Why does the government intervene in markets to maintain competition?

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Privatisation
What is privatisation? 1. Sale of state owned shares in companies (more relevant recently) 2. Contracting out of services previously provided by the state, aka compulsory competitive tendering, e.g. in school cleaning, refuse collection etc. 3. Selling of individual state assets 4. Deregulation Why were firms privatised? Improve efficiency: nationalised industries were accused of X-inefficiency the profit motive after privatisation would ensure this would be eliminated. Improving the quality and range of services: the profit goal and the discipline of the market would ensure this, as to attract customers producers would have to provide a range of high quality goods. Lower prices: these would result from competition. Widening of share ownership: if more of the labour force become shareholdsers, it is likely that they wont view the company owners as capitalists who are opposed to them. Revenue raising: the sale of state owned assets and shares delivered a one-off boost to government revenue and thus a reduction in public sector borrowing. Global competition: new companies would be strong and efficient enough to compete on a global scale. However, the attainment of some of these aims is not necessarily easy privatisation can create a private monopoly (as firms arent automatically created) and exposes the economy to the disadvantages of monopoly. New competition would, however, create a greater degree of allocative efficiency. It is partially for these reasons that regulatory bodies have been set up to oversee the privatised industries and act as a surrogate for competition this is to protect the consumer from the potential abuse of monopoly power/disadvantages of competition. Regulation is particularly important in the water industry, where there are regional monopolies. Has privatisation been successful? Raised government revenue - 90bn between 1979 and 1997. Loss making firms began to make a profit. Previously state owned firms are no longer such a burden only postal services and rail networks still really receive funding from the government. Led to huge losses in the coal, steel and telephone sectores. Desire for wide shareholder ownership among the population has not been achieved to a significant extent. Contracting out of public services such as hospital cleaning and court security has led to a decline in quality.

Energy: Real prices of gas and electricity fell in the 1990s similar in telecommunications. But major oil price rise in 2008 and rise in gas prices believed to be due to tacit collusion amongst the big six suppliers. Energy companies some consumers are not aware that theirs isnt the cheapest or they cant be bothered to switch suppliers customer inertia. Many domestic consumers overpay on their energy bills. Water: Water bills have risen significantly since privatisation in 1989. OFWAT was able to reduce customers bills on average due to large efficiency improvements in 1999. OFWAT prevented regional water providers from raising prices more than 18% from 2004-5, due to efficiency gains they thought could be made. Rail:

Not as successful collapse of Railtrack. Regulated rail fares rose in real terms since 1997. Standard of service worsened for several years after privatisation. BUT more recently there have been improvements to track infrastructure as investment has begun to pay off. More trains are now arriving on time. There has been a lot of investment via the government for rail infrastructure, although this is set to decrease in the next few years.

Regulation
Duties of regulators: 1. Make the firm act as if they were in a competitive market 2. Once there is competition the regulator has to consider price 3. They will seek to reduce barriers to entry and exit Regulation of privatised industries in the UK: Telecoms regulated by OFTEL (Office of Telecommunications) which was replaced by OFCOM (Office of Communications) in 2003. Gas OFGEM (Office of Gas and Electricity Markets), formerly OFGAS (Office of Gas Supply). Electricity OFGEM, formerly OFFER (Office of Electricity Regulation). Water Office of Water Services (OFWAT) and the Environmental Agency. Railways ORR (Office of the Rail Regulator) and the Strategic Rail authority. Price Capping: RPI-X: this takes the retail price index (measure of inflation) and subtracts a factor X, which is determined by the regulator. X represents the efficiency gains that the regulator has determined can reasonably be achieved by the firm. It does give the firms the opportunity to plan investment programmes and estimate with some accuracy their revenue streams. This method was once used to regulate British Telecom:

Between 1997 and 2002 the price formula for telecoms was RPI 4.5% E.g. if RPI inflation was 8%, BT would be able to raise its prices by 3.5%

RPI + K: uses the RPI and adds K, which represents the additional capital spending that a firm has agreed with the regulator is necessary. This is used by the water regulator to determine regional prices for water companies. The K factor is different for each company, depending on how much they are required to spend to maintain and improve their quality of service. Advantages: - Firms are allowed to keep any profits they make if they improve efficiency to a greater level than the regulator deemed was reasonable. - Because the X or K factor is in place for 5 years, firms can plan ahead and know that they will not be penalised for making further efficiency gains. Criticisms: - Setting the figure for X and K is difficult. - The firm needs to provide accurate information about its costs to the regulator it may not do so. - If X is set too high then the company will have insufficient funds to invest and the standard of service will fall. - If X is set too low then excessive profits will be earned these profits are often used to invest in other areas which the regulator cant control to make even more profits. - Length of time if X is set for too long then changes in market conditions cannot be taken into account. - If it is too short and there isnt enough of a time scale it will be difficult for companies to plan ahead with long term investments. - Sometimes the regulator and the regulated industry have built up a close relationship, with the regulator being less strict on the firms under its control this is often referred to as regulator capture. Rate of return: Used in the US before price capping was adopted there. Allows a firm to make a certain level of profit based on their capital before the remainder of the profit is taxed at 100%. The regulator sets what it thinks is a normal rate of return on the capital employed in the business. Rate of return is set higher than the interest paid to acquire the capital. Criticisms: - There is no incentive to make efficiency gains past a certain level there is no profit motive. - Firms arent rewarded for their success they are in fact penalised for it and encouraged to make limited profits. - Firms are encouraged to overstate the value of their capital to ensure that they can increase the rate of return on their investment increasing their profits imperfect information. Performance targets: Regulator can set performance targets that it will then monitor. These may be based on improvements in the quality of service or reductions in the number of customer complaints. This may be supported by a system of fines should the firm fail to meet the targets/rewards if the firm meets them.

