The Telegraph reports that line rental for all British Telecom customers will increase by £1/month.

photo: fabbio

For somebody who receives paper bills, this is a rise from £11.50/month to £12.50/month for those on paper billing. For those on paperless billing (i.e. online), bills will increase from £10.25/month to £11.25/month. According to BT, customers can mitigate the price rise by switching to paperless billing at the same time. This is a fantastic demonstration of price discrimination.

On face value, having to pay an extra of £1.25/month for a paper bill seems ridiculous. It is obvious that this £3.75 per quarterly bill charge isn’t there to cover BT’s costs. There is no way that printing, processing and mailing a phone bill every quarter would cost more than 30p. That would leave BT with an additional £3.45 of pure profit per quarter for every paper bill customer.

I’ll explain using the old prices of £11.50 for paper billing and £10.25 for paperless billing.

The market rate for line rental is £11. BT’s rivals such as Virgin Media charge approx. £11. For BT to be price competitive, it must have a lower line rental than Virgin. If BT generally offered line rental at the paper bill rate of £11.50, it would be extremely uncompetitive against Virgin. However, at the paperless rate of £10.25, BT would be much cheaper than Virgin. But they’d probably make a lot less money as the profit on each line rental would be lower than it could be.

Companies get the best of both worlds by charging customers who don’t mind paying more (price inelastic customers), more. Customers which do shop around for line rental and do care how much they pay (price elastic) will pay less.

photo: markhillary

The costs of paper and paperless billing have absolutely nothing to do with the different line rental charges. It’s simply a way for BT to differentiate between how price elastic customers are. My grandmother can’t be bothered to shop around or to go to the effort of accessing electronic bills. She has paper bills and pays £11.50.

On the other hand, somebody like me will shop around to find the best deal. If BT charged me £11.50 as well, I would choose Virgin for a saving of 50p/month. But as BT’s paperless line rental is lower than Virgin’s line rental, I would choose to go with BT and paperless. For me, the cost saving would be worth the small extra effort to check an online bill.

By charging different prices to different customers depending on how much they are willing to pay, BT can increase their customer base without cutting their prices for everybody and their profits.

It is quite a clever way of operating price discrimination and has a double whammy in allowing BT to proclaim that it is encouraging people to be green. It’s something businesses do a lot and something well worth being aware of. See my previous post , “Why is popcorn at the cinema so expensive?”, for another example.

Tags: UK

photo: Peter

I received an email from a friend yesterday. She is currently taking a year out and taking on some voluntary work to promote peace in the middle east. It’s such a fantastic thing to do in my opinion and I have a lot of respect for her for doing it!

However, it seems like even she can’t avoid the credit crunch which is impacting us all at home. I’ve written about the fall in the value of the Pound before on this blog. £1 would buy you $2.05 at the start of the year, now it would buy you about $1.50.

And that’s really, really bad news for anybody who has income denominated in Pounds and costs denominated in dollars. If the gap year cost $8,000 at the start of the year, that would have worked out around £4,000. That cost has now increased to over £5,300. That’s a huge shortfall in funding and now she thinks she might have to cut the gap year short which would be a real shame. My prediction is that we’ll see a bounce in the value of the British Pound soon but obviously the exchange rate is very volatile. That’s a big problem: the cost of everything (accommodation, food, etc.) in terms of your home currency can change dramatically from day to day.

The volatility of exchange rates poses extra risks both importers and exporters. Somebody (or some company) buying products in dollars and selling them in pounds will have seen their costs rise by 33% in just the past few months. That could easily make the difference between a healthy profit and a huge loss.

Reducing or hedging the risk

photo: michale

So let’s set the scene. I’m an importer of widgets from the US. I import $1 million of widgets per month. The exchange rate is $2 to £1. So my imports cost me £500,000.

However, I believe the pound is overvalued. I reckon the UK is going to go into recession soon and the pound is going to be a lot weaker. I go to my bank manager and I ask him to guarantee an exchange rate for the next year. Obviously, my bank manager probably won’t guarantee me a rate of $2 per £1 for a whole year. The reason for that is simple: if the pound does indeed get weaker, he’ll lose out. A more realistic rate he might offer is $1.8 per £1. Providing the pound stays at the $2 level, my bank manager would have made a cut of $0.20 per £1; giving my bank a profit of $100,000.

I’m now paying £550,000 for my currency. That’s more than the £500,000 it would have cost me without the agreement, so essentially I’m paying £50,000 for the service of being able to “lock in” my exchange rate for a year. But because I believe the pound will fall in value, I don’t mind. If I could predicted a fall to $1.5 per £1, I would have known my costs would rise to £660,000. So I predict that agreeing a rate for my currency in advance would save me £110,000, in addition to giving a more stable cashflow.

