Government Intervention Flashcards
What are the basic principles of government intervention and how can these be questioned?
Basic principles:
UK(&EU) competition policy starts on the assumption that monopolies are “bad” and competition is “good”. There is a net welfare loss in a monopoly, perfect competition is both allocatively&productively efficient, consumers gain from a wider choice and better quality under competition.
This assumption can be challenged in a number of ways: existence of EoS, contestability, the idea that profits can finance investment. Large firms may still struggle in the global market.
What is the CMA and what is it responsible for(6)?
The Competition & Markets Authority is a body established to oversee UK competition policy. It is responsible for:
- investigating mergers
- conducting market studies
- investigating possible breaches of prohibitions against anti-competitive agreements
- bringing criminal proceedings against individuals who commit cartels offences
- enforcing consumer protection legislation
- encouraging regulators to use their competition powers
How does the CMA prevent collusion and cartels?
If the CMA can prove firms are acting in anti-competitive manner (“restrictive practices”) and are abusing their market power it can fine them up to 10% of their worldwide revenues and individual directors can face prison sentences.
To encourage “whistle blowing” any firm involved in anti-competitive practices, but then confesses & provides evidence against others is given amnesty. These measures should, in themselves, discourage price fixing.
How does the CMA regulate mergers?
lf 2 firms plan to merge (or have recently merged) they may be investigated by the CMA if either
- The newly merged firm will have 25%+ market share
- The firm being taken over has a revenue of £70 million+
OR
- It is in a ‘strategically important’ industry (water, newspapers…)
The CMA will consider whether the merger will result in “a substantial lessening of competition within any market…in the UK”
The CMA has a number of options- it can allow the merger, ban the merger or allow it under certain conditions (this may involve selling off parts of the new firm or putting price restrictions or improving contestability).
How does the CMA work in general?(4)
- Relevant markets
They use the “hypothetical monopoly test” to determine the market. This says the market is the “smallest set of products & producers such that a hypothetical monopolist could raise profits by a small increase in price.”(usually 5%). This is to effectively see whether there are any substitutes or to measure the XED of products.
- “Substantial Lessening of Competition”
If the CMA is happy the merged firm has 25% of the market it must then decide if there will be a lessening of competition. This involves looking at a number of areas, such as:
- Power of other firms in the industry
- Level of contestability in the industry (particularly barriers to entry/ sunk costs)
- Opportunities to “abuse” market power- often linked to possibility of price discrimination or using market power to force out other firms.
- EU legislation
With firms increasingly global & especially within the EU some form of international control is also required. The EU competition policy which is similar to the UK, run by the Directorate Genera for Competition, part of the European Court of Justice.
- “Public Interest”
In a few, strategically important, industries a wider criteria than “lessening of competition” may be used & is often passed on to a government minister for a final decision. This may look at is such as national security, employment issues, control of technology etc.
What is nationalisation and privatisation?
After WWII the UK government “nationalised” many industries. The that a single nationalised industry would be able to achieve economies of scale & would not have to profit maximise. This should mean lower prices & greater quantities.
However, many nationalised industries failed to live up to expectations. They became inefficient lacked inefficiency”), since there was no incentive to reduce costs & offered a poor quality prod innovation, since there was no incentive to increase revenues.
The 1980s saw a massive programme of “privatisation”. This involved selling off many nationalised industries British Gas, BT, Rolls-Royce…), but also includes “deregulation This is where the state removes legal barriers to new firms entering a market, often licensing restrictions. It also includes “contracting out”, where the government/local council sell contracts to provide services to private firms rather than providing the service itself.
How can the government regulate privatised industries?
The danger with privatisation is that selling off a state monopoly may just create a private monopoly which will not act in consumers interests & be worse than a state run monopoly.
