Facts, Analysis and Comment.

Interesting Issues in Competition Policy/Economic Regulation

This web page contains notes on the following issues:

1. Does competition policy penalise success?
2. Consumer Welfare, Total Welfare, or Rivalry?
3. Effects-based v. Form-based (or per se) Decision Making
4. What about mergers which reduce choice?
5. What about protecting competitors?
6. Harvard, Chicago & Austrian Schools
7. Intermediate Customers and Suppliers
8. Buyer Power
9. Structural v. Behavioural - including Information - Remedies
10. The use of Econometrics
11. National Champions
12. Price Matching - 'Never Knowingly Undersold'
13. Switching & Inert Customers

1. Does Competition Policy Penalise Success?

"Ofcom's plans for Sky send a stark warning about the dangers of success": Daily Telegraph 18 September 2009 quoting the Chief Executive of BSkyB. This is large companies' most frequent cry, and one cannot avoid having some sympathy with it. Take Tesco, for instance, one of the UK's best companies at deploying retail innovation, cutting costs and meeting the needs of its customers. They had grown their share of the UK grocery sales to 26% when along comes the Competition Commission (CC) and suggests that there should be a presumption against further expansion in towns etc. where they would end up with more than 60% of the local market. You can well understand their frustration, which led to their appealing what they saw as an unnecessary 'cap on growth' to the Competition Appeal Tribunal.

Equally, however, there is no doubt that aggressive behaviour - which is absolutely fine in a genuinely competitive and cut-throat market - can look (and often is) much less attractive when used by a large company to cut the throats of upstart newcomers, or others with less market power. That is why many countries have enacted abuse of dominance legislation and why the UK has gone even further and legislated for wide-ranging and powerful market investigations.

But a minority of competition economists (often known as the Chicago School - see further below) do deprecate the use of 'abuse of dominance' legislation to control the power of otherwise successful companies. And rather more economists are uncomfortable with the UK's Market Investigation legislation, as a result of which imperfections in markets can be remedied by the CC without the Commission even finding evidence of 'abuse'. They argue that the existence of such legislation only serves to deter innovation, investment and growth, and that the markets would self-correct in the longer run, if the dominant companies do indeed get flabby and complacent.
(See "Supermarkets" below for a further discussion about competition in the retail sector.)

2. Consumer Welfare, Total Welfare or Rivalry?

In principle, it is open to competition authorities to choose one of three slightly different tests when deciding whether to intervene in a market or merger.

UK and other EU authorities generally apply a rivalry test when assessing the benefits of otherwise of a prospective merger. Does the merger result in a substantial loss of competition? They are not required to prove that a substantial loss of rivalry will lead to harm to consumers. EU/UK legislation and jurisprudence proceeds on the basis that competition leads to dynamism which is inevitably good, even if its direct effects cannot be measured or estimated. One advantage of this approach is that it is relatively simple.

The alternative would be to apply a somewhat more permissive 'outcome test' by seeking to assess consumer welfare or total welfare. This would involve carrying out a form of cost benefit analysis in which the efficiency benefits of the merger are compared with the likely detrimental effects (increased prices etc.). This is a much more complex approach and so open to greater argument. Its theoretical advantages are therefore generally reckoned to be outweighed by its practical disadvantages.

But UK authorities generally prefer to apply a consumer welfare test when assessing the economic consequences of market behaviour, such as restrictive agreements and other exclusionary behaviour. Is the behaviour likely to lead to consumers experiencing a detriment such as higher prices or lower quality? The alternative is to try to assess total welfare (that is consumer surplus + producer surplus) by seeking to compare the advantage to the industry against the likely detriment to the consumer. Under this approach, higher prices would be permissible if they were offset by higher company profits. In the long run, however, the two approaches in principle converge because industry cost savings should eventually be passed on to consumers. But the comparative simplicity of the consumer welfare approach, and the (small p) political attractions of taking a shorter term, less permissive and pro-consumer stance, mean that the consumer welfare approach is generally to be preferred.

But some overseas authorities, such as the Germans, take a harder line, preferring to use the rivalry test so as to help preserve their 'mitttelstand' of medium sized, often family-owned, businesses.

3. Effects-based v. Form-based Decision Making

Legislators and competition authorities can in principle also choose between two quite different approaches to deciding whether particular activity is illegal. The form-based approach requires the regulator to do no more than to look at the behaviour of a company and decide whether it is inherently or intrinsically illegal. (Lawyers talk about behaviour being illegal 'per se'.) Secret price fixing cartels clearly fall into this category. But this approach does generally require there to be clear threshold criteria for illegality, and these can be hard to define. UK competition law for instance, once contained complex restrictive trade practices legislation, with its own court, but this became unworkable. There has therefore been a general trend in Europe for authorities instead to examine the economic effects of potentially anti-competitive behaviour. This alternative approach is called 'effects based' or 'economics based' decision making and this is now generally preferred at least in most abuse of dominance cases as well as merger control.

