Case study ‘Record Industry’

CD FIRMS CLEARED OF PRICE PLOT RIP-OFF

Record companies were controversially cleared of overcharging for compact discs yesterday.

They had been accused of keeping prices artificially high – CDs cost about 1 pound to make, almost exactly the same as cassettes. But they sell in Britain for between 12.99 and 15.99 pounds, much more than a cassette and almost double what is charged in the United States.

However, the Monopolies and Mergers Commission ruled that although there is a monopoly by five companies – EMI, PolyGram, Warner, Sony, and BMG – it does not operate against the public interest.

Instead, pricing policies are justified because of strong competition within the industry, according to the watchdog body. The major firms, accounting for about 70% of the UK market, ‘competed vigorously among themselves’ and also with the independent sector, it added.

Daily Mail 24.6.94

Tasks:

Investigate the record industry and produce a short report of your findings to explain:

• The motives of the organizations that supply records and CDs

• How, and why, changes in consumer wants have affected the use of the resources and production in the record industry

• The factors that may have caused consumer wants for records and CDs to change. Use appropriate diagrams to illustrate the changes in the market conditions you have discussed and their likely impact on market price and quantity traded.

• How record companies and record shops compete

• The degree of price and non-price competition in the record industry. Do your findings support the ruling made by the Monopolies and Mergers Commission that record companies have not acted against the public interest?

• The external costs and benefits of producing records and CDs. (Hint: consider the resources required to produce records and CDs. For example, oil is raw material for vinyl records and plastic; electricity can be produced by burning oil, gas or coal)

Compare your findings on competition and business behaviour in the recorded music market with another product market where there is evidence of a higher or lower degree of business competition. For example, the gas supply industry is a good example of a near-total monopoly, while the markets for agricultural produce and raw materials tend to be highly competitive.

1.3. The Effects of Government Policy on Markets

Key words: macro-economic policy, aggregate demand, economic recession and recovery, disposable income, policy instruments, fiscal policy, fiscal boost, direct and indirect taxes, the budget, budget deficit, national debt, monetary policy, foreign exchange rate, price ceiling, price floor, VAT, subsidies, merger and merger activity, takeover, asset stripping, nationalization, privatisation

Government intervention in markets

The governments of the UK and the European Union (EU) have a great deal of power to intervene in product markets. The reasons why successive governments have used this power are:

• To regulate prices set by private firms with a significant command over the market supply of a product who may use this power to restrict supply and force up market price.

• To increase or regulate the amount of competition for supply in markets dominated by one or a handful of large firms.

• To counteract anti-competitive activities, such as price fixing rings.

• To protect consumers from misleading marketing and unscrupulous trading practices.

• To encourage the consumption of a product by keeping prices low, or discourage consumption by keeping prices high.

• To raise the incomes of some producers in order to encourage them to continue to supply their product.

• To stabilize prices in markets susceptible to dramatic changes in the conditions of supply and therefore price.

• To protect environmental and social interests, such as public health and moral concerns, such as exploitation of child labour.

• To protect employment.

The governments can use a number of measures to intervene in markets to influence price and quantity traded, either directly or indirectly by influencing consumer demand or producer supply:

• macro-economic policy

• micro-economic policy

• legislation and regulation

• public ownership and privatisations

Macroeconomic policy

Macroeconomics is the study of how an economy works as a whole, including the overall level of income and prices, total employment and unemployment, the base rate of interest, total savings and investment, the rate of growth in total output, the balance of overseas trade, and the currency exchange rate.

Most governments in the developed world have four main macro-economic objectives. These are:

• to achieve low and stable inflation in the general level of prices

• to reduce unemployment

• to encourage economic growth, i.e. growth in total output

• to secure a favourable balance of payments, i.e. between inflows from inward investment and payments for exports, and outflows from investment overseas and payments of imports

It is assumed that if the government can meet these objectives, it will create an economic climate which is favourable to business. For example, it is argued that high inflation destroys business confidence and jobs. Business will find it difficult to plan ahead if the costs of their materials and equipment are rising quickly. When prices rise quickly, consumer demand falls. As firms experience a fall in demand, they cut back production and shed resources, including labour. Unemployment will therefore tend to rise.

Aggregate demand

Central to the success of macro-economic policy is the control of the level of aggregate demand in the economy. Aggregate demand refers to the demand of all consumers of the nation in the very widest sense, i.e. consumption of goods and services by public, investment in new plant and machinery by firms, expenditure on goods and services by the government, and spending on the nation's exports by other countries.

Rising aggregate demand is normally characteristic of economic recovery and boom. Most business organizations experience rising sales and order books. To fulfil orders and meet demand, firms may create employment opportunities and invest in expanding their capacity to produce. However, if firms are unable to keep pace with rising demand, stocks will fall and firms will tend to increase their prices. During an economic boom when total demand outstrips the supply of all goods and services, prices will tend to rise rapidly and eventually choke off demand and, if incomes fail to keep pace with prices, demand will start to fall.

