. If VAT rates change, then prices should change which creates short term difficulties with labelling. VAT is added to the price of what they sell but reclaimed on their purchases.

VAT changes affect the ability of the consumer to buy at the margin. Recent years have seen VAT in the UK reduce from 17.5% to 15%, return to 17.5% and then increase to 20% on most items excluding food and children’s clothes.

Those people on a fixed budget will be able to buy less of something which may be the item the business sells if it is considered a non-essential. For other customers a small increase (2.5% either way) will make little impact on deciding whether to buy an item or not although it may bring forward purchases to beat the increase.

Impact Of Excise Duties On Business

Tax is raised on purchases of items like petrol and diesel, cigarettes and alcohol through various duties. This may be because the government is trying to discourage consumption e.g. environmental issue for petrol, health issues for cigarettes.

Increases in excise duty make the items more expensive for consumers and will dampen demand although there is a “you’ll have to grin and bear it” factor too. I can’t say that my purchasing behaviour seems to be influenced much by the duty except where it forces prices to go past a psychological barrier.