March 5, 2020

Boris Johnson, Brexit, and protecting British companies

written by Felix Brockerhoff
Boris Johnson, Brexit, and protecting British companies

Both focus on protecting national interests by using populistic headlines. It could be argued that, with regards to their style of politics, they are friends in mind. Boris Johnson may want to look on the other side of the Atlantic to evaluate which US laws protecting national economy could be applicable for the UK.

WHAT WOULD BORIS JOHNSON FIND WHEN LOOKING ACROSS THE ATLANTIC?

Why is that of interest? After Brexit was announced, bankruptcy rates of medium size firms (SMEs) in the UK rose by 10%, while decreasing for the rest of the EU at the same time. Thus, protecting the SMEs could well be a starting point for an economic program. So, what would Boris Johnson find when looking across the Atlantic? There is a long-standing law in America, which aims at protecting the interests of local SMEs in particular; The Buy American Act. In short, the idea of this law is to provide American SMEs a price preference in public tenders compared to bigger and/or foreign firms.

From a micro-economic perspective, price preferences can be modelled as an additional payment to a firm (e.g. a British firm) when winning a contract – which is a subsidy. When is that relevant? Let’s consider a SME participating in a tender. It has to decide on the bid strategy considering the expected value of the contract (including the subsidy), and the global competition. But does a firm always benefit from a subsidy? And what do subsidies mean with respect to the bankruptcy risk mentioned above?

THE EFFECT OF DOMESTIC PRICE PREFERENCES

Three distinct scenarios have to be considered when evaluating the effect of domestic price preferences:

  1. No change in allocation: Non-preferred firm still wins, irrespective of the preference: Preferred firms bid lower than without the subsidy, however the non-preferred firm still wins as they are much more competitive. In this scenario, preferences are not changing the outcome.
  2. No change in allocation: Preferred firm wins, but not because of the preference: A preferred firm would have won the contract even without preferences. Preferences therefore don’t change the allocation, but only mean an additional payment and higher profits to the preferred firm. That corresponds to a “welfare neutral” transfer from the taxpayer to the owner of the firm.
  3. Change in allocation: Preferred firm wins, only because of the preference: One could say that this is the desired effect from an economic perspective. A preferred firm wins the contract due to the, now possible, lower bid. While without preferences, a nonpreferred firm would have won the contract. Preferences therefore change the allocation.

But is the desired scenario 3) good news? Due to the limited liability of SMEs, and the corresponding risk seeking behaviour, they are more exposed to bankruptcy. But why are limited liability firms more risk seeking? Take construction as an example: When placing a bid, the firm has only a cost estimation. As we all know, costs can, and often do, increase unexpectedly or companies underestimate complexity. Then, costs exceed the bid plus the equity of the firm. In that case, the SME must declare bankruptcy.

From an expected utility point of view, this leads to an interesting optimisation problem for the firm. If costs are low, profits are high. If costs are high, losses are capped at the equity of the firm. That is changing behaviour from risk-neutral to leading risk-loving.

GAMBLING FOR RESURRECTION

It can be shown that firms with limited liability bid below possible cost realisations, because they can take full advantage of the benefit but do not have to pay the full cost in case of bankruptcy. Knowing about preferences, preferred firms bid even lower, since preferences effectively play the role of a reduction of expected costs. In the finance literature, we would call that outcome profile a put-option and sometimes that behaviour is also referred to as “gambling for resurrection”. If I have one shot left to survive, I take risky bets which are higher.

Hence, we must conclude that a price preference is changing behaviour in a non-desirable way.

In summary, the effect of subsidies in the form of preferences for local firms is ambivalent. On the one hand, they of course increase the number of contracts awarded to local firms. On the other hand, they might at the same time increase the risk of bankruptcy for these firms.

One should be careful with implementing these kind of measures, especially in markets where uncertainty about their own costs is high, and firms have low equity rates. If the target is to reduce the number of bankruptcies, preferences might not be the measure of choice.

WHAT SHOULD BORIS JOHNSON DO?

Before introducing these kinds of subsidies to protect the local economy, Boris Johnson would be well advised to first get a deep understanding of the markets he intends to influence. In more volatile industries, he might consider quotas, i.e. some contracts are only awarded to local SMEs. They are not optimal from a competition (= price) perspective, but have no strategic effect on the bidding behaviour of SMEs.

Title image by Rodrigo Santos on Unsplash