Falling aggregate demand is characteristic of economic recession or slump. Trading conditions become difficult as demand for goods and services falls and firms experience rising stocks and falling orders. Prices are likely to fall as supply exceeds demand - or at least rise less fast. If recession continues, firms will cut back production. Investment in new research and development and machinery will also suffer as long-term plans are cut back. Unemployment tends to rise and growth in the productive capacity of the economy will falter.

The government is able to influence the level of aggregate demand for goods and services and, therefore, business trading conditions and employment opportunities, by using a number of policy instruments. These are:

• the general level of taxation

• the general level of public sector expenditure

• the base rate of interest

These policy instruments are used because:

• the amount consumers have to spend on goods and services depends on their level of personal disposable income, i.e. income after the deduction of tax

• as the interest rate rises, firms tend to reduce their investment in new capital goods, such as machinery

• total public expenditure, for example in the UK, accounts for around 39% of aggregate demand

• as the interest rate falls, the value of the national currency in terms of foreign currencies tends to fall reducing the price of national goods and services sold abroad.

Fiscal policy

Using taxation and public expenditure to influence the level of aggregate demand in the economy is known as fiscal policy. During times of economic recession the government may give the economy a fiscal boot by cutting taxes and/or increasing public expenditure. During times of high inflation the government may increase taxes and/or reduce public spending.

There are two main types tax the government can charge:

Direct taxes are levied directly on the incomes of people and firms, and include income tax, corporation tax, capital gains tax and inheritance tax

Indirect taxes are levied on goods and services, and therefore only have an indirect effect on incomes via spending; the main indirect tax is Value Added Tax (VAT); VAT is an ad valorem tax. This means the tax is levied as a percentage of the price of a commodity. VAT is levied on most goods and services. Indirect taxes also include customs duties, excise duties and licenses.

The budget

Each year the government presents its plans for public spending and revenues to the country's supreme legislative body. This is known as the budget. The government uses the budget to announce new taxes, abolish old taxes, or revise tax rates. If the government plans to spend more than it expects to raise from tax revenues, there is a budget deficit. A fiscal boost to the economy involves increasing budget deficit by spending more or cutting taxes. If the government reduces its budget deficit over last year, then it is planning a fiscal contraction in an attempt to reduce aggregate demand to reduce price inflation.

Most years the government has to borrow money to finance the shortfall between expenditure plans and total government revenues, including taxes, interest and dividends on loans and public sector share holdings, and profits from public sector trading activities, such as the Post Office. The difference between spending plans and revenues each year is what the government must borrow. If the government revenues exceed expenditures, it is able to repay some of the national debt - the total amount of borrowing by the public sector – and, therefore, reduce yearly interest charges.

Monetary policy

The main instrument of monetary policy is the interest rate charged on short-term loans from the Central Bank, which is the main bank in the economy and operator of government monetary policy, to the monetary sector, other banks and finance houses. By raising the interest rate, the government is able to influence the level of aggregate demand as banks and other lenders will usually follow by raising their own base rates of interest on loans to consumers and firms.

‘Tightening’ monetary policy involves raising the rate of interest to make borrowing money more expensive. As a result, demand for goods and services will tend to fall. Firms will also tend to borrow less to invest in new machinery and premises. It follows that reducing interest rates tends to increase the demand for borrowed funds to spend on consumer goods and services and capital goods to expand the productive capacity of firms.

Interest rates can also affect the price of goods and services we buy and sell overseas by influencing the value of the national currency on the foreign exchange market. An increase in the interest rate relative to those offered in other countries will increase the demand for the national currency and its price. As the value of the currency rises, exports become more expensive and demand for them is likely to fall. However, the price of imports will also fall, thereby reducing inflation. It follows that reducing interest rates can help reduce the value of the national currency and the prices of exports. This may create an increase in the demand for our exports and result in export-led growth in the economy.

Micro-economic policy

The study of micro-economics focuses on how individual markets work and not how the whole economy works. Thus, it considers how prices are determined by the forces of demand and supply in particular markets.

Unlike macro-economic policy instruments, which are intended to affect the overall level of income, prices, and employment in the economy, micro-economic policy instruments are targeted at particular markets in an attempt to influence the market price and quantity traded. A number of policy instruments are available:

• setting price ceilings and floors

• the selective use of indirect taxes

• the selective use of tariffs and quotas on imports

• the selective use of public expenditure

Price floors and ceilings

Governments can impose a fixed price in a given market.

If a maximum – ceiling – price (Pmax) is fixed below the free market price (Pe), it will result in an excess of demand over supply. ‘Black markets’ supplying goods at higher prices to those who can afford to pay may develop.

If a minimum – floor – price (Pmin) is fixed above the free market price (Pe), it will result in an excess of supply over demand.