This has been used to monitor train-operating companies in the UK and to help determine future price increases.

Judging the effectiveness of regulation: You can look at: - The impact on real prices to customers. - Levels of competition in the industry. - Employment and productivity levels in the industry. - The quality of service. - Investment levels in the industry. - How far has the regulator been able to adapt to changes in market conditions and technology. - Comparing a firm to the rest of the industry.

UK Competition Policy
Competition policy as set out in the Competition Act of 1998 and the 2002 Enterprise Act (the latter two policies):
Inquiry Type Anti competitive agreements Vertical price fixing, supplier dictates retail price, exchanging information to restrict competition etc. Abuse of dominant market position by a firm or two or more firms Excessively high pricing, predatory pricing etc. Merger Policy Growth through takeovers By OFT Grounds for referral. It is suspected that the agreement has an appreciable effect on competition Test Are the firms behaving in a way which prevents, restricts or distorts competition? Outcome Enforce changes; fine up to 10% of UK turnover.

OFT (can refer to CC)

Has the firm got a dominant market position? Dominant is unlikely below 40% in the UK

Is it exploiting this dominant position to the detriment of consumers?

Enforce changes; fine up to 10% of UK turnover.

OFT (can refer to CC) OFT (can refer to CC)

At least 25% market share by the combined firms in all or a substantial part of the UK or at least 70m turnover for the firm being taken over and substantial lessening of competition is suspected. Suspicion that the market structure prevents, restricts or distorts competition.

Will there be a substantial lessening of competition without compensating benefits to consumers?

Prohibit it; allow it on changed terms.

Market Policy Organic growth

Does the market structure prevent, restrict or distort competition?

Require changes.

Competition policy in the UK is less rigid than in the US generally. Policy is therefore more linked to individual cases. This was embedded in UK legislation from legislation in the 1940s. Since then, legislation has been tightened through a Sequence of Acts. Less formal agreements are also covered by the legislation (as seen in the table above). The conduct of policy is entrusted to two agencies: the Office of Fair Trading (OFT) and the Competition Commission.

Office of Fair Trading: The OFT plays a role in investigating the four different inquiry types listed above. The OFT has preliminary responsibility for investigating a proposed merger, and then has the power either to impose sanctions directly or to refer the market to the Competition Commission for a full investigation. The OFT can also investigate any firm thought to be abusing market power locally or nationally it has to investigate whether the firm has a dominant position. The OFT will look at the contestability of the market the firm is operating in and whether it is engaging in anti-competitive policies for example in 2006 OFT required London Underground to allow other free newspapers to be distributed, other than Associated Newspapers Ltds Metro. The mission statement of the OFT states: The OFT is responsible for making markets work well for consumers. We achieve this by promoting and protecting consumer interests throughout the UK, while ensuring that businesses are fair and competitive. The possible results of an OFT investigation are: Enforcement action by the OFTs competition and consumer regulation divisions. Referral of the market to the Competition Commission. Recommendations for changes in laws and regulations. Recommendations to regulators, self-regulatory bodies and others to consider changes to their rules. Campaigns to promote consumer education and awareness this has happened on numerous occasions, having found that the problem with the market lay in the way consumers understood its workings, and not with the market itself. A clean bill of health this indicates that the OFT may not find anything wrong with the market for example a multi-million pound investigation into price fixing in the supermarket industry was stopped in 2010.

The Competition Commission: The Competition Commission covers mergers, markets and regulated sectors (where aspects of the regulatory system may not be operating effectively/where there are disputes between firms and regulators). The Enterprise Act shifted the emphasis of assessing the merger away from the public interest and towards considering what it does to competition. The Act prevents ministers from overruling the Competition Commission decisions on acquisitions/mergers. The Competition Commission has not played a major role in the economy in the past rarely intervened most mergers arent referred and many have not been in the public interest. This may be because it can take around two years when mergers are referred often the CC dont bother there are managerial costs, workers may leave the firm during the investigation if they think it will be shut down etc. The Enterprise Act has made the Competition Commissions place stronger as an authority to which complex merger cases and investigations into abuses of market power are referred by the OFT the number of cases since the act has risen significantly. E.g. in 2010 Zipcar agreed to buy Streetcar (both car clubs consumers can book the use of a car for set periods of time): - Zipcar US firm with cars in London. - Streetcar UK firm with cars in various UK cities.

