Controlling Monopolies and Promoting Competition (Edexcel A-Level Economics A): Revision Notes

Controlling Monopolies and Promoting Competition

Controlling and regulating monopoly

The Competition and Markets Authority (CMA) investigates mergers that could increase market concentration. The CMA is particularly concerned about markets where concentration is already high. Natural monopolies present special challenges for policy-makers seeking to promote allocative efficiency.

Understanding natural monopolies

A natural monopoly occurs when one firm can supply an entire market more efficiently than multiple firms could. This happens because the industry has substantial economies of scale compared to market demand. In these industries, the minimum efficient scale of production is actually larger than the total market demand.

Industries like railway systems, water supply, gas supply and electricity generation often operate as natural monopolies due to their large fixed costs relative to marginal costs.

The fundamental problem with natural monopolies

Because the largest firm can always dominate and undercut smaller competitors due to its natural cost leadership position, the market tends towards monopoly. If the monopoly chooses to maximise profits by setting marginal revenue equal to marginal cost, it will produce output $Q_m$ and charge price $P_m$, earning supernormal profits but creating allocative inefficiency.

Price regulation

Regulation emerged as one approach to controlling natural monopoly behaviour. Regulatory bodies focused initially on price controls, with the main method being to permit price increases each year at a rate set below changes in the retail price index. This became known as the RPI minus X rule.

The basic principle was to force companies to seek productivity gains to eliminate inefficiency that had accumulated over time. The X represents the productivity improvement that the regulator believed could be achieved, measured in terms of changes in average costs.

However, this approach has inherent problems:

• Setting the X value: How does the regulator determine the appropriate productivity target? This is particularly problematic when companies have better information about their costs than regulators do, creating asymmetric information issues
• Quality trade-offs: Firms might achieve productivity gains by reducing product quality or by neglecting long-term investment and allowing maintenance standards to decline
• Diminishing returns: As time passes and the RPI minus X system proves effective, inefficiency gradually gets squeezed out. The X value must be reduced over time as it becomes increasingly difficult to achieve further productivity gains

Profit regulation

An alternative regulatory method involves placing a limit on the rate of return that firms can earn, thereby preventing them from making excessive supernormal profits.

During 2022, significant rises in oil and gas prices fuelled inflation and caused many households to struggle with energy bills. Simultaneously, some oil producers announced substantial profits. This raised the question of whether profit caps would be appropriate in such circumstances.

Another approach considered was imposing a windfall tax on energy producers to recover some of the profits being earned. Although some large companies appeared to be making substantial profits in the UK, they also had to pay taxes on operations elsewhere. Nonetheless, the 2022 Autumn Statement announced an increase in the Energy Profits Levy from 25% to 35%.

Quality standards

By the mid-2010s, concerns had grown about the effectiveness of price regulation alone. There was a perception that companies were focusing too heavily on cost-saving rather than output delivery, and that they were pursuing static rather than dynamic efficiency. Environmental issues and output quality were receiving insufficient attention.

The regulators Ofwat (water) and Ofgem (gas and electricity) acted to phase out the RPI minus X controls, replacing them with the RIIO method. RIIO stands for Revenue using Incentives to deliver Innovation and Outputs.

RIIO is a price control mechanism that specifies the outputs companies must deliver and the revenue they can earn for delivering these outputs efficiently. The aim is to provide better incentives for companies to meet quality standards, rather than focusing solely on costs.

Performance targets

Under RIIO, companies that deliver their output targets within budget gain additional revenue generation. However, companies that fail to meet their performance targets face financial penalties. Companies must report to their regulator on an annual basis.

In water supply, the government strategy requires companies to provide social tariffs for customers who cannot afford to pay for water. This is monitored as part of the performance approach.

Some limitations of the regulatory approach

Promoting competition and contestability

Beyond direct regulation, governments intervene in various ways to promote competition. This reflects the view that competition provides the best way of ensuring consumer protection and efficient resource allocation. It is also important that contestability can be introduced to discourage dominant firms from abusing their market power.

Encouragement of small businesses

Measures exist to encourage small businesses to grow and compete effectively. Following the wake of the 2008/09 financial crisis, the UK government was particularly keen to restore confidence in the economy.

The Department of Business Innovation and Skills (BIS) noted that small and medium-sized enterprises (SMEs) provided nearly 60% of jobs and 50% of GDP. A new set of measures to help small businesses was launched in 2010/11, including steps to improve access to finance and provide other forms of support. The underlying rationale was to help small businesses compete more effectively and provide targeted support to small firms with high growth potential.

However, promoting small businesses carries an opportunity cost for government, as it may divert funds from elsewhere. It may also work against market pressures under which large firms might operate more efficiently.

