Competition Policy, Regulation and Contestability

 The exam

 Contestability

 Competition Policy

 Privatisation

 Regulation
1 HOUR 30 MINUTES LONG
- 40% A2
- TOTAL 72 MARKS

 Supported choice:  Data question:

 8 questions for 4 marks
each
 Total 32 marks
 Spend no longer than 40
minutes here
 50% evaluation
 4 questions
 Total 40 marks
 Spend 50 minutes here
 The supported choice:

 Definition: 1 mark
 Diagram: 1 – 3 marks
 Annotation: 1 mark
 Application/calculation: 1 – 2 marks
 Further analysis: 1 – 2 marks
 KOs – 1 – 2 marks
 The data response:

 4 mark question
▪ purely knowledge and application marks
▪ remember to apply your knowledge to the industry in
the extract
 8 mark question
▪ 4 marks for identification, explanation and analysis
▪ 4 marks for evaluation – 2 good evaluation points
 The data response:

 12 mark question
▪ Definition/knowledge – 1 mark
▪ Application, analysis & diagram – 5 marks
▪ 6 marks for evaluation
 16 mark question
▪ 8 marks for identification, explanation and analysis
▪ 8 marks for evaluation – (2 + 2 + 2 + 2) safest
 A perfectly contestable market has no sunk
costs (entry and exit barriers) and perfect
information (thus only normal profits are
earned)

 Contestability = a firm’s potential to

overcome sunk costs and enter the market
and so share in its supernormal profits
 Sunk costs - costs that a firm must incur to
enter a market and are irrecoverable if the
firm subsequently exits

 Markets with high concentration, and the

potential for abuse of monopoly power, may
not need regulation if the OFT considers
them contestable with low exit costs
What are the determinants of contestability?

1. Technological change
2. Natural monopoly
3. Economies of scale
4. Branding & advertising levels
5. Limit pricing
6. Information asymmetry
7. Rights to distribution or raw materials
In 2006, Coca-Cola launched a sugar-free soft
drink called “Coke Zero” and spent £8 mn on
advertising the brand. Which of the following is
most likely to make it difficult for other firms to
enter the soft drink market?
A The absence of consumer loyalty for Coca-Cola.
B High sunk costs.
C Strong government laws on anti-competitive
practices.
D High levels of contestability.
E A low concentration ratio.
The bonuses to customers available through
supermarket loyalty cards, such as those
offered by Tesco & Sainsbury’s, are likely to
make the industry:
A Less integrated
B Less contestable
C Less concentrated
D Less profitable
E More contestable
In June 2005 the European Commission
reported that Coca-Cola imposed exclusivity
agreements with retailers to stock their soft
drinks. A motive to act in this way is to:
A increase the choice of soft drinks.
B obtain benefits from horizontal integration.
C diversify into unrelated markets.
D obtain benefits from vertical integration.
E reduce concentration in the soft drinks market.
Example – Japanese electronics (Economist 11/09)

Japanese companies serve 70% + of the worldwide market in 30

+ technology sectors worth more than $1 billion apiece. Japan’s
champions share certain characteristics. They invest
handsomely in R&D. They often own their supply chains and
some firms even make the very machines they use, in order to
control costs, remain independent of suppliers and maintain a
deep understanding of their technology. The components,
tools and materials in which Japanese firms excel are highly
customised. It is only by working closely with clients over many
years that suppliers gain insight into their future technical plans
and are trusted to learn about thorny problems that a clever
supplier might solve. Moreover, the knowledge cannot be
transmitted by reading a patent but accumulates by working
with colleagues over many years.
To what extent is this market contestable?

 Define contestability
 Evidence:
 What are the sunk costs?
 Is there asymmetric information?
 What are the levels of profits?
 Are any firms poised to enter?
 If there’s a regulator, it suggests it’s uncontestable!
To what extent is this market contestable?

 Evaluation:

 Argue the opposite way – it is contestable…….

 Magnitude of factors – use extract/data
 Is contestability changing in the long-run?
The Office of Fair Trading, OFT:
 Promote competition & protect the
consumer interest
 Prevent abuse of monopoly power
 Prevent restrictive practices
 Refer investigations to Competition
Commission
 Regulate industries
The Office of Fair Trading, OFT powers:

