Competition Policy (Edexcel A-Level Economics A): Revision Notes
Competition Policy
Introduction to competition policy
For markets to allocate resources efficiently, businesses need to make appropriate economic decisions. However, when markets become concentrated, firms may gain sufficient market power to make decisions that harm consumers and reduce overall economic welfare. This creates a form of market failure that requires government intervention.
When firms achieve market dominance, they can distort resource allocation in several ways. A profit-maximising monopoly, for example, may use its market power to raise prices and reduce output. This behaviour leads to a reduction in consumer surplus and can create deadweight loss for society. Competition between firms, by contrast, tends to encourage innovation and reduce X-inefficiency (productive inefficiency that occurs when firms don't minimise their costs).
Government intervention through competition policy aims to protect consumers and promote efficient markets. However, policymakers must carefully balance the benefits of competition against the potential loss of economies of scale. If competition requires fragmenting large firms into smaller units, society might lose the cost advantages that come from large-scale production.
The Competition-Efficiency Trade-off
Regulators face a delicate balancing act: while breaking up large firms increases competition, it may also eliminate valuable economies of scale. The challenge is to maintain enough competition to protect consumers without sacrificing the efficiency benefits that large-scale operations can provide.
What is competition policy?
Competition policy is a set of measures designed to promote competition in markets and protect consumers in order to enhance the efficiency of markets.
The main aims of competition policy include:
- Protecting consumers from the abuse of market power
- Preventing markets from becoming too concentrated
- Monitoring merger activity that could threaten competition
- Encouraging competitive behaviour that benefits society
- Addressing anti-competitive practices such as cartels and price-fixing
Competition policy recognises that market concentration itself isn't always harmful. A high concentration ratio (where a few firms dominate a market) doesn't automatically mean the market is anti-competitive. The key question is whether the market structure leads to anti-competitive conduct that harms consumers.
The role of contestability in competition policy
Contestability is an important consideration when assessing whether a concentrated market requires intervention. A perfectly contestable market is one where:
- There are no barriers to entry or exit
- Sunk costs are zero or very low
- New firms can enter and compete on equal terms with existing firms
In a perfectly contestable market, even a monopoly cannot set prices significantly above average cost without attracting new entrants. The threat of potential competition (hit-and-run entry) constrains the monopolist's behaviour, even without actual competition. Therefore, regulators might not need to intervene if a market is sufficiently contestable.
The Risk of Collusion in Concentrated Markets
When examining concentrated markets (including oligopolies), regulators must consider the risk of collusion. Firms might collude to act together, behaving as if they were a joint monopoly. This is particularly concerning when:
- There are only a few firms of similar size in the market
- The market is not expanding, so growth can only come at rivals' expense
- Firms might tacitly agree to avoid aggressive competition
The aim of competition policy is therefore to prevent markets from becoming so heavily concentrated that they become liable to work against the public interest. This involves monitoring markets where concentration is increasing through merger activity and examining markets that have already become concentrated.
The Competition and Markets Authority
Since April 2014, competition policy in the UK has been administered by the Competition and Markets Authority (CMA). The CMA was formed by merging two previous agencies: the Office of Fair Trading (OFT) and the Competition Commission.
Creating a single regulatory body aimed to:
- Simplify the implementation of competition policy
- Avoid duplication of effort
- Reduce costs
- Enable the CMA to operate with shorter investigation timeframes
- Reduce uncertainty for firms under investigation
Main functions of the CMA
The CMA has five main functions:
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Investigating mergers: The CMA examines mergers that could potentially lead to a substantial lessening of competition (SLC). This is the primary focus of merger policy.
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Investigating markets: The CMA assesses particular markets where there are suspected competition problems, even without a specific merger or acquisition taking place.
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Antitrust enforcement: The CMA investigates possible breaches of UK or EU prohibitions against anti-competitive agreements and abuse of a dominant position in the market.
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Taking action against criminal cartels: The CMA has the power to bring criminal proceedings against individuals who participate in cartel arrangements (agreements between firms to fix prices, limit production, or divide markets).
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Consumer protection: The CMA works to protect consumers from unfair trading practices and ensure markets work well for consumers.
The CMA's Comprehensive Approach
The CMA doesn't just focus on mergers and market structure. Its remit extends to criminal enforcement against cartels and protecting consumers from unfair practices. This comprehensive approach recognises that competition problems can arise from both market structure and firm behaviour.
Control of mergers
One way markets can become more concentrated is through merger activity. A merger occurs where firms join together to form a single firm, potentially reducing competition in a market by increasing concentration.
When does the CMA investigate mergers?
A merger becomes subject to investigation by the CMA if:
- The firms involved have a combined market share in the UK of more than 25%, AND
- The combined assets of the firms exceed £70 million worldwide
Meeting these criteria doesn't mean the CMA will automatically block the merger. Instead, it triggers an investigation to determine whether the merger would result in a substantial lessening of competition (SLC).
CMA investigation process and outcomes
The CMA has wide-ranging powers when investigating mergers. However, there is no presumption that the CMA will find problems with a proposed merger. An investigation may conclude that the merger raises no concerns about an SLC.
On several occasions, the CMA's predecessor (the OFT) launched consumer awareness campaigns, finding that problems in markets were caused by how consumers understood and used services, rather than by anti-competitive behaviour from firms.
Worked Example: Safeway Takeover (2003)
In 2003, several UK supermarkets attempted to acquire Safeway. The competition authorities had to evaluate multiple takeover bids.
The Decision: The final judgement was that all takeover bids were unacceptable except for the bid from Morrisons.
The Reasoning: The Morrisons bid would create a more even balance in size among the largest supermarkets. This would likely intensify competition, as the increased balance would make it easier for firms to compete effectively with each other in the market.