Deregulation

Deregulation occurs when a government removes restrictions placed on producers in a market to encourage competition. This reflects the belief that competition benefits consumers by encouraging innovation and efficiency improvements, and by limiting the market power of firms.

The main argument for deregulation is that over-regulated firms may become complacent, which can result in X-inefficiency. Over-regulation may stifle innovation and risk-taking that could otherwise lead to new developments benefiting consumers.

Deregulation can lead to more intensive competition. Until 2006, the Royal Mail held a monopoly in the postal service market in the UK, having maintained that position for 350 years. Action was taken to make the market more contestable. From 1 January 2016, any licensed operator could deliver mail to business and residential customers. This led to a surge of new businesses providing delivery services.

Direct provision or competitive tendering?

An approach that government could take to correct a market failure, or to improve resource allocation, is to undertake direct provision of a good. In the case of public goods, there must be some form of government involvement, as a free market will not ensure their provision.

Direct provision is closely akin to nationalisation, and many governments have been reluctant to follow this route. It has been recognised that the same arguments applying to the impact of competition on private sector efficiency are also relevant for public sector activity. Therefore, there is no guarantee that direct government provision will produce a more efficient allocation of resources. Furthermore, governments may not have the administrative or practical experience to engage directly in the production process.

However, direct provision is not the only way of ensuring a good is supplied. Several approaches have been developed whereby the public sector can ensure provision through some form of engagement with the private sector.

Contracting out

The simplest form of public-private cooperation is contracting out. Under this arrangement, the public sector issues a contract to a private firm for the supply of some good or service. One example is waste disposal, where a local authority may issue a contract for a firm to provide the necessary service.

Competition between firms can be encouraged by a competitive tendering process. In other words, the contract would be announced and firms invited to submit bids specifying the quality of service they are prepared to provide, and at what price. The local authority would then be positioned to choose the most competitive bid. The effectiveness of this approach would be reduced if firms engaged in collusive tendering.

Public-private partnerships

More complex models of cooperation between public and private sectors have been developed, involving various kinds of public-private partnership (PPP). A PPP is an arrangement by which a government service or private business venture is funded and operated through a partnership of government and the private sector.

The most common partnership model is the Private Finance Initiative (PFI), later reformed as PF2.

The Private Finance Initiative

The PFI was launched in 1992 as a way of trying to increase private sector involvement in the provision of public services. This established a partnership between the public and private sectors. The public sector specifies, perhaps in broad terms, the services it requires, and then invites tenders from the private sector to design, build, finance and operate the scheme.

In some cases, the project may be entirely free-standing. For example, the government may initiate a project such as a new bridge, which is then taken up by a private firm that recovers its costs entirely through user charges such as tolls. In other cases, the project may be a joint venture between the public and private sectors. The public sector could become involved with such a venture to secure wider social benefits, perhaps through reductions in traffic congestion that would not be reflected in market prices, and that would not be fully taken into account by the private sector. In other cases, it may be that the private sector undertakes a project and then sells the services to the public sector, often over a period of 25 or 30 years.

The aim of the PFI was to improve the financing of public sector projects. This is partly achieved by introducing a competitive element into the tendering process. In addition, it enables the risk of a project to be shared between the public and private sectors. This was intended to enable efficiency gains to be made.

One effect of the PFI is to reduce the pressures on public finances by enabling greater private sector involvement in funding. However, it might be argued that this may actually raise the cost of borrowing, if the public sector would have been able to borrow on more favourable terms than commercial firms.

The introduction of a competitive element in the tendering process may be beneficial, but on the other hand it could be argued that the private sector may have less incentive than the public sector to give due attention to health and safety issues. There may be a concern that private firms will be tempted to sacrifice safety or service standards in the quest for profit. Achieving the appropriate balance between efficiency and quality of service is an inevitable problem to be faced whatever way transport is financed and provided. However, it becomes a more critical issue to the extent that use of the PFI switches the focus more towards efficiency and lower costs.

Privatisation

During Margaret Thatcher's Conservative government in the 1980s, there was widespread privatisation (the transfer of nationalised industries into private ownership). One central argument was that this would force managers to be accountable to their shareholders, which would encourage an increase in efficiency.

However, this did not remove the original problem: that these industries were natural monopolies. Therefore, wherever possible, privatisation was accompanied by measures to encourage competition and contestability, which were seen as even better ways to ensure efficiency improvements. This proved more feasible in some industries than others because of the nature of economies of scale. There is little to be gained by requiring several firms in a market where economies of scale can be reaped only by one large firm. However, changing technology in some industries did allow some competition to be encouraged, especially in telecommunications.

Extension: anti-competitive behaviour

The CMA does not only investigate mergers and acquisitions, but also examines cartels (price-fixing) and other forms of anti-competitive behaviour by firms.

