Competition Policy – Definition, Examples and Evaluation

Competition policy features measures to prevent the abuse of market power.

Types of competition policy include:

Price caps
Regulations such as for quality of service.
Breaking up firms or blocking mergers.
Removing barriers to entry
Bans on collusion + fines

Who enforces competition policy? In the UK, the key bodies are the Competition and Markets Authority (CMA) and some bodies for individual sectors like Ofgem for gas and electricity.

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Price cap

A price cap is a maximum price – firms are not allowed to price above the cap.

An example of a price cap is the cap used for the water industry, which Ofwat sets. Every five years, Ofwat sets water prices for the next five years, based on supply/demand as well as what firms may require to invest in water infrastructure.

Here is a diagram for the price cap for a price making firm:

Price cap on monopoly at allocatively efficient price.

The price cap reduces the price from p to p1. The output produced rises from q to q1. Also the price is set at the allocatively efficient price (p=MC). So there is a welfare gain (the welfare loss from monopoly is eliminated). Consumers see higher consumer surplus, due to lower prices and higher output.

However supernormal profits do fall. So firms are less likely to be dynamically efficient. There are reduced profits for reinvestment in improving the quality of the good or reducing costs. So consumers may be worse off over time.

In practice, the price cap can permit a certain level of investment or reduction in costs over time.

In a natural monopoly, there are significant economies of scale. In other words, long run average costs fall as output rises. An adjustable price cap, like the RPI-X, means that if the firm cuts its costs, the X term increases. So prices must be lower in the future too. In a natural monopoly, this makes sure firms pass on lower costs to consumers. Firms have to lower prices to the price cap rather than retain all supernormal profit.

Regulations, such as quality of service

Examples of regulations include rail or energy: making sure there are sufficient safety standards, or accountability in case of service issues.

So firms should provide higher quality service for consumers. Without regulations, firms could cut quality to reduce costs and increase profits.

But improving quality may increase business costs and lower profits.

Evaluation for regulations and price caps

The success of regulations, including price caps, depends on:

Extent of regulatory capture. Firms will lobby the regulator or the government, dilute the power of regulation.
Deciding the right level of price cap / regulation. If regulators set the price cap too high, then does not affect market much and may not reduce welfare loss. If they set the price cap too low, firm may leave the market or quality might be cut. Estimating the allocatively efficient price is difficult.
Whether regulations increase barriers to entry. Some regulations could make it harder to enter the market and increase barriers to entry. This reduces contestability.
Degree of market power, brand loyalty and the price elasticity of demand. Regulations, such as quality standards, increase firm costs. The more price—inelastic the demand, the more the firm can pass on higher costs to consumers by raising prices. This also happens if the firm has lots of market power. Even if consumers get higher quality, they may face higher prices.

Break up monopolies or block mergers

The CMA blocked a planned merger between Sainsbury’s and Asda. This was because of CMA concerns of a potential reduction in competition and higher prices.

Additionally the CMA has ordered Facebook (Meta) and Giphy to break up. This was after they had already merged. Here there were concerns about a reduction in competition. Facebook and Giphy competed in the market for online advertising space. But also, Giphy supplies gifs to Facebook and there were concerns Facebook would restrict access for other platforms to Giphy’s gifs.

This diagram shows the effect of blocking or breaking up a merger:

Breaking up a merger moves the firm away from the monopoly outcome (p=MC) to the perfectly competitive outcome (ATC=AR=MC). This is also the allocatively efficient point, so total welfare increases (the “welfare loss” labelled in the diagram is eliminated). The output level rises from q to q1 and the price falls from p to p1.

Breaking up a horizontal merger may prevent abuse of monopsony power (where there is a dominant buyer of a good).

As with regulations, this may reduce firm supernormal profits. So investment by firms may fall. This may also disincentivise firms from growing due to the threat of being broken up.

Also by preventing mergers, firms cannot exploit economies of scale. Larger firms experience lower long run average costs and hence lower prices for consumers if passed on. So breaking up a monopoly could raise prices.

Evaluation

The success of breaking up or blocking a merger depends on:

Extent of economies of scale / size of the firm. The greater the extent of economies of scale, the less beneficial it is to break up a monopoly. This is the case for “natural monopolies”.
Extent of synergies from any merger. If the merging firms share similar cultures and objectives, the merger is more likely to be successful. This makes preventing such a merger less desirable, all else equal.

Make markets more contestable / deregulation

Example: allow competition on delivering parcels in 2006 (previously only Royal Mail was legally allowed to deliver parcels).

Example 2: deregulation of the UK energy market led to new firms entering, such as Octopus and Bulb.

Deregulation reduces costs for firms. Deregulation can specifically reduce the barriers to entry into a market. So more firms enter the market. Supernormal profits are competed away, until there are zero supernormal profits.

But deregulation may go too far. Again In the UK energy market, Bulb, a new entrant, went on to fail. The firm had not hedged its bets sufficiently against the risk of increasing wholesale gas prices. There were risks that firms with weak balance sheets were entering the market, meaning they could not cope with large price fluctuations. This led to a call for more regulation on energy firms’ balance sheets.

Evaluation of making markets more contestable

The success of deregulation to make markets more contestable depends on:

The extent of economies of scale and branding. Other barriers to entry may persist (branding, economies of scale) and deregulation will not remove these.
Also the reason for the regulation. Regulations may be there for a reason. The quality of service could fall if deregulation occurs. Or firms may cherry-pick profit making services (e.g. bus routes), leading to reduced service or loss making routes. However if the regulation does not defend a consumer or other interest, then eliminating the regulation is less likely to harm consumers.

Fines for collusion

An example of a collusion fine is:

The CMA, in 2020, fined construction suppliers Vp and MGF over £15 million. This was for “sharing confidential information relating to current and future pricing and co-ordinating their commercial activities to reduce strategic uncertainty”. These businesses provided “groundworks products” to protect excavations from collapse.

Fines for collusion reduce incentives to collude, making collusion less likely. So prices fall (relative to when there is collusion), increasing consumer surplus.

Yet the threat of a fine for collusion can prevent firms from colluding too.

But preventing collusion means colluding firms see lower profits and less reinvestment. Firms can no longer work together to exploit economies of scale.

The success of fines depends on the size of the fine. Suppose the fine is small relative to firm revenue or profits. Then the fine does not disincentivise collusion much, making collusion less likely to be halted.

Threat of intervention

Regulators do not need to intervene to affect firm decisions.

Simply the threat of regulation can have an effect.

If firms know the CMA may break up big firms, firms are less likely to grow to such a large size or raise prices well above allocatively efficient prices.

Recent trends

One big trend is the move into digital market regulation. The CMA set up the digital market unit (DMU) in 2021 to regulate big technology platforms. This has already had an effect, with the Facebook-Giphy merger being reversed.

Tech companies have become accustomed to buying up smaller competitor firms. The reaction of the CMA, as well as recent changes to US competition authorities, will make this more difficult going forward.

EU competition policy

Since the UK left the European Union (EU), EU competition law does not automatically apply to the UK. Leaving the EU gives the UK the opportunity to take different stances on competition policy.

EU competition policy includes:

Collusion prevention
Preventing abuse of market power
Merger regulation
State aid – state subsidies to companies that may give an unfair advantage to that company. Generally not allowed within the EU unless particular circumstances apply.
Example of EU competition law: the European Commission is considering fining Apple for restrictions around Apple Pay. The Commission claims Apple have limited competitors’ access to mobile wallet technology.

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