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Chapter 16: Competition policy, privatization and deregulation

INTRODUCTION Government economic policy is commonly designed to serve a variety of economic and political objectives.

Two broad approaches to industrial policy: y Laissez-faireapproach which views the role of government as unnecessary and advocates that its activities should be strictly limited to supporting and re-enforcing the operation of market forces. An active approach which argues for government intervention to improve the functioning of the market. In reality industry policy lies typically between two extremes. It consists of: y y y y Competition policy which attempts to influence the conduct of certain markets and firms. Regional policy which focuses on the location of industry. Innovation policy which aims to promote technological advancement. Trade policy designed to protect specific firms and industries.

I.

THE ECONOMIC FOUNDATIONS OF COMPETITION POLICY

I.I The acquisition and maintenance of market dominance Two main routes to the acquisition and maintenance of dominance can be distinguished: efficiency or the pursuit of market power. Dominance through efficiency gains: y Firms may acquire spare resources either because of economies of scale or scope or because of organizational improvements, enhanced know-how and expertise. If hiring or subcontracting the use of these surplus resources is very costly (due to transactional difficulties), efficiency is enhanced by internal expansion which, depending on the nature of the resources, will be vertical or horizontal, national or international. Expansion, however, may lead to dominance.

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Other means to dominance: y Legal protection:

Public authorities often grant monopoly rights to public utilities (electricity, water, gas, telecommunications, etc.) for reasons of productive efficiency since these industries are believed to be natural monopolies. Patents are another way of granting market power. y Collusion:

The aim of collusion is to reduce competition and facilitate monopolistic pricing. y Mergers:

They may occur for reasons of efficiency, and they are necessary for the takeover mechanism to exist which is at the heart of the market in corporate control. y Predatory behavior:

Predatory or strategic behavior may be used either to eliminate existing competition so as to acquire dominance or in order to discourage potential competition so as to maintain dominance, or both.

I.II The impact of market dominance Allocative inefficiencies

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y y

Assuming profit maximization the price, Pm, and output Qm, of the single-product whose cost and demand curves are AC0 and D. Compared with the perfectly competitive market price, Pc, and output,Qc, the monopoly output is too small and the price too high. That is, price is higher than marginal cost, implying that resource allocation under monopoly is less efficient compared with the competitive ideal. To identify the extent of distortion (net welfare loss), compare the monopoly price and output with that which maximizes social welfare. Social welfare is the sum of consumers and producers surplus (W=S+ ) Welfare loss (deadweight loss)associated with monopoly is indicated by the area ABC. In perfect competition the price Pc and there is no producer surplus (no long run profit). Consumers expenditure on Qc units is equal to area 0PcCQc but their true valuation of Qc is the total area under the demand curve so the consumers surplus is equal to area PcZC. The exercise of dominance implies that price increases to Pm which creates producers surplus (profit) equal to area PcPmABbut reducesconsumers surplus which is now equal to area PmZA. The welfare loss of monopoly depends on the size of the industry and the price elasticity of demand. The larger the extent of industrial monopolization and the more essential the monopolized products the larger the deadweight loss will be and the more significant the role of competition policy.

The above analysis implies that monopolization leads to allocative inefficiency. Production inefficiency and other effects of market dominance y The exercise of dominance does not simply imply a higher price. Dominance can manifest itself in the form of price discriminatory practices, vertical restraints and other restrictive conditions of sale or as an influence on the speed of innovation, the extent of advertising, investment and the variety and quality of output.

I.III Ownership and incentives Ownership objectives and performance y Economists assumed the objectives of public enterprises to be the maximization of social welfare and prescribed the pricing and investment rules that their management should follow to achieve its objectives. Public sector managers, however, are likely to pursue their own objectives unless effective monitoring and control systems operate which eliminate discretionary behavior. Objective of privately owned firms is to profit maximize, which implies marginal cost pricing and allocative efficiency in the case of perfectly competitive markets. When the market is dominated by one firm, profit maximization is achieved when the output is such that marginal revenue equals marginal cost and the price is higher than marginal cost implying allocative inefficiencies. Public sector managers select the output that maximizes social welfare. They therefore produce more output and set a lower price compared with private sector managers. Thus, public enterprises would be more efficient than their private sector counterparts.

y y y

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Ownership and managerial incentives y Privately owned competitive firms are likely to achieve both productive and allocative efficiency since the controls and incentives that operate under private ownership tend to promote productive efficiency while competition promotes allocative efficiency. When competitive pressures are absent or ineffective, it is likely that privately owned firms may not perform better than publicly owned ones. Public ownership may impede market competitiveness. The opposite may indeed be true since the public enterprises often operate under legal protection which makes the market noncontestable.

y y

II. II.I

COMPETITION POLICY UK competition policy Competition Act 1998 introduces block prohibitions under two chapters.