In order to overcome this danger there are 2 main options:
- Break up the state monopoly into a number of firms, who would then compete with each other & with private companies that can enter the market. This has been done in the bus/coach markets. However there are 2 problems: if a natural monopoly was broken up the economies of scale would be lost, AC would rise & prices would rise. Also there is the danger of “creaming off” the new private companies only offer the product in the areas it is most profitable & some other areas lose the product
- Setting up a “regulator”, which acts as a “surrogate for competition”. In other words the regulator forces the firm to behave as if it were in a competitive market. In the UK regulatory agencies were set up for the utilities- OFGEM (office for Gas & Electricity Regulation), OFWAT (water supplies), OFCOM (telecom). These regulators set limits on prices (& possibly profits) & set performance targets for the business
What is the role of the regulatory agency?
The first role of the regulator is to stop the firm abusing its monopoly position.
In the USA regulators use the “rate of return” principle- the regulator sets a maximum profit as a percentage of the size of the business (based on the capital employed/ assets). Any profit above this level is taxed at 100%. The problem with this is it does not encourage the firm to become more efficient if costs rise it can simply raise prices & maintain profit levels.
In the UK regulators use “price capping”, where they set a maximum price the firm can charge. The advantage is that if the firm can become more efficient & reduce its costs then it can make greater profits, but the consumer is not “exploited” since prices are limited.
Finally the regulator may want to ensure a good quality service, so it sets performance targets which have to be met or else the firm will be fined.
What are the two ways to price cap?
To price cap the regulator may use the “RPI-x” formula. The firm will be allowed to increase prices by inflation (RPI) MINUs a which the regulator thinks the firm ought to be able to save by being more efficient. ie ifthe regulator believes the firm should be able to make 5% efficiency savings & RPI/inflation is 3% then the firm must cut prices by 2% (3-5=-2).
The alternative is to use “RPI+K”. The idea here is the firm may need to make some capital investments & so should be allowed to make more profit to finance this. K is then the amount to be reinvested, so the firm can raise prices by inflation a bit extra (K). The idea is again if the firm can cut other costs it can increase profits further & the consumers will gain, even though prices have risen by more than inflation, because the investment will improve the quality in the long term.
What are the issues with regulation?
The main problem with price capping is determining the value of “X” or “K”. There is a danger of “regulatory capture”- this is where the regulator builds a good relationship with the firm & is “generous” in its calculation of the cap or there may be asymmetric information where the regulator cannot know the cost structure of the firm & so not be able to set an accurate cap.
There is also an issue with how long the price cap should be fixed. If the period is too short it may encourage firms to take a short term view (especially if they have been awar contract to run an service) & they won’t invest. However, too long and an unpredicted events may make the price cap “too soft” (ie if some form of cost cutting technology was discovered) or “too harsh” (if costs rose unexpectedly).
It is notoriously difficult to set performance targets which can’t be “twisted” by the firm, to make them appear to perform well when in reality they don’t.
What is contracting out?
Contracting Out - a situation in which the public sector places activities in the hands of a private firm and pays for the provision.
What is competitive tendering?
Competitive tendering - a process by which the public sector calls for private firms to bid for a contract to provide a good or a service. The local authority looks for efficiency in choosing the most competitive bid.
What is a PPP?
Public-Private Partnership - an arrangement by which a government service or private business venture is funded and operated through a partnership of government and the private sector.
What is the PFI?
The Private Finance Initiative - a funding arrangement under which the private sector designs, builds, finances and operates an asset and associated services for the public sector in return for an annual payment linked to its performance in delivering the service. The public sector specifies, in broad terms, the services it requires and then invites tenders from the private sector to design, build, finance and operate the scheme. It can then be a free-standing project or a joint venture between the public and private sectors. 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 is to improve the financing of public sector projects. This is partly achieved by introducing a competitive element to the tendering process, but 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.
What are the criticisms of the PFI?(2)
- Despite reducing the pressure on public finances by enabling greater private sector involvement in funding, it may raise the cost of borrowing, as the public sector would have been able to borrow on more favourable terms.
- Private firms may prioritise efficiency and low costs over quality of the service (health and safety).
