Markets: Mechanism, Failure & Intervention (AQA A-Level Economics): Revision Notes

Competition Policy

The theoretical background to competition policy

Competition policy exists because perfectly competitive markets, while theoretically ideal, rarely exist in the real world. Understanding the difference between perfect competition and monopoly helps explain why governments need to intervene in markets.

Perfect competition is the ideal market structure because it delivers important benefits to society. When markets are perfectly competitive, two key principles operate. First, without economies of scale, perfect competition is more productively and allocatively efficient than monopoly. This means resources are used in the best possible way and goods are produced at the quantities consumers actually want. Second, in perfect competition, consumer sovereignty rules. This means consumers, not firms, have the power in the market. Consumers get what they want at fair prices.

In contrast, monopoly leads to the opposite situation. Monopolies create producer sovereignty, where firms have the power to manipulate consumers. By restricting output and raising prices, monopolies harm consumer welfare. The result is a net welfare loss to society, plus a transfer of consumer surplus into producer surplus and monopoly profit. Essentially, consumers lose out while monopolists gain excessive profits.

However, even though perfect competition is theoretically superior, it doesn't exist in most real-world markets. When firms operate in markets with high levels of competition but not perfect competition, economists believe that competition policy can help prevent the abuses that occur when firms possess significant monopoly power.

Competition policy refers to the part of government economic policy that tries to make imperfectly competitive and monopolistic markets more competitive. The aims of competition policy include:

• Preventing the exploitation of monopoly power
• Reducing costs of production
• Improving efficiency
• Eliminating excessive profit so that prices reflect costs of production
• Removing entry and exit barriers that separate markets

When monopoly might be preferable to competition

Competition policy recognises that monopoly isn't always bad. There are two main circumstances where monopoly may actually be preferable to having many small competitive firms:

Economies of scale: When the market size is limited but economies of scale are possible, monopolies can produce at a lower average cost than smaller, more competitive firms. This means the monopoly can potentially offer lower prices to consumers than would exist in a competitive market, as long as the monopoly doesn't abuse its power.

Innovation and dynamic efficiency: Under certain circumstances, firms with monopoly power may be more innovative than firms that aren't protected by entry barriers. When this is the case, monopoly may be more dynamically efficient than a more competitive market. The monopoly profits provide funds for research and development, and the protection from competition gives firms the security to invest in long-term innovation.

The three different parts of UK competition policy

UK competition policy comprises three main elements: policy towards monopoly, mergers, and restrictive trading practices. Each addresses different aspects of anti-competitive behaviour in markets.

Monopoly policy

Although the term "monopoly policy" is commonly used, it's actually somewhat misleading. In the UK, there are very few pure monopolies where a single firm controls 100% of the market. Instead, monopoly policy focuses on oligopolies and concentrated markets dominated by just a few firms. These markets share many characteristics with monopoly, even if they're not technically pure monopolies.

The Competition and Markets Authority (CMA) is the government agency responsible for advising on and implementing UK competition policy. The CMA was established through the merger of two older organisations: the Office of Fair Trading (OFT) and the Competition Commission (CC). This merger took place in 2013, with the CMA beginning operations in 2014.

The CMA's responsibilities extend beyond investigating pure monopolies. It also examines mergers that might create a new monopoly or a highly concentrated market structure. A highly concentrated market is one where a single firm, or a small number of firms, controls a large share of the market.

The cost-benefit approach to monopoly policy

UK competition policy has always been based on a pragmatic, case-by-case approach rather than blanket rules. Economists recognise that monopoly can be either beneficial or harmful depending on the circumstances. Therefore, each case must be judged on its individual merits.

How the CMA investigates monopolies:

The CMA uses several tools to scan the UK economy systematically for evidence of monopoly abuse:

• Market structure indicators: Concentration ratios provide evidence of monopolistic market structures
• Market conduct indicators: Consumer and trade complaints allow the CMA to monitor anti-competitive business behaviour
• Performance indicators: These help identify markets where firms may be exploiting their position

When the CMA discovers evidence of monopoly behaviour that appears contrary to the public interest, it investigates further. The investigation focuses on whether specific features of the market (including structural features and conduct by firms or customers) prevent, restrict or distort competition.

Alternative approaches to the problem of monopoly

For over 70 years, the UK has adopted a regulatory and investigatory approach to monopoly. Relatively few firms and takeover bids are actually investigated. The rationale is that the possibility of a CMA investigation creates sufficient incentive for most large firms to behave well and resist the temptation to exploit monopoly power against the public interest.

However, the CMA's "watchdog" role is not the only possible way to deal with monopoly. Several alternative strategic approaches exist, though they have generally fallen out of favour in the UK:

Compulsory breaking up of monopolies (monopoly busting): Some free-market economists believe the advantages of competitive markets can only be achieved when the economy is as close as possible to perfect competition. They argue that monopoly is inherently bad and impossible to justify. Therefore, the government should adopt an automatic policy rule to break up monopolies whenever they're discovered. UK policy-makers have rarely adopted this approach, though the government does have legal powers to order the break-up of established monopolies. The term for this approach is "monopoly busting."