 Fines up to 10% UK annual turnover

 Imprison directors for up to 5 years
 Enter and search businesses for evidence
 Block mergers
 Whistle blowing rewarded
The Competition Commission:
 Investigate mergers > 25% market share
 Investigate dominant firms > 40% market share
 Investigate restrictive practices:
 Cartels/collusion – price fixing or coordinated
investment
 Predatory & limit pricing
 Restriction supply to distributors
 Full line forcing
 Creation artificial entry barriers – advertising, brand
proliferation
In 2007, the European CC instructed
Microsoft to make freely available some of its
patented technical information to rivals. The
most likely effect on the market is to:
A increase concentration.
B increase contestability.
C strengthen computer patents.
D increase entry barriers.
E increase Microsoft’s profits.
An investigation into store cards by the CC in
2006 found that most retailers were charging
annual interest rates of 30%, far greater than the
rate required to cover costs. The CC proposed
measures to reduce interest rates and so make
the retail store card market:
A less contestable.
B more allocatively efficient.
C more concentrated.
D more profitable.
E less regulated.
In December 2004, the EU CC blocked the
proposed merger between the state-owned
gas and electricity industries in France. The
most likely motive was to
A enable both industries to achieve MES.
B prevent a further increase in entry barriers.
C avoid diseconomies of scale with mergers.
D increase profits in both firms.
E protect producer surplus in each industry.
Promote competition so: But larger firms can:
 Allocative efficiency &  Generate economies of
so lower prices scale and lower prices
 Productive efficiency &  Reinvest profits into R
so lower costs & D (dynamic
 Greater CS & no efficiency)
welfare loss  Match large overseas
 Better choice competitors
 Greater quality  Cross-subsidise loss-
making services/goods
Evaluation to consider:
 Argue the opposite view.
 How contestable is the market?
 Is there any evidence that competition can
increase in short-run?
 How do incumbents respond? Price wars or
aggressive advertising etc.
Evaluation to consider:
Argue the opposite view.
How contestable is the market?
Is there evidence that competition can increase?
How do incumbents respond? Price wars or aggressive advertising etc.
Privatisation is the transfer of economic
activity out of the public sector and into the
private sector in order to:

 Improve productive efficiency

 Increase competition & lower prices
 Improve choice and quality
 Increase innovation
The government appointed Goldman Sachs
to sell off Tote in April 2008. Tote owns 540
shops valued at £320 bn. The most likely
reason to sell off Tote is:
A encourage more gambling.
B reduce industry contestability.
C avoid an OFT investigation.
D achieve benefits from privatisation.
E open up the industry to “hit & run” competition.
Public private partnerships (PPP):

 A partnership where private sector firms deliver

public services or projects on behalf of the public
sector.
 Public sector operations are contracted out to
private firms, who are more considered to be more
efficient and specialised at these services.
 Competitive tendering introduces competition
between firms as they bid for contracts, thus driving
down costs.
Private Finance Initiative (PFI):

 Private sector firms finance, maintain and lease

infrastructure (which was previously publicly owned
and funded) to the public sector.
 Examples:
 Metronet & London Underground
 Midland Expressway & M6 toll road
 Construction of many prisons and NHS hospitals
The benefits: But there are concerns:
 Lower costs & greater  Lack of competition may
productive efficiency raise private profits and
 Use of specialised firms not be cost effective
can deliver higher quality  Cost cutting can be at
product the expense of quality
 Construction within  Little risk as risk
budget & on time ultimately liable on
 Lease reduces need for public sector
large public spending  Large procurement &
 Risks of project administration costs
transferred to private  Governments can
sector borrow more cheaply
 Regulation aims to mimic the effects of
competition and so:
 Use price caps to keep prices low
 Ensure profits re-invested
 Ensure product and service quality is high through
performance indicators
 Take into account externalities
 Promote competition
 Price-caps:

 RPI-X: “X” expected efficiency improvements

 RPI + K: “K” additional capital expenditure

 RPI + Y: “Y” reflects unavoidable cost increases

Household water bills are regulated by Ofwat
according to RPI + K. In 2007, RPI was 3.9%
and K set at 3.1%. This meant water bills
A decreased in nominal terms by 0.8%
B increased in both real and nominal terms
C increased by no more than the rate of inflation
excluding mortgage repayments
D increased in nominal terms by 3.1%
E decreased in real terms by 3.9%
An advantage of using RPI – X to regulate a
privatised monopoly is it allows the firms to
A raise prices by less than mortgage interest
payments
B keep supernormal profits achieved by
additional efficiency improvements
C raise the price of goods the firm does not
export
D makes only normal profits
E do no more than break-even
Ofcom ended more than twenty years of
price controls for telephone calls on BT in
2006. The most likely reason for this is that
A BT is no longer required to raise prices by less
than mortgage interest payments
B profit capping is ineffective in protecting
consumer interests
C BT’s prices have increased above inflation
D significant competition now exists
E technological change is set to increase
Qu. Examine the likely impact of price caps…….
 Define price caps
 Used to regulate natural monopolies…..
 Types of price caps used
 Analyse the benefits:
 Increase productive efficiency
 Lower real prices
 Prevent profiteering at consumer’s expense
 Fund necessary investment
 5 year price caps allow planning ahead
Qu. Examine the likely impact of price caps…….

 Evaluation:
 Regulatory capture
 Asymmetric information
 Problems of setting price caps – regulatory failure
 Risks of unexpected shocks (although RPI + Y)
 Comparison with other types regulation
Qu. Examine the likely impact of performance
targets on …….

 Define performance targets – regulator acts

as surrogate competition by trying to improve
standards of customer service
 Application to data or examples – next day
delivery targets for Royal Mail or number of
trains on time
Qu. Examine the likely impact of performance
targets on …….
 Need to increase investment
but higher SR costs or into wrong technology
 Increase allocative efficiency
but at expense of higher prices
 Need to change working practices
but can have problems with trade unions
 May lower productive efficiency
but investment could deliver LR improvement
 May reduce profits
but not if already meeting targets
In the US, limits have been placed on profits of
privatised utilities relative to the value of their
capital assets. What are the disadvantages of
(rate of return) regulation?
A Firms will undervalue their capital
B Quality may decline as the regulator forces costs
down
C Firms can make unlimited supernormal profits
D Firms have little incentive to become
productively efficient
E Firms are encouraged to make excess profits to
pay out as dividends to shareholders