Competition policy

Competition and the government

An awareness that market failure can arise from imperfect competition has led governments to introduce measures designed to promote competition and protect consumers. Such measures are known as compeititon policy.

A key focus of such legislation in the past has been monopoly, as economic analysis highlighted the allocative inefficiency that can arise in a monopoly market if the firm sets out to maximise profit. More recently however, the scope of legislation has widened, and since 1997 competition policy has been toughened significantly.

Underlying this aspect of government policy has been the growing belief tat competition induces firms to eliminate X-inefficiency as well as encouraging better resource allocation. However, this must always be balanced against the possible sacrifice of economies of scale if competition can only be enabled by fragmentation of the production process. The question of contestability is also important, as it is possible that the very threat of competition may alter firms behaviour.

X-inefficiency does not only occur in the private sector, and a further set of measures has tried to address the question of efficiency in the provision of public sector services by encouraging some private sector firms to be involved in partnership with the public sector in its economic activities.

Economic analysis and competition policy

In a previous article I have compared the structures of perfect competition and monopoly, and it is this analysis that lies at the heart of competition policy.

This diagram should remind you somewhat. Here it is assumed that there is an industry that can operate under perfect competition with lots of firms, or as a multi-plant monopolist.

Under perfect competition, price would be set where MC = AR, supply equals demand, at price Pc and quantity Qc. However, a monopolist would restrict output to Qm and raise price to Pm. Consumer surplus would be reduced by this process due to the deadweight loss. It is this deadweight loss that imposes a cost on society that competition policy is intended to alleviate.

Indeed, this analysis led a belief in what became known in economics literature as the structure-conduct-performance paradigm. At the core of this belief, is the simple idea that the structure of the market, in terms of the number of firms, determines how the firms conduct themselves and therefore determines how well the market performs in achieving productive and allocative efficiency.

Thus, under perfect competition firms cannot influence price, and all firms act competitively to maximise profits, thereby producing good overall performance of the market in allocation resources. On the other hand, under a monopoly the single firm finds that it can extract consumer surplus by using market power, and as a result the market performs less well.

This point of view leads to a distrust of monopoly, or indeed of any market structure in which firms might be seen to be conducting themselves in an anti-competitive manner. Moreover, it is the structure of the market itself that leads to anti-competitive behaviour.

If this line of reasoning is accepted, that a monopoly is always bad, and mergers that lead to higher concentration in a market will always lead to allocative inefficiency in the market performance. Thus, legislation in the USA tends to presume that a monopoly will work against the interest of society. However, there are some important issues to consider before pinning much faith on this assumption.

Cost conditions

The first issue concerns the assumption that cost conditions will be the same under perfect competition as they are under monopoly.  This simplifies the analysis, but there are many reasons to expect that economies of scale in a number of economic activities. If this assumption is correct, then a monopoly firm will face lower cost conditions that would apply under perfect competition.

In the diagram above, LRSpc represents the long run supply schedule if an industry is operating under perfect competition. The perfectly competitive equilibrium would be at output Qpc and Ppc. However, suppose that a monopolist had a strong cost advantage, and was able to produce at a constant long-run marginal cost LMCm. It would then maximise profit at QmPm. In this situation, the monopolist would actually sell more at a lower price than a firm under perfect competition.

Notice that in the monopoly situation, the market does not achieve allocative efficiency, because with these cost conditions setting P to MC, or AR to MC would require the firm to produce a huge amount of output. However, this loss of allocative efficiency is offset by the improvements in productive efficiency that are achieved by the monopoly firm.

It could be argue that the monopolist should be regulated, and forced to produce at the allocative efficient amount. However, what incentives would this establish for the firm. If a monopolist knows that whenever it makes supernormal profits the regulator will step in and take them away, it will have no incentive to operate efficiently. Indeed, Joseph Schumpeter argued that monopoly profits were an incentive for innovation, and would benefit society, because only with monopoly profits would firms be able to engage in R&D. In other words, it is only when firms are relatively large, and when they are able to make supernormal profits, that they are able to devote resources to R&D. Small firms operating in a perfectly competitive market do not have the resources nor the incentive to be innovative.

