Ethiopia: Vertical Integration, Government Revenue and Prices: A theoretical Amplification

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Aug 12th, 2014
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By Teshome Abebe (PhD)

A recent paper by Professor Said Hassan, “The Devaluation of the Birr: A Layman’s Guide”, attempted to summarize the impact devaluation of the birr would have on prices in Ethiopia. In a response, Tsehai Alemayehu, in his “Professor Hassan’s Essay on the Devaluation of thet Birr”, rebuts the conclusions advising an exercise of caution in using the model presented by Said. Another paper by Asghedom G/Michael titled, “Fallacies of Neoliberal Macroeconomic policy Prescriptions for Developing Nations”, attempted to decipher, though not successfully in my view, to what extent the World Bank’s recommendations on devaluing the birr might have on the Ethiopian economy, and by inference, on the price level and other macroeconomic targets. And in “America’s Africa: Command or Market Based?”, my good friend and former colleague Daniel Teferra argued effectively, that private property rights is the sine qua non of economic growth (emphasis mine), and concluded by asserting that, “It is not possible to create market-based economy without private property right.”

I cite just these four pieces as an example of the ongoing interest in the Ethiopian economy, as well as an example of the robust discussions taking place on a variety of topics related to that subject. Two of the pieces view the changes in prices as exogenously influenced, and one of the essays views prices as being influenced by the extant property rights regime as well as the level of competition in the economy. I believe, as my colleagues do, that while there may emerge specific differences in the particular views held and conclusions reached, they all contribute to a wealth of discussions and tabling of ideas that others might wish to refine or even possibly use.

In that sense, what is presented below is only a theoretical argument, a hypothesis that is testable. I have no access to firm structure data in Ethiopia, and I am not even sure that such desired data exists. Furthermore, I am neither a tax expert nor do I claim knowledge of the tax laws and the specific corporate tax structure in the country. Nonetheless, I acknowledge the preponderance of indicators that vertical integration is taking place among the major players in the Ethiopian economy. If this is true, it has implications for adverse consequences on government revenue in the form of corporate taxes as well as in its impact on consumers through prices paid for goods or serves. The impact on prices depends on the nature of market structure in place, as illustrated in the arguments made in the Model that follows.

Let us dispense off with what we mean by vertical integration. Vertical integration, whether forward or backward, is the merging together of two businesses that are at different stages of production. A food manufacturer merging with or acquiring a farm would be an example. Businesses are said to be ‘downstream’ or ‘upstream’ of each other depending whether they are nearer or further away from the final consumer.

It is observed that the benefits of vertical integration come from the greater capacity and opportunity it provides organizations to control access to inputs and other related factors, such as, costs, quality, delivery, and other supply chain considerations. Well known examples have been the oil industry (the exploration and extraction business coupled with ownership of refineries and further downstream to distribution), and the sports industry in the United States (ownership of teams coupled with ownership of cable companies and other video distribution concerns). Economists and accounting specialists agree that two important considerations are key in the vertical integration decision: the overall cost of administering the activities, and the impact the integration is likely to have on asset control. Among the asset control considerations are: principally, taxes and regulations on market transactions; and the capture of upstream or downstream profit margins. No need to expand further on these as the purpose of the paper is to raise awareness and provide a theoretical analysis of the impact of vertical integration on corporate taxes (government revenue) and consumer prices. Suffice it to state that of the advantages emanating from vertical integration of interest to economists include, the efficiency gains and the facilitation of investment in highly specialized assets or areas where others may be reluctant to invest. Of the disadvantages to vertical integration of concern to economists are restrictions of competition, diffusion of talent and competencies, and the potential high cost of investment in a new competency.

The Model:

In consideration of the intended audience, and in the interest of making the model understandable and straightforward, I will make some broad assumptions without which, the conclusions would be highly speculative and inappropriate. Furthermore, the intent here is to describe the model without the usual tools employed by economists for such purposes (such as mathematical equations and graphs). Those in the profession will quickly see how pertinent the assumptions are but may also find them to be too accommodating to the purpose for which they are deployed. In all cases, however, they are viewed as reasonable and consistent with microeconomic theory.

Let us begin by assuming two firms, each with monopoly power in its own market. One firm is the upstream firm, we will call it Firm A, the second firm is the downstream firm, we will call it Firm B. Let us now suppose that Firm A produces a product and sells it to Firm B which then sells the final product to consumers. If Firm A is a monopolist, i.e. has monopoly power, it can charge Firm B a monopoly price. Firm A maximizes profits by setting its production level at the level where its marginal cost is equal to its marginal revenue. Because Firm B is also a monopolist, it considers the price it pays to Firm A as part of its marginal cost of production. As a result, it now uses this higher cost of production, higher marginal cost, to determine its new price, and which it now passes on to the consumers. Firm B (also a monopolist) maximizes its profits by setting production at the level where the new and higher marginal cost is equal to its marginal revenue. Both firms exercise their monopoly power and maximize profits, but the consumer ends up paying a higher price. In this instance, the consumer faces the double forces of two monopoly actions as both firms exercise their market power.

Now, if we introduce vertical integration and assume that Firm B buys Firm A, the upstream firm, Firm B has no economic reason to charge itself a higher price, i.e. exercise monopoly power on itself. As a consequence, the cost of Firm A’s products to Firm B is exactly the marginal cost of production in Firm A. To summarize: while two separate monopolies exercise their monopoly power twice, a single vertically integrated monopoly applies its monopoly power only once. Economic theory leads us to conclude that the result will be a lower price and a somewhat higher quantity for the consumer.

What about the revenue and tax impact associated with vertical integration? This too, can be explained using economic theory as in the following paragraph. The owners of the two vertically integrated firms will maximize total profits of the combined unit. As in our previous example, Firm A will continue to sell its output to Firm B at a price called the ‘transfer price’. The transfer price could change for a variety of reasons, and these changes in the transfer price in turn change the accounting profits of the individual firm. Depending upon the requirements of the tax laws of the particular country, accounting profits are reported to the tax authorities but not the overall profits of the newly combined firms. Therefore, the owners of the combined firms can charge lower transfer charges depending what is advantageous to them and what tax and other considerations dictate. Alternatively, if for instance, the profits of Firm B are to be taxed, the owners could charge a very high transfer price for products of Firm A so that the tax bill is as low as possible. In summary: as far as the tax bill is concerned, when Firm A and Firm B are vertically integrated, the tax authorities should be extremely skeptical of the reported accounting profits of the enterprise!


Teshome Abebe, PH. D. is Professor of Economics, and may be reached at: teshome2008@gmail.com.

 

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