Economics (9640) | Competition policy

Welcome to the World of Competition Policy!

Hello Economists! You've spent a lot of time learning about different market structures, from the ideal world of perfect competition to the powerful grip of monopoly. We know that monopolies and dominant firms often lead to higher prices, lower output, and inefficiency (a misallocation of resources).

So, what does the government do about this? They use Competition Policy!

This chapter is about the tools and rules governments use to keep markets fair, encourage rivalry, and stop powerful firms from exploiting consumers. It’s essentially the government acting as a referee in the economic game!

Key things you will learn:
1. How governments try to prevent firms from abusing their dominance.
2. How mergers are regulated.
3. The different tools used to promote market rivalry.

What is Competition Policy?

Definition and Core Objectives

Competition Policy refers to the government's set of laws, regulations, and administrative rules designed to promote competition and fair trading in markets, primarily by controlling the actions of firms with significant market power.

The main goal of competition policy is to enhance economic welfare, specifically consumer welfare. They achieve this by promoting various forms of efficiency:

• Allocative Efficiency (ensuring P = MC).
• Productive Efficiency (ensuring firms produce at the lowest possible cost).
• Dynamic Efficiency (encouraging innovation and R&D).

Tools of Competition Policy: Dealing with Market Power

Competition policies typically target three main areas where firms misuse their power: abuse of dominance, excessive concentration (mergers), and anti-competitive agreements (collusion).

Controlling the Abuse of Monopoly Power

If a firm holds a dominant position in the market (meaning they have significant market share and power, but are not necessarily a pure monopoly), the policy focuses on preventing them from exploiting this power unfairly.

An "abuse" occurs when a dominant firm acts in a way that harms competition or consumers.

Examples of Abusive Practices:

• Excessive Pricing: Charging prices that are much higher than costs over a sustained period, harming consumers.
• Predatory Pricing: Setting prices below average variable cost (AVC) temporarily to drive smaller competitors out of the market. (Analogy: This is like a wealthy parent giving out free high-quality toys to stop the neighborhood toy shop from operating, knowing the shop owner can't afford to compete).
• Refusing to Supply: Denying rivals access to an essential facility or resource owned by the dominant firm.
• Tying and Bundling: Forcing a customer to buy one product (the less desired one) in order to buy a second product (the desired one).

The Competition Authority (like the CMA in the UK) investigates these abuses and can impose massive fines if rules are broken.

Key Takeaway: Competition policy doesn't just hate big firms; it hates bad behaviour by big firms.

Regulating Mergers and Takeovers

When two firms combine (a merger), the resulting entity usually has a larger market share and, therefore, increased monopoly power. Competition authorities scrutinize mergers to ensure they do not substantially reduce competition.

The Process of Regulation (Simplified Step-by-Step):

1. Notification: Firms planning a large merger must notify the competition authority.
2. Investigation: The authority investigates whether the merger will lead to a Significant Reduction of Competition (SRC).
3. Decision: The merger can be approved, approved with conditions (e.g., forcing them to sell off certain parts of the business), or blocked entirely.

Did you know? In 2021, the UK's CMA investigated Facebook's (Meta's) acquisition of Giphy, fearing it would limit competition in the animated images market, eventually forcing Meta to sell Giphy back. This shows competition policy actively intervening in tech markets.

Controlling Restrictive Practices (Collusion and Cartels)

Sometimes, firms choose not to compete, even if they aren't dominant individually. They agree amongst themselves to fix prices or divide up markets. This is called collusion, and when formalized, it becomes a cartel.

Restrictive Practices are agreements between firms that limit competition, often involving:

• Price Fixing: Agreeing on a common price, eliminating the incentive for price competition.
• Market Sharing: Dividing a geographic area or group of customers among firms.
• Output Restriction: Agreeing to limit total output to keep prices high.

These practices result in monopoly outcomes (high prices, low output) even without a single dominant firm. Competition policies treat these practices very seriously, often imposing the harshest penalties.