Price controls to restrict monopoly abuse: Although price controls have been used by UK governments at various times to restrict firms' freedom to set prices, this policy has only been used in a limited way in recent years. Under the influence of free-market economic theory, price controls have fallen out of favour as a general policy tool.

Taxing monopoly profits: As well as controlling prices directly, the government can tax monopoly profit to punish firms for exploiting their monopoly power and making excessive profit. Monopoly taxes have not generally been used in the UK, except on a few occasions. For example, landlords face a "windfall" tax on gains when land they own becomes available for property development. Similarly, banks have faced special taxes on windfall profits from high interest rates.

Rate of return regulation: In the USA, regulators have imposed maximum rates of return on capital that utility companies can earn. In principle, these act as price caps, since utilities face fines if they set prices too high and earn excessive returns. However, in practice, rate of return regulation often has unintended consequences instead of increasing productive efficiency. This type of intervention can encourage utility companies to raise costs so that raising prices doesn't lead to higher profits, allowing them to comply with the regulation. The higher costs, resulting from productively inefficient use of resources, may allow business managers to enjoy an easier life. Monopolies protected by high entry barriers are especially likely to allow costs to rise.

State ownership of monopoly: In the past, UK Labour governments sometimes viewed monopoly problems as resulting solely from private ownership and the pursuit of private profit. At its most simplistic, this view suggests that monopoly problems disappear when firms are nationalised or taken into public ownership. In public ownership, monopolies are assumed to act solely in the public interest.

Privatising monopolies: Conservative governments opposed state ownership, arguing it produces particular forms of abuse that wouldn't occur if industries were privately owned. According to the Conservative view, inefficiency and resistance to change stem from workers and management in state-run monopolies believing they'll always be bailed out by government if losses occur. It's also alleged that interference by governments for social and political reasons makes it difficult for nationalised industries to operate efficiently. Conservatives believe that privatising state-owned monopolies improves efficiency and commercial performance. Privatisation exposes industries to the threat of takeover and the discipline of the free market. In some cases, privatisation has also subjected previously state-owned monopolies to competition.

Deregulation and removal of barriers to entry: Most economists believe that privatisation alone cannot eliminate monopoly abuse; it merely changes the nature of the problem to private monopoly and commercial exploitation of a monopoly position. When the telecommunication, gas and electricity monopolies were privatised, regulatory bodies were established: Ofcom and Ofgem, operating alongside the CMA. One method of exposing monopolies (including privatised utility industries) to increased competition is using deregulatory policies to remove artificial barriers to entry.

Contestable market theory and competition policy

In recent years, contestable market theory has had a major impact on UK monopoly policy. The theory suggests that, provided there is adequate potential for competition, a conventional regulatory policy is unnecessary. The government's main role should be to discover which industries and markets are potentially contestable.

The growing influence of contestable market theory has been accompanied by the introduction of deregulatory policies designed to develop conditions with reduced barriers to entry and exit, or a complete absence of such barriers.

Merger policy

Whereas a government's monopoly policy deals with established monopoly or markets already dominated by large firms, merger policy is concerned with takeovers and mergers that might create a new monopoly. Strictly speaking, a merger involves the voluntary coming together of two or more firms, whereas a takeover is usually involuntary (at least for the victim being acquired through a hostile takeover). However, the term "merger policy" covers all types of acquisition, whether friendly or hostile, willing or unwilling.

Until quite recently, the government itself decided whether to refer merging companies to the competition authorities for investigation. This approach left governments open to criticism that when deciding against a merger reference, they were bending to the lobbying power of big business and engaging in political opportunism.

Now, the CMA makes virtually all merger references. The CMA keeps itself informed of all merger situations that might be eligible for investigation on public interest grounds. Currently, a takeover or merger is eligible for investigation if it is expected to lead to a substantial lessening of competition (SLC).

Restrictive trading practices policy

Restrictive trading practices undertaken by firms in imperfect product markets can be divided into two categories:

• Practices undertaken independently by a single firm
• Collective restrictive practices involving either a written or an implied agreement among two or more firms

Independently undertaken restrictive practices include:

• Decisions to charge discriminatory prices
• Refusal to supply a particular resale outlet
• Full-line forcing, whereby a supplier forces a distributor that wishes to sell one of its products to stock its full range of products

Collective restrictive practices:

The most common example of a collective restrictive trading practice is a cartel agreement, in which firms come together to fix or rig the price of a good. By agreeing to restrict output and raise prices collectively, cartel members can enjoy the benefits of monopoly without actually merging into a single firm.

Both independently undertaken and collective restrictive trading practices are now dealt with by the Competition and Markets Authority. The CMA usually asks the firm or firms involved to drop the practice voluntarily on the grounds that it is anti-competitive. A cartel agreement is usually banned unless the firms involved can persuade the CMA that the agreement is in the public interest. For example, firms might argue the cartel protects the public from injury or provides other benefits.

Case study: European Competition Commissioner fines Google €4.3 billion

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