Merger investigated by the OFT which decided it could be anti-competitive. Referred to the CC for a 6 month investigation. Two other car club operators in London which are smaller than Streetcar and Zipcar the merged firms would account for over 80% of London car club services. CC worried whether Zipcar-Streetcar would raise their hourly rental prices once they no longer had to compete with one another this would harm consumers in the short run. BUT CC also believed that new entrants would eventually come in the long run, replacing competition. CC going to decide in January whether to block the merger.

The Takeover Panel: Established in 1968. They are concerned with the fair takeover of a firm from the point of view of the shareholders. It is concerned with the process of a merger, rather than its desirability. Relevant Markets problem: One of the things that has to be done in investigations is to identify the relevant market until the scope of the market has been defined, it isnt possible to calculate market shares or concentration ratios. This can be an issue disagreements over regional scope, which products should be included etc. One way to resolve the issue is to apply the hypothetical monopoly test under this approach the product market is defined as the smallest set of products and producers in which a hypothetical monopolist controlling all such products could raise profits by a small increase in price above the competition level this is then defined as the market. E.g. during the investigation into the Zipcar-Streetcar merger, Zipcar argued that they were not just part of the car club industry, but also the car rental industry and even the transport industry, so in fact their firm would have a very small market share. However, the CC kept the market as being the car club market.

EU Competition Policy
Inquiry Type Restrictive practices between firms Vertical price fixing, supplier dictates retail price, exchanging information to restrict competition etc. Abuse of market power Excessively high pricing, predatory pricing etc. By EUC Grounds for referral. Are the firms suspected of restrictive practices when trading between EU countries? Test Are the firms behaving together in a way which prevents, restricts or distorts competition? Outcome Enforce changes, fine up to 10% of EU turnover

EUC

Is the firm suspected of abusing its market power? NB it is assumed to have enough market power if it suspected of abuse.

Is it exploiting the dominant position to the detriment of consumers?

Enforce changes, fine up to 10% EU turnover

Merger Policy

EUC

5billion worldwide turnover p.a. of proposed combined entity and EU element (e.g. sales in EU of more than 250million by each of two or more firms)

Will it impede effective competition?

Require changes.

EUC = European Commission. An example of where the EUC has intervened where there are restrictive practices is in the airline industry. BA was fined 90m for participating in an air freight cartel fuel and security surcharges were rigged over six years (1999-2006) airlines fined 799m in total. The EU traditionally left such matters to individual member states unless there is an appreciable effect on trade between members. Since legislation in 1987 and 1992, however, the number of cases has increased. However, between 1991 and 2006 only 19 out of 2,700 mergers were disallowed the EUC still wants firms to benefit from economies of scale.

Public Private Partnerships (PPP)

Public goods there has to be some sort of government involvement as a free market wont ensure the provision of these goods. However, this doesnt mean the public sector has to provide them directly there can be some sort of engagement with the private sector. Contracting out: A situation in which the public sector places activities in the hands of a private firm and pays for the provision. The public sector issues a contract to the private firm for the supply of some good or service. E.g. waste disposal, where a local authority may issue a contract to a private firm for the supply of some good or service. Competitive tendering: A process by which the public sector calls for private firms to bid for a contract for the provision of a good or service. The contract would be announced and firms invited to put in bids, specifying the quality of service they are prepared to provide and at what price. The local authority would then be in a position to look for efficiency in choosing the most competitive bid. 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. The most common partnership model is the Private Finance Initiative (PFI). Private Finance Initiative (PFI): 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. This was launched in 1992 as a way of trying to increase the involvement of the private sector in the provision of public services. This established a partnership between the public and private sectors. The public sector could get involved with such a venture in order to secure wider social benefits, perhaps through reductions in traffic congestion, and this would not be fully taken into account by the private sector. In other cases, the private sector may undertake a project and sell the services to the public sector, often over a period of 25-30 years.

Most PFIs are regarding transport and local government (42% in the first ten years of the scheme). For example projects involving London Underground were signed in 2003, and there was also a PFI with the Channel Tunnel Rail Link in 2000. The aim of the PFI is to improve the financing of public sector projects introducing a competitive element to the tendering process and enabling the risk of the project to be shared between the public and private sectors. Criticisms: - The price of borrowing may increase if the public sector would have been able to borrow on more favourable terms than commercial firms. - The competitive element may mean that the private sector may have less incentive to give due attention to health and safety issues as compared to the public sector. - A balance between efficiency and quality of service is hard to achieve.