Memory Aid: If you spot a cartel, remember the firms are trying to get away with PRICE:
Pricing schemes
Restricting output
Interfering with tenders/bids
Colluding (secret agreements)
Exploiting the consumer

Measures to Promote Competition and Reduce Entry Barriers

Prevention is often better than cure. Rather than constantly chasing abusive monopolists, competition policy also focuses on making markets more competitive in the long run. This is achieved by tackling barriers to entry.

Policies to Enhance Competition:

• Deregulation: Reducing legal barriers (e.g., simplifying licensing requirements).
• Liberalization: Opening up state-owned monopolies (like utilities or telecoms) to private sector competition.
• Patent Reform: Reducing the length or scope of patent protection to allow rivals quicker access to new technologies (though this must be balanced against incentivizing R&D).
• Promoting Small Firms: Providing grants or legal protection to startups to help them challenge existing incumbents.

Key Takeaway: By lowering sunk costs and legal requirements, the government encourages contestable markets, making dominant firms behave competitively even if no new firm actually enters.

Price and Profit Controls

In some cases, especially concerning natural monopolies (like railways or water utilities) where competition is impractical or inefficient, the government might impose direct controls.

Price Caps: The regulator sets a maximum price the firm can charge.
Example: A regulator might cap water prices to RPI - X (Retail Price Index minus an efficiency factor X). This forces the utility to cut costs to maintain profit, thus promoting productive efficiency.

Profit Controls: The regulator sets a maximum rate of return (profit) the firm can achieve.

Benefits of Controls: They directly prevent the firm from setting the monopoly price, resulting in lower prices and greater output for consumers (improving allocative efficiency).

Drawback: Regulators face asymmetric information. They don't know the firm's true costs, meaning the regulated price might be set too high (still allowing excessive profit) or too low (threatening the firm's long-term survival or investment).

Evaluating Competition Policy: The Economic Debate

Competition policy is expensive and complex, so economists constantly debate whether the benefits outweigh the costs and limitations.

Arguments in Favour of Competition Policies (The Benefits)

Competition policies address market failure caused by monopoly power and lead to improvements in economic welfare.

• Lower Prices and More Choice: By banning price fixing and promoting entry, firms are forced to compete for consumers, leading to prices closer to Marginal Cost (P=MC).
• Increased Efficiency: Firms must become productively efficient (lowering their costs) to survive competition, and dynamic efficiency improves through the rivalry spurred by new entrants.
• Stimulating Innovation: The constant threat of rivals encourages dominant firms to invest heavily in R&D to maintain their market edge.
• Fairer Distribution: Competition prevents large amounts of consumer surplus from being transferred to monopoly profit, leading to a more equitable outcome.

Limitations and Costs of Competition Policies (The Arguments Against)

Even well-intentioned policies face significant hurdles in the real world.

1. Information Problems and Costs:

• Administrative Costs: Investigation, legal work, and enforcement are costly for taxpayers.
• Asymmetric Information: Regulators struggle to determine if prices are "excessive" because only the firm knows its true costs. If they guess wrong, they might damage essential investment.
• Risk of Type I/Type II Errors: Blocking a beneficial merger (Type I error) or allowing a harmful merger (Type II error).

2. Regulatory Capture:

• This occurs when the regulatory body, intended to act in the public interest, ends up acting in the interest of the firm it is supposed to be regulating. (Analogy: The school referee starts taking bribes from the richest team captain). This often happens because the firm has better information and offers future jobs to the regulators.

3. Loss of Economies of Scale:

• Monopolies, especially natural monopolies, achieve massive internal economies of scale, leading to very low average costs. Breaking them up might increase competition but simultaneously raise average costs for the smaller resulting firms, leading to higher prices.

4. Conflicts with Dynamic Efficiency:

• The prospect of abnormal profit is a crucial incentive for firms to undertake risky and expensive R&D. If the government constantly threatens to control prices or break up successful firms, this reduces the incentive for innovation.

Key Takeaway: The Evaluation Balance

The success of competition policy depends on finding the right balance: encouraging efficiency and low prices today, while still allowing enough profit and market size to incentivize massive investment and innovation for tomorrow.