Tutor2u Economics Essay Plans Summer 2002

Transcription

1 Microeconomics Revision Essay (6) Economic Efficiency and Competition Policy (a) Distinguish carefully between static efficiency and dynamic efficiency. (20 marks) (b) Discuss the importance of these concepts when the Competition Commission is carrying out an investigation into the conduct and performance of a dominant firm. (30 marks) Economic efficiency relates to how well an economy allocates its scarce resources to meets the needs and wants of consumers over time. We make a distinction between static and dynamic efficiency Static Efficiency Static efficiency occurs at a point in time and focuses on how much output can be produced now from a given stock of resources, and whether producers are charging a price to consumers that fairly reflects the cost of the factors used to produce a good or a service. There are two main types of static efficiency Allocative Efficiency Allocative efficiency occurs when the value consumers place on a good (reflected in the price people are willing and able to pay) equals the cost of the resources used up in production. The condition required is that price = marginal cost. In the diagram below we show a contrast between price and output under conditions of perfect competition (where allocative efficiency is achieved in the long run) and a profit maximizing monopoly (where price is above marginal and average cost leading to a net loss of economic welfare) Price Competition Price Monopoly Ms MC Pm Pc Md Monopoly AR MS2 MR Output Qm Qc Output Pareto defined allocative efficiency as where no one could be made better off without making someone else at least as worth off. This can be illustrated using a production possibility frontier all points that lie on the PPF are allocatively efficient because we cannot produce more of one product without affecting the amount of all other products available. Page 1

2 Productive Efficiency Productive efficiency is achieved when the output is produced at minimum average total cost (AC). If a supplier has achieved minimum average total cost in the long run, is has exploited the available internal economies of scale and reached the minimum efficient scale. Productive efficiency exists when producers minimize the wastage of resources in their production processes. Costs SAC1 SAC2 SAC3 LRAC MES Output (Q) Linked to productive efficiency is the concept of X-inefficiency X-Inefficiency Libenstein (1966) pointed to potential cost inefficiencies arising from a lack of effective competition within a market. These are known as X-inefficiencies and are often used as part of the case against pure monopoly. Companies that face little or no real competition often allow their fixed costs of production to rise for example by running inefficient administration systems and by allowing the build up of sizeable expense account systems that bear scant relationship to the output / performance of the company s employees. X- inefficiencies cause an increase in average total costs at each level of output. X-inefficiencies are less likely to occur when a specific market is genuinely contestable i.e. where the threat of new competition and the presence of actual competition put pressure on businesses to keep their costs under control and give them little leeway to exploit their monopoly power. Dynamic Efficiency Dynamic efficiency occurs over time. It focuses on changes in the degree of consumer choice available in markets together with the quality of goods and services available. For example the opening up of the market for parcel deliveries has had an impact on price and output levels (these are changes in static efficiency). However we have noticed the entry of new suppliers into the market, an increase in the level of capital investment and improvements in the quality and reliability of services in local, regional, national and international parcel deliveries this represents an improvement in dynamic efficiency. Dynamic efficiency also refers to the rate of technological advancement in a particular market or industry this is linked to the investment made by suppliers in new capital and research and development. Page 2

3 (c) Discuss the importance of these concepts when the Competition Commission is carrying out an investigation into the conduct and performance of a dominant firm. (30 marks) The examiners will always reward reference to relevant industries and markets some of which may have come under the investigation of the Competition Commission and/or the Office for Fair Trading The Competition Commission is an independent public body established by the Competition Act The Commission replaced the Monopolies and Mergers Commission ("MMC") on 1 April 1999 The Commission has two distinct functions. (1) The Commission carries out inquiries into matters referred to it by the other UK competition authorities concerning monopolies, mergers and the economic regulation of utility companies (2) The Appeal Tribunals hear appeals against decisions of the Director General of Fair Trading and the Regulators of utilities in respect of infringements concerning anti-competitive agreements and abuse of a dominant position Economic efficiency concepts are certainly part of the Competition Commission s deliberations when they investigate mergers and market activity in particular industries. The structure conduct performance model has been at the heart of investigation of markets by the competition authorities over the years