What I’ve just described is an “exchange rate derivative” (or a future). The activity is known as hedging.

Hedge Funds

In amidst the credit crisis, hedging has a bad name and reputation. Imagine my company is publicly floated on the stock market at the price of £2 per share. However, a hedge fund believes that my company is overvalued or expects sales to be poor in the next quarter. The hedge fund makes an agreement with somebody (e.g. a bank) that it will sell shares in my company at the price of £1.80 in one years time. So my bank manager is sitting there and thinking: great! I’m getting a £2 share for the price of £1.80… a profit of 20p instantly! If shares in my company then fell to £1.50, the hedge fund makes a profit of 30p by offloading something worth £1.50 for £1.80.

photo: Alex // Berlin _ as+photography

But here is the moral issue. A hedge fund is making a profit out of the fact that my company is doing badly. In fact, the worse my profits are and the more people I have to make redundant, the more money the hedge fund will make. Isn’t this profiting from somebody elses misery?

I hope the similarities between the currency hedge and the company hedge are fairly obvious. Hedge funds make a profit out of the fact that my widget company performs badly. My widget company makes a profit out of the fact that the British economy is doing badly.

But whilst there may be a debate to be had over the morals of short selling, it isn’t in doubt that hedging can serve a positive purpose. My friend, who no longer has enough money to complete the gap year she had been planning for a long time, could have avoided being in the situation she is currently in by hedging the Pound. She would have had the knowledge that whatever happened to the British economy and the British Pound, her costs would always be the same. If the Pound fell, she would have made a profit. If the Pound later rose, she would have paid well over the odds for her gap year. But at least the cost of the gap year would be fully known and the risks from currency fluctuates eliminated.

Tags: UK

photo: CarbonNYC

Everybody who lives in the UK should read about the “exceptional” pre-budget report this year. There are some big tax changes which probably affect you. To sum it up, there is a new 45% band of income tax; VAT is falling to 15% for 13 months; excise duties on alcohol, tobacco and petrol are rising.

I wrote about the possibility of VAT cuts two weeks ago. Given VAT is falling from 17.5% to 15%, we should see a fall in the price of goods by 2% from Monday, assuming that the full VAT cut is passed on. In my previous article, I discussed whether retailers are likely to absorb the VAT cuts as extra profit, pass it on as-is or perhaps even cut prices by even more than 2%.

Worth keeping an eye on anyway and not making any big purchases of electronics or gadgets quite yet until we see how retailers are going to react.

For full details, see the government’s full pre-budget report, “Facing global challenges: Supporting people through difficult times”.

Tags: UK

photo: Phillip

There has been a lot of discussion in the UK lately about a possible cut in Value Added Tax from 17.5% to 12.5%. I’m not sure how likely it is that this will happen - the radio news seems to believe it is inevitable but many other news organisations seem to disagree.

A cut in VAT from 17.5% to 12.5% could lead to big discounts on every item sold in the UK. The savings can be fairly substantial - £26 off an iPhone PAYG or £72 on a £1,000 plasma TV. However, it would depend on how and whether those cuts were passed onto the consumer.

Retailers could leave prices unchanged. Imagining a £100 product, £17.50 would have previously gone towards the UK government. After the VAT cuts, the government would only take a cut of £12.50 leaving the retailer with an extra profit of £5 per unit.

photo: Cosmic Kitty

Retailers can increase their turnover at a time where their costs may be rising but they cannot afford to raise prices for fear of losing customers. But perhaps with retailers knowing that Christmas is coming up, people would buy their product without an additional discount. Hence there would be no need to pass on the VAT cut.

Retailers could pass on part or all of the VAT cut. If the entire VAT cut was passed onto the consumer, the £100 product would now cost £92.81. The retailer makes the exact same amount of money they did before; but its great news for the consumer as consumers save a lot of money. In a time when peoples disposable income levels are falling, this increase in demand could ensure retailers get the sales they need.

Retailers could discount prices by even more. The retailer may want to cut the price of the product from £100 to £90. However, that might not be too attractive to them - it represents a loss of £10 for every product sold. However, given that the government is absorbing so much of the price cut themselves this may make it a lot more attractive for retailers to cut their prices.

photo: Olaf

So how does this affect you? I personally believe that if Mr Darling did cut VAT, it would take several weeks, even months for that to filter through to the prices that we pay at the shop every day. Companies have price promises to honour; companies have catalogues which cannot be reprinted immediately, etc. And with Christmas coming up, consumer spending should hopefully pick up anyway. So we would be unlikely to see any big price cuts this year.

However, New Year 2009 could be a bumper one for new year sales. If Christmas sales figures aren’t as high as retailers expect, I believe retailers could offer much bigger discounts than in past years.

If there are some big purchases you were planning to make, it may well be worth waiting until after the pre-budget report and possibly the new year.

Tags: UK