Within Europe, the Germans continue to favour form-based decision-making rather more than do other member states. German merger control laws, for instance, have clearer (and tighter) limits than those of other member states. The Americans, in contrast prefer to avoid approaches which, in a sense, assume illegality in certain circumstances.

But one big attraction of the form-based approach is speed of operation, allowing ex ante (before the event, or prohibitive) action, rather than relying on ex post (after the event) action which allows maybe irreparable damage to be done before time-consuming analysis begins (often impeded by information asymmetry) and eventual decision and punishment. This choice is accordingly part of the ex ante v. ex post debate within the wider debate about the ineffectiveness of much regulation.

4. What about mergers which reduce choice?

UK competition policy does not protect societies against mergers which reduce consumer choice (and hence reduce total welfare) without reducing rivalry. Two examples help illustrate this point.

Imagine a town in which a mainstream supermarket is competing with a (somewhat down-market) discounter (a sort of local Aldi or Lidl) - or with a local upmarket rival along the lines of Waitrose. Is there any objection to the Aldi/Lidl/Waitrose store being acquired by Tesco or Sainsbury's - a more direct competitor to the existing mainstream supermarket? The answer, in UK law, is an emphatic "no" as the net result is a clear increase in rivalry now that the two stores are competing head to head. But the inhabitants of the town are unlikely to see it the same way, for their breadth of choice has clearly been reduced.

Alternatively, what if the Aldi/Lidl/Waitrose business were to be acquired by a clothes retailer? Again, although customers clearly now have much less choice of where to shop for food, the merger of a clothes store and a food store does not reduce competition between those stores (for there was none) and so the merger would be allowed.

5. What about protecting competitors?

Competition policies and legislation do not provide any protection for competitors, such as smaller firms. As long as there is sufficient competition for customers' business, the health of any particular competitor, or group of competitors is immaterial. In particular, competition authorities do not protect small firms against effective (and perhaps business fatal) competition from larger firms, as long as those firms are not abusing their dominant position.

Indeed, some competition practitioners regard competitors' complaints about potential mergers to be a very good sign that the competitors fear more intense competition which would be good for consumers. Put another way, a more oligopolistic post-merger market structure should be good for all the companies in the market, as prices of all companies will tend to drift upwards as they collectively assert their market power.

This scepticism about competitors complaints may well be justified in the case of, say, Virgin Atlantic expressing concern about a merger between two other airlines. In practice, however, competitors may have real concerns about a newly merged, more powerful competitor abusing its dominant position in ways which just fall under the competition authorities' radar, or which the authorities are powerless (or do not have the resources) to attack. Given the fairly lamentable track record in progressing abuse cases, such concern is presumably often justified. I understand that some of the mobile phone companies are objecting to the proposed Orange/TMobile merger on the grounds that it will slow down the pace of innovation across the industry.

6. Harvard, Chicago & Austrian Schools

Competition policy debates often tend to resolve into disputes between those who favour intervention (the Harvard School of economists) and those who have greater belief in the long-run efficiency of markets and are relatively sceptical about the effectiveness of government intervention and regulation (the Austrian and Chicago Schools). The latter are more likely to believe that competition will erode high profit margins and that markets may be contestable if not actually currently contested. (In other words, they believe that apparently powerful companies will often not exploit their market power for fear of being taken by surprise by a new entrant.)

Chicago/Austrian School economists still object to hard core cartels, and mergers which create monopolies, but are sceptical that apparently predatory behaviour does any harm, and contend that most oligopolies and tacit collusion do very little harm.

There is these days relatively little support for pure Chicago/Austrian School economics, but there is also a good deal of concern that regulatory interventions can all too easily lead to unintended consequences. Most competition authorities therefore sit somewhere between the extremes characterised by the two schools of thought, and increasingly employ econometrics and game theory to analyse potentially problematic behaviour.

7. Intermediate Customers and Suppliers

Many companies do not supply the final consumer but instead supply goods and services to manufacturers, retailers etc. A pure consumer welfare test would perhaps permit most mergers between such companies, especially where the intermediate customers - such as large supermarkets - are relatively powerful (in other words, they have strong buyer power - see further below). In practice, however, there is a strong presumption, at least in the UK, that mergers that substantially reduce competition between intermediate suppliers will eventually result in harm to consumers.

