Profit pool

As part of the research I did when writing my post on ecological protectionism, I read a report of the Boston Consulting Group (BCG) on the EU carbon tax. This report introduced the interesting concept of the ‘profit pool’. 

The concept has been introduced by consultants to have companies think about where they make profit in the value chain. “The term value chain refers to the process in which businesses receive raw materials, add value to them through production, manufacturing, and other processes to create a finished product, and then sell the finished product to consumers”1. It is often used interchangeably with supply chain, although the concept of supply chain stresses the physical movement of goods, data and such. 

Both value chain and supply chain are often looked upon from the perspective of one company, but the process from – mining, growing, breeding or extracting – raw materials to the sales of the finished product is often comprised of several companies. Therefore, you can also use the profit pool concept for the whole value, or supply, chain.

When I taught economics the value chain was only covered to illustrate different kinds of integration in the value chain – vertical integration – or across value chains – horizontal integration. The value, or supply, chain, however, allows for many more interesting explorations, which ranks it high on my to-include-in-the-curriculum list. 

When you read the topic of a carbon border tax in the post mentioned above, did it trigger the concept of price elasticity? Often, when discussing the topic of levying taxes I used price elasticity to explain how the tax burden is distributed across suppliers and buyers. What I did not discuss was the effect of the tax on the distribution of profits across the value chain.

When price elasticity is low, between -1 and 0, which means that an increase in price due to taxation results in a relatively smaller decrease in demand, the buyers take up the greater part of the bill, but the decrease in demand may not be what was intended by policy makers. A high price elasticity, lower than -1, on the other hand, does lead to a relatively higher decrease in sales, with suppliers carrying the lion’s share of the tax burden.

Price elasticity can be applied anywhere in the value chain – it is not confined to finished products. Eventually, however, it is the price elasticity of the finished product that ripples through the value chain. 

The profit pool in the value chain will not be affected solely by the tax burden that falls to the suppliers. Even when the whole tax burden falls to consumers, the probable decrease in demand will absorb part of the profit pool. Moreover, economies of scale may decrease and raise the cost of production – another reduction in the profit pool. 

When the carbon tax is levied lower down in the value chain on raw materials, the relative share of these raw materials in the total costs has to be taken into account. The BCG mentioned this aspect in relation to the ethylene used in the production of plastic soda bottles:

“Although the [carbon tax] could translate into a 50% cost increase for producers of ethylene, for example, the tax would add only about 1% to the retail price of a soda sold in a plastic bottle.”2 

Which gives us some perspective, although it does not give us any clue about who, in the business to business relation of the ethylene producer and the plastic bottle manufacturer, is going to take the largest part of the tax burden. Nor does it tell us if it is possible that the tax burden will be transported up the value chain. This likely depends on the balance of power in respective markets and the bargaining skills of company representatives. Bargaining about a piece of the profit pool. 

I used price elasticity not only to assess how the tax burden was distributed, but also to analyse the effectiveness of the taxation. With the profit pool of the value chain I add another tool of analysis to my portfolio, making me ask the question: When companies lower down the value chain have to take the heat, will they be able to invest in the necessary adaptations to decrease CO2 emissions or will they cease to exist? You may ask now: “Isn’t that what we want?” And I agree, we do want lower, or even better no, CO2 emissions. However, if companies lower down the value chain see their piece of the pie shrinking, how can they invest in alternatives that respect the ecological ceiling? – You can also find me on LinkedIn

Image by Виктория Бородинова on Pixabay

  1. Investopedia
  2. How an EU Carbon Border Tax Could Jolt World Trade, Boston Consulting Group, 30 June 2020