Price-fixing by firms in a cartel is illegal in most countries globally. In the UK it is potentially a criminal offence.

Intervention to protect suppliers and employees

Restrictions on monopsony power

The main focus of the CMA's work is on mergers and markets where there could potentially be problems with firms gaining a dominant position. In the past, the Competition Commission had also identified issues with competition involving a monopsony, rather than a monopoly position. A high-profile example involved UK supermarkets.

Large supermarkets form a major part of the food industry in the UK, providing consumers with low prices and a wide variety of products. However, issues were raised about the way some supermarkets were treating their suppliers and farmers. When small farmers are supplying supermarkets that have substantial buying power, there is a possibility of exploitation of market power.

The proposed merger of Sainsbury with Asda in 2018 raised concerns that the combined group would have enhanced monopsony power over its suppliers. This echoed concerns that had been rising over a number of years, notably the controversy over the pricing of milk in supermarkets. Farmers argued that the price they were receiving for milk at the farm gate was not covering their costs, and that the supermarkets were using the product as a loss leader at the farmers' expense. The CMA blocked this merger from taking place in 2019.

A monopsony producer is able to use its market power to control its supply chain and to keep its costs to a minimum. This may benefit consumers, who face lower prices for the final goods. However, the impact of a monopsony is to put pressure on suppliers, which may force some small enterprises out of business. It may also lead to less diversity in the range of goods on offer. Monopsony in a labour market may lead to lower levels of employment, with workers receiving lower wages. Control of monopsony may be needed to protect both suppliers and employees.

Nationalisation

In the past, one response to a natural monopoly would have been to nationalise the industry (take it into state ownership), since no private sector firm would be prepared to operate at a loss, and the government would not allow firms running such natural monopolies to act as profit-maximising monopolists making supernormal profits. Nationalisation would protect consumers from exploitation and also protect employees.

To prevent the losses from becoming too substantial, many utilities such as gas and electricity supply adopted a pricing system known as a two-part tariff system. Under this system, all consumers paid a monthly charge for being connected to the supply, and on top of that a variable amount based on usage. In terms of the natural monopoly diagram, the connection charge would cover the difference between $AC^*$ and $P^*$, spread across all consumers, and the variable charge would reflect marginal cost.

However, as time went by, this system came to be heavily criticised. In particular, it was argued that the managers of the nationalised industries were insufficiently accountable. The situation could be regarded as an extreme form of the principal-agent problem, in which the consumers (the principals) had very little control over the actions of the managers (their agents), a situation leading to considerable X-inefficiency and waste.

The impact of government intervention

Successive UK governments have taken serious action to promote competition, using a variety of tools and approaches. The objective of such intervention is to have an impact on a range of important indicators:

• Prices: If firms compete with each other on price, then consumers should gain as they will face lower prices than if firms are free to exploit their market power. However, low prices may not always be what consumers want to see
• Profits: If firms face intense competition, they may find their profits are eroded, and some firms may not be able to sustain their market position
• Efficiency: Firms facing intense competition may become efficient in the short run, in the sense that they are likely to eliminate X-inefficiency to reduce average costs. However, if profits are low, they may not be able to achieve dynamic efficiency by innovating and developing new products
• Quality: Firms facing severe competition may not be able to maintain quality standards in their production, or they may not be in a position to look for product improvements
• Choice: Competition may force firms to focus on a narrower range of products in order to keep their costs down

Competition should ensure that consumers face reasonable prices, with good-quality products and variety of choice. Indeed, the whole basis of the market system is that the consumer is king, and firms only make profit when they are producing the products that consumers wish to buy.

Evaluating effectiveness

How effective has intervention been in practice? This is difficult to evaluate, as it is not possible to observe how things would look in the absence of intervention. There have been instances where the CMA or its predecessors have stepped in to prohibit a merger or acquisition, or have set conditions that safeguard consumer interests. The number of merger cases brought to the CMA's attention seems high, but many are ruled as not being contentious or not meeting the threshold rules for investigation. It might be argued that the very existence of the CMA with its powers to intervene may act as a deterrent to anti-competitive actions.

Limits to government intervention

Government intervention through direct controls must be carefully designed to avoid introducing market distortions. This is reflected in the changing approaches over time that attempt to rectify flaws that have become apparent.

Regulatory capture

In some cases, regulatory capture is a problem. This occurs when the regulator becomes so closely involved with the firm it is supposed to be regulating that it begins to champion its cause rather than imposing tough rules where they are needed. In this situation, regulation is not likely to have the desired impact.

Asymmetric information

Asymmetric information can also come into play when the companies have better information about the way they are operating than their regulators. This makes it difficult for regulators to set appropriate targets or identify when firms are not operating efficiently. Firms may use their superior information to their advantage, making regulation less effective.