8. Buyer Power

A company (or small number of companies) has strong 'buyer power' if it/they can resist price rises that would otherwise be imposed by a supplier (or suppliers) with market power. The large supermarket chains, for instance, are reckoned to have sufficient buyer power to be able to impose quite tough deals on even their largest and most powerful suppliers. Buyer power is therefore generally regarded as a good thing, as long as the benefits are passed on to the final consumer - which depends on the companies with buyer power themselves operating in a competitive market. Unfortunately, however, companies that are so large that they have significant buyer power are also sometimes large enough to have significant market power when they are selling their products. They therefore make large profits by buying at lower prices and selling at higher prices than would be possible in a truly competitive market.

9. Structural v. Behavioural - including Information - Remedies

Competition Authorities generally want to do the minimum necessary to correct whatever problem they encounter. Companies, too, would generally prefer to offer to change their behaviour (such as by limiting price rises) rather than have their merger plans blocked, or be forced to sell off part of their business so as to reduce market power. Pretty much every investigation therefore ends up with a lively debate about the most appropriate 'remedies' - unless it is a 'clearance' of course.

One problem with behavioural remedies - such as telling customers (through notices on tills or bills) to take care because they might be about to be ripped off - is that it is very hard to design remedies which are effective. This is often because humans take decisions for all sorts of complex reasons, which are not easily understood, let alone easily modelled by economists. And it is sometimes because the mere provision of more information seldom helps - and might hinder - the resolution of an underlying information problem, such as an inability to grasp the meaning of an interest rate, or a difficulty in resolving a complex problem such as what medicine is likely to be most effective , or what phone or electricity tariff offers best value for money. Or sometimes the problem is simply that the information (for instance a leaflet warning notice on a till) can be crowded out by the sales patter of an assertive salesperson.

Interesting research projects in this area include the joint Better Regulation Executive/National Consumer Council project which led to an interim report Warning: Too Much Information Can Harm in July 2007. The Office of Fair Trading (OFT) commissioned a literature review of the issue, from the Centre for Competition Policy at the University of East Anglia, at around the same time.

Another problem is that information remedies add to suppliers' costs, and so tend to increase prices. The annual cost of meeting the CC's informational remedies in connection with the sale of extended warranties was estimated to be around £1m pa.

See also my note on behavioural economics, and my merger control web page for a discussion of the need, if possible, to avoid behavioural remedies in merger cases.

10. The use of Econometrics

The vastly increased availability of data from companies' (such as supermarkets') IT systems plus the increased power of competition authorities' own computer systems mean that attempts are now often made to model companies behaviour so as demonstrate certain behaviours and correlations. But the models and spreadsheets have to be transparent and audit-able (not least by the companies under investigation) and easily explained to business people affected by regulatory decisions, and also to non-economist judges in court actions and appeals. (Correlation does not prove causality, for instance.) This severely limits the use of the more complex models.

11. Competition Policy and National Champions

There is no inherent tension between industrial policy and competition policy. Both (or at least both should) result in more efficient, innovative and therefore rapidly growing businesses. But there can be some tension between (a) those who want to create 'national champion' businesses by encouraging firms to merge, and (b) competition authorities who generally resist mergers which substantially reduce domestic competition. This interesting and important subject is explored in the 5th essay in the collection of the late Professor Geroski's Essays in Competition Policy.

The protection of nationally important UK companies from being taken over by foreign 'predators' is discussed here.

12. Price Matching - 'Never Knowingly Undersold'

Competition Authorities are in a bit of a bind when it comes to investigating price promises and the like. Many customers would not use Expedia, and similar websites unless they promise that they offer rooms etc. at the same price (or lower) than if you book direct with the hotel, or via another website. But these Most Favoured Customer agreements are fundamentally anti-competitive as they deter any competition between websites and/or between websites and the hotels. Such agreements between websites and hotels have accordingly been ruled to be illegal as a form of cartel. Unfortunately, the result has been to encourage a switch to unilateral promises that the vendor will match a lower price offered by a competitor. (John Lewis, in the UK, is famous for its pledge that it is never knowingly undersold, a rather clunky way of making the same promise.) The obvious highly anti-competitive result is that no-one bothers to compete with the person making the promise, thus ensuring that the customer is denied the opportunity to save money by shopping around. This could in theory be attacked as an abuse of dominant position, but most if not all companies making these promises are not dominant in their market.

An interesting and relatively readable analysis of the law and practice in this area has been published by the Centre for Competition Policy. You can read it here.

13. Switching & Inert Customers

See separate webpage here.

Martin Stanley