Key Lesson: Competition authorities don't just look at market share in isolation—they consider how the merger will affect the competitive dynamics of the entire market.
Worked Example: Sainsbury-Asda Merger (2018-2019)
In 2018, a merger between Sainsbury and Asda was proposed.
The Numbers:
- Combined market share would have been 31.4%
- Compared to Tesco's market share of 27.6%
The Argument: Proponents argued this would allow the merged group to compete more effectively with Tesco.
The Outcome: In April 2019, the CMA blocked the merger because it was expected to result in an SLC.
Key Lesson: Even efficiency arguments and the promise of better competition with rivals may not be enough if the merger itself significantly reduces competition. The CMA concluded that the reduction in competition would harm consumers, despite the efficiency arguments.
Globalisation and national champions
An important consideration in merger policy is that a firm dominating the domestic market may still face significant competition in the broader global market. This has led to debate about how governments should treat their large firms.
Some economists argue that governments should allow large firms to dominate the domestic market so they can become 'national champions' in the global market. This argument has been particularly prominent in the airline industry, where some national airlines receive substantial government subsidies to help them compete internationally.
Others argue that if a large firm faces competition within the domestic market, this actually helps encourage productive efficiency, making the firm more capable of competing with international rivals.
The relevant market
An important step in any merger investigation is identifying the relevant market. This is a market defined in such a way that no major substitutes are omitted but no non-substitutes are included.
Until the scope of the market has been properly defined, it isn't possible to calculate market shares or concentration ratios accurately. This is crucial because these measures determine whether a merger triggers investigation and how serious any competition concerns might be.
Defining the relevant market
Several questions arise when defining the relevant market:
- Product scope: Which products should be included? For example, is the market for sugar just granulated sugar, or does it include all types of sugar (organic, caster, etc.)?
- Geographic scope: Which region defines the market? For example, should bus services in Scotland be considered part of the Scottish market for travel, or a separate market?
- Substitutes: Which products are close enough substitutes to be included in the same market?
The hypothetical monopoly test
One method for addressing these questions is the hypothetical monopoly test. This approach defines the product market as the smallest set of products in which a hypothetical monopolist could raise profits by a small increase in price above the competitive level.
If consumers would switch to a substitute product in response to a price increase, then the market has not been defined widely enough to be regarded as a monopoly. This test relies on the concept of demand-side substitutability - whether consumers view products as substitutes for each other. This can be evaluated using cross-price elasticity of demand.
Two Types of Substitutability
Demand-side substitutability examines whether consumers would switch to alternative products if prices increased. This can be measured using cross-price elasticity of demand.
Supply-side substitutability considers whether suppliers could easily switch production to enter the market if prices rose. This relates to the concept of contestability—a market is more contestable if other firms can readily switch into it when potential substitutes are available.
Worked Example: 21st Century Fox and Sky Merger (2018-2019)
The CMA intervened in a proposed merger between 21st Century Fox and Sky plc.
Initial Position: The European Commission initially indicated it was happy for the merger to proceed.
The Concerns: Concerns were raised that the merger would give Rupert Murdoch too much influence over UK media, given his ownership of newspapers including The Times, Sunday Times, and Sun.
CMA Findings: The CMA issued its provisional findings report in January 2018, concluding that the merger would be 'expected to operate against the public interest'.
The Complication: Disney announced its intention to take over 21st Century Fox, meaning the merger would be under review by the US regulator. The merger eventually came into effect in 2019.
Key Lesson: This case illustrates the complexity of defining relevant markets, particularly in media industries where market power concerns extend beyond simple price considerations to include influence over public opinion and media plurality.
Competition policy in the European Union
When the UK was a member of the European Union, UK competition policy was closely coordinated with EU legislation. Cases of large-scale mergers and acquisitions handled by the European Commission (EC) could also be considered by the CMA, and vice versa. The same principle applied to cartels if the EC chose to exercise its jurisdiction.
This arrangement made sense because it allowed the EC to investigate potential abuse of market power where effects transcended national boundaries. However, it meant the CMA had to focus primarily on cases of mainly UK interest, or cases which the EC chose not to pursue.
An example of EC action occurred in July 2018, when the EC fined Google a record €4.34 billion for illegally using the Android operating system to cement its dominant position in search engines.
Brexit and Competition Policy
Brexit offered the UK an opportunity to adopt its own independent stance on competition policy, but it substantially increased the workload for the CMA. The challenge has been to continue coordinating action with EC investigations while operating independently.
Coordination problems are not new in this context, given the global nature of large corporations. For example, in one of the most famous competition investigations, Microsoft faced trial in the USA for alleged predatory action in launching its internet browser. Although the initial judgement went against Microsoft, a lengthy appeal followed. The EU then launched its own court action against Microsoft, making similar allegations about how it marketed its media player.
Key Points to Remember:
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Competition policy protects consumers from market power abuse and promotes efficient resource allocation by monitoring mergers and preventing anti-competitive behaviour.
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The Competition and Markets Authority (CMA) administers UK competition policy, investigating mergers, markets, cartels, and anti-competitive practices. It intervenes when mergers involve firms with more than 25% combined market share and over £70 million in assets.
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Contestability is crucial in competition policy. Even concentrated markets may not require intervention if they are contestable, meaning new firms can enter and compete freely without significant barriers.
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Defining the relevant market is essential for competition investigations. The hypothetical monopoly test helps identify which products and geographic areas should be included by examining whether consumers would switch to substitutes in response to price increases.
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Competition policy must balance promoting competition against preserving economies of scale, and domestic market considerations against global competition. Real-world cases like Sainsbury-Asda and the Fox-Sky merger demonstrate the complexity of these decisions.