This diagram, with less drastic differences in cost conditions, shows the deadweight loss due to monopoly power in red, but also the gain in productive efficiency in green. This is part of monopoly profits, but under perfect competition it would be production cost. In other words, production in a monopoly is less wasteful in its use of resources in the production process.

Is society better off under monopoly or perfect competition? In order to evaluate the effect on total welfare, it is necessary to balance the loss of allocative efficiency against the gain in productive. It would seem in the above diagram that the rectangle is larger than the triangle, so society is better off with the monopoly. Of course, there is also the distribution of income to take into account – some consumer surplus becomes part of the monopolies profits.

Contestibility

A second important issue concerns contestability. If barriers to entry are weak, and if the sunk costs of entry and exit are low, the monopoly firm will need to temper its actions to avoid potential entry.

Thus, in judging a market situation, the degree of contestability is important. If the market is perfectly contestable, then the monopoly firm cannot set a price that is above average cost without allowing hit and run entry. In this case, the regulator does not need to intervene. Even without perfect contestability, the firm may need to set a price that is not so high as to induce entry. In other words, it may choose not to produce at the profit maximising level of output, and to set a price below that level.

Concentration and collusion

The structure-conduct-performance argument suggests that it is not only monopolies that should be the subject of competition policy, but any market in which firms have some influence over price. So, oligopolies also need careful attention, because of the danger that they will collude and act as if they were a joint monopoly. After all, it was argued that where a market has just a small number of sellers there may be temptation to collude, either as a cartel or tacitly. For this reason, government authorities may be wary of markets in which concentration ratios are simply high, even if not at 100%.

For this reason, it is important to examine whether a concentrated market is always and necessarily an anti-competitive market. This is tantamount to asking whether structure necessarily determines conduct. A high concentration ratio may mean that there is a small number of firms of more or less equal size, or it could mean that there is one large firm and a number of smaller competitors. In the latter case, you might expect the dominant firm to have sufficient market power to control price.

With a small number of equally sized firms it is by no means certain that they will agree to collude. They may be very concious of their respective market shares, and so act in an aggressively competitive way in order to defend them. This may be especially true when the market is not expanding, so that a firm can only grow at the expense of other firms. Such a market could well display intense competition, causing it to tend towards the competitive end of the scale. This would suggest that the authorities should not presume guilt in a merger investigation, since the pattern of market shares may prove significant in determining the firms conduct, and hence the performance of the market.

Globalisation

Another significant issue is that a firm comes that comes to dominate a domestic market may still face competition in the broader global market. This may be especially significant in the European single market. In this regard, there has been a longstanding debate about how a domestic government should behave towards large firms. Some economists believe that the government should allow such firms to dominate the domestic market so that they can become ‘national champions’ in the global market. This has been especially apparent in the airline industry, where some national airlines are heavily subsidised by their national governments in order to allow them to compete internationally. Others have argued that if a large firm faces competition within the domestic marker, this should help encourage productive efficiency, enable it to become more capable of comping with international competition.

Summary

  • Competition policy refers to a range of measures designed to promote competition in markets and to protect consumers in order to enhance the efficiency of markets in resource allocation
  • One view is that market structure determines the conduct of firms within a market, and this conduct then determines the performance  of the market in terms of allocative efficiency. This is called the structure-conduct-performance model
  • However, there may be situations in which the monopolist can enjoy economies of scale, and thereby gain productive efficiency.
  • In the presence of contestability, a monopolist may not be able to charge a price above average cost without encouraging hit and run activity
  • In a concentrated market, the pattern of market shares may influence the intensity of competition between firms.
  • A firm that is a monopoly in its own country may be exposed to competition in the international markets in which it operates.
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