A Narrative of Abundance

This is also a first draft for the same piece I am developing. Constructive criticism is welcome.

Britain is a wealthy country. The UK has been a member of the club of rich nations, the OECD, since it was founded in 1961 and it grows steadily richer. We were not a poor country in 1980, but by 2019 we were twice as rich when measured by GDP per head. Part of the story we need to tell is about how the economy has led to such abundance.

In a production economy the output of economic activity is greater than the inputs. The value of the goods or services produced must be sufficient to provide for the wages of labour, a return on capital and to pay other direct costs. In fact, most production creates a surplus above the minimum needed for these purposes. Surplus is the difference between a subsistence economy and an economy which is capable of developing.

While it might seem like an obvious idea, economists have used different terms for “surplus” and encumbered it with theoretical and critical appendages. Adam Smith called it “extraordinary profit”. Neo-classical economists talk about “economic rent”. Marx drew on Ricardo’s labour theory of value to explain “surplus value”. (See box) For the purposes of a new narrative the term surplus will serve well enough although I may occasionally say rent where that is more natural.

In the market story profit is not a dirty word, but rent is. Profit is understood as the appropriate return to capital, the payment for patiently tying up capital in production. Rent however is a sign that a market is not functioning well so that the supplier or suppliers have power in the market enabling them to extract additional rewards. This view obscures an important reality of a production economy. Surplus is ubiquitous. It arises in many forms and is, in fact, the aim of any business with ambitions towards growth.

In what follows I will first outline the main types of market power which leads to surplus. I will show some evidence that business understands the pursuit of rent and finally explore what this means for our new narrative.

Market Power

Saudi Arabia can produce oil at a cost of around $3 a barrel. Adding capital, administrative and transport costs this rises to $9. If it sells at $50 a barrel then it has a surplus of $41 for every one of the 12 million barrels a day it sells. Oil is an extreme example of a resource rent. All the other oil producers share in resource rents. Even the UK where the total costs are $44 a barrel can provide large surpluses to Shell and BP.

Oil is not unique; all commodities are subject to the same dynamic. Some producers have lower costs of production than others and so win greater surpluses when they sell at the world price. Metals like copper, nickel and zinc; cereals like wheat, maize and rice; raw materials like timber, rubber and cotton; foodstuffs like beef, sugar and coffee; all are capable of delivering resource rents to particular producers.

Monopoly is another source of surplus. In most markets there are buyers prepared to pay a high price and many more ready to buy if the price is low. This gives the monopoly supplier an opportunity.  She can choose to keep production low and earn a large surplus on each sale or increase production and earn a lower surplus but by selling more increase the total take. A monopolist will try to set the price which maximises the total surplus.

Although the market story has a distaste for rents, governments are a major source of monopoly power. Governments grant patents to entrepreneurs who then have a monopoly on the production of their invention. In effect, patents offer the promise of monopoly profits as an incentive to innovation. They offer a bargain where the patent holder has excusive rights to the invention but must disclose it in the patent filing. Thus, when the patent expires, usually after 20 years, the innovation can spread more widely.

Pharmaceutical companies  are a good example of businesses which run on surpluses created by government. Technology firms too rely on patents, although software is protected by copyright which has longer time limits and fewer disclosure requirements.

Some monopolies occur naturally. If there are strong economies of scale then it may be cheaper to have a single producer or supplier. Natural monopolies include utilities where each household or business needs only one connection to the network. Amazon has built its business on economies of scale becoming a utility for online shopping and gains a monopoly surplus as a result

Digital technology has brought us a new kind natural monopoly, one where the economies of scale are on the demand side. We use Skype, for example, because other people we want to talk to use it. In fact, the larger the number of other users the more useful it is to us. This same logic applies Microsoft operating systems and office software. We want to be compatible with the systems everyone else is using.

There are many techniques businesses use to attract a surplus from branding to enable them to charge premium prices, to differential pricing – charging more to less price-sensitive customers. Monopoly profit may not need a single supplier but an industry with a small number of big players who don’t compete on price can create enough surplus to go around.

Business Strategy

Many businesses generate very little surplus. In small businesses like local shops, restaurants, workshops and professional bureaus the surplus is adsorbed into the income of the owners. Any business with ambitions to grow will want to create a surplus to pay for investment in expansion. However, it is in large corporations where making a surplus is approached as a scientific effort. As a student of business studies I learned that most corporations do not seek a level playing field. In fact, the aim is to tilt the field in their favour. Few firms will express it that way; the term of art is “competitive advantage”. A company with an advantage over its competitors is one which can reap extraordinary profits.

Competitive advantage is a central idea in business strategy. Various techniques are used to identify and to sources of advantage. One well known tool, Michael Porter’s five forces model, provides a framework for analysing an industry to assess its scope for generating surplus. The five forces are:

•          rivalry among competing firms,
•          bargaining power of suppliers,
•          bargaining power of buyers,
•          barriers to entry,
•          substitute products.

Recall that surplus is the difference between the price a firm can charge and the total costs of production. Where a firm sits in the supply chain can affect its surplus. If its suppliers or buyers have strong bargaining power then they can set their prices so that the surplus come to them. Rivalry between firms can erode the surplus, but in many industries firms prefer to compete on quality or by differentiating their products rather than on price. The availability of substitutes can put a limit on surplus if customers might switch if they judge that the price advantage outweighs the inconvenience.

Barriers to entry offer a range of possibilities. Intellectual property, such as patent, can be a barrier. So too can government regulation, where licencing or safety rules are onerous. Large economies of scale or the need for high capital investment can discourage new entrants who would face risking high investment cost in order to challenge the incumbents.

Take the pharmaceutical industry as an example. Supplier power is low but buyer power can be significant if the NHS chooses to use it. Rivalry is limited as each company sells differentiated products. Substitute products are limited except for those who believe in homeopathy. Incumbent companies are protected by many barriers to entry. The high costs of R&D have to be borne for a long period before there is any income. Regulatory approval is also time consuming and technically complex and finally patents provide a temporary monopoly for each successful product. It is not surprising that a small number of incumbents dominate this industry.

Firms and their investors can use this model to identify how competitive pressure might impact on the opportunity for completive advantage and consequent surplus.