January 24, 2018 / 2:58 PM / a year ago

Breakingviews - Hadas: Carillion and the danger of low prices

LONDON (Reuters Breakingviews) - Customers rarely complain that prices are too low. Mostly they just take pleasure in getting a bargain. If they bother to think about it, they probably assume there must be some good industrial reason for any discount, such as better technology or economies of scale.

A Carillion sign can be seen in Manchester, Britain July 13, 2017. REUTERS/Phil Noble

Sometimes, though, it pays to pay more. Carillion provides a fine example. The customers of the British contractor presumably thought they were getting good deals, but they were wrong. Low prices have turned into bad news – disrupted projects, disgruntled subcontractors and higher costs, not to mention terrible publicity for the UK government, which was closely connected to the company and its bosses. And shareholders really suffered. The company’s market capitalisation was nearly $2 billion two years ago; as of Jan. 15 it is in liquidation.

Carillion was an extreme case. To fail so totally in a business which requires very little long-term investment is always hard. It is almost impossible when the economy is strong. The collapse was caused by incompetence in many parts of the organization, and ultimately, a toxic level of under-pricing.

The damage from charging too little is usually subtle. For example, the hypothetical losses suffered by shareholders when companies charge less than customers would theoretically be prepared to pay are so subtle as to exist only in a conceptual region, known to economists as opportunity costs. Shareholders’ pain in these cases generally receives, and deserves, little sympathy.

However, under-pricing can cause substantial damages. Consider Uber. The ride-hailing service offers its customers an alternative to traditional taxis, and an unrealistic bargain. The company does not disclose full financial results, but the most recent quarter showed a negative profit margin of 15 percent. No wonder passengers often feel they are getting a wonderful deal.

Average prices would need to be almost 30 percent higher to give Uber the 10 percent margin typical of a successful and growing company. The actual boost to prices would probably be larger, since the riders of a profitable Uber would have to pay the higher costs that come with participating in a regulated industry and equitable treatment of drivers. If Uber were to achieve market dominance, it would have a strong incentive to charge much higher fares.

Success is doubtful, but Uber has more time than Carillion. It can run losses as long as investors shovel in cash. That may well be long enough to do significant and unmerited damage to the existing taxi systems. But this bait-and-switch strategy undermines the common good of society. It is not just the licensed taxi drivers who are at risk. The final result may be a less efficient or more expensive system than the one which Uber disrupted with unsustainable and unfair low prices.

Amazon’s situation has a certain similarity. While the U.S. e-commerce giant’s domestic retail operations are now profitable, the company can afford to run them at close to breakeven, because it can rely on a comforting gush of cash from its commercially unrelated Web Services business. That operation provides about three quarters of the company’s operating profit from less than 10 percent of its revenue, based on its full-year accounts for 2016.

Amazon’s mail order revolution promises far more good than Uber’s transit disruption. However, the strategy of persistently undercharging for shipping is almost as aggressive as undercharging for rides. While the company stays on the right side of laws against below-cost pricing, rivals have just grounds for complaint.

Loss-making shipping prices are no longer a justifiable investment in the future, but a barrier to entry. Today’s Amazon is a multi-category-killer and its $7.2 billion losses on shipping in 2016 dwarfed the two retail divisions’ combined operating profit of $1.1 billion. Now only rivals with very deep pockets can hope to keep down with Amazon’s prices.

As economist Friedrich von Hayek pointed out in 1945, the fast responses of the price system usually work far better than the heavy hand of central planners. However, the gains only come when prices are realistic. And too low can be just as disruptive as too high.

One option is for governments to step in. Many of them recognise the problem. Many jurisdictions have laws which limit below-cost pricing. For example, the discounts available and length of sales are limited in many European countries. The legal system, though, has not kept up with technology. A renewed effort is in order, including regulations to ensure that current prices reflect likely future costs, not investors’ rapacious dreams.

It is hard to ban Carillion’s style of under-pricing – bidding too low for complex contracts. However, it is possible to firm up the rules on which bids are deemed acceptable. Better still, governments and other purchasers of outsourced services should learn that penny-wise really can be pound-foolish.


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