Chapter I prohibits any:

agreements between undertakings, decisions by associations of undertakings or concerned practices which a) may affect trade within the UK, and b) have as their object or effect the prevention, restriction or distortion of competition within the UK. y Chapter II prohibits the abuse of a dominant position. It specifies that:

conduct may in particular constitute such an abuse if it consists in a) imposing unfair purchasing or selling prices or other unfair trading conditions; b) limiting production, markets or technical development to the prejudice of consumers; c) applying dissimilar conditions to equivalent transaction with other trading parties, thereby placing them at a competitive disadvantage; d) making the conclusion of contracts subject to acceptance by other parties of supplementary obligations which have no connection with the subject of the contract. II.II y EC competition policy

The Commission of the ECs views competition policy as a means to promoting market competitiveness and structural readjustment, the main aim of which is to prevent practices which eliminate competition between member states and adversely affect the economic integration of Europe. The fundamental provisions of EC policy are included in Articles 85 and 86 of the Treaty of Rome. Article 85(1) prohibits all agreements between undertakings, decisions by associations of undertakings, and concerted practices which have as their object or effect the prevention, restriction or distortion of competition within the Common Market. Article 86(1) is concerned with market dominance. It condemns

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any abuse by one or more undertakings of a dominant position within the Common Market or a substantial part of it in so far as it may affect trade between Member States. Article 86 specifies that abuse may consist in unfair purchasing or selling, restricting production or technological development, discrimination, etc., while a dominant position has been defined by Court of Appeals as a position of economic strength enjoyed by an undertaking which enables it to prevent effective competition being maintained on the relevant market by affording it the power to behave to an appreciable extent independently of its competitors, its customers and ultimately of the consumer.

II.III

US competition policy

y y

The Sherman Act prohibits trade restriction and outlaws monopolization or attempts and conspiracies to monopolize. The Clayton Act outlaws price discrimination and prohibits certain vertical restraints such as tie-in sales as detrimental to competition.

In brief, while competition in the USA id essentially consistent with the SCP (structure-conductperformance) paradigm (until the late 70s), in the UK it has adopted a more pragmatic approach and EC policy favors more of a free market Austrian approach.

III.

PRIVATIZATION

Aims of privatization: y To improve the economic performance of the enterprise or service transferred to the private sector; y To improve competition by market liberalization; y To widen share ownership as a means to popular capitalism; y To reduce the public sector borrowing requirement; y To resolve conflicts that had arisen between public sector management and the government by reducing the government involvement in industry; y To discipline public sector trade unions; y To gain a political advantage.

IV. y y y

DEREGULATION AND FRANCHISING Deregulation is the policy of removing regulatory constraints on a market. It facilitates the introduction of competition and thus induces a better economic performance. It can apply to any market, whatever the ownership of the firms that operates within it and leads to liberalization.

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Contestability theory has revived interest in an old solution to market liberalization in the case of sustainable natural monopolies (gas, electricity, water): franchising. The essence of franchising is the argument that excess profits can lead to competition for the market rather than competition in the market (Bailey and Friedlander 1982). Since introducing competition in production is inefficient, the government retains state ownership or regulation of production but introduces competition by auctioning the right to the monopoly. The winner of auction gains the contractual right (franchise) to be the monopolist for a certain period of time, at the end of which the contract is renewed by competitive bidding. Franchising enhances productive efficiency since the holder if the franchise will attempt to minimize production costs in order to increase profits. If the franchise is awarded to the lower bidder it can be shown that allocative efficiency will also improve.

QUESTIONS: 1. ..is an approach which views the role of government as unnecessary and advocates that its activities should be strictly limited to supporting and re-enforcing the operation of market forces. A) Active C) Passive B) Laissez-faire D) Competition 2. The aim of is to reduce competition and facilitate monopolistic pricing. A) Collusion C) Franchising B) Privatization D) Deregulation 3. ..is the policy of removing regulatory constraints on a market. A) Franchising C) Deregulation B) Privatization D) Collusion 4. Which one is NOT one of the aims of privatization? A) To improve competition by market liberalization; B) To widen share ownership as a means to popular capitalism; C) To reduce the public sector borrowing requirement; D) To reduce a political advantage; 5. The essence of ..is the argument that excess profits can lead to competition forthe market rather than competition inthe market (Bailey and Friedlander 1982). A) Franchising C) Deregulation B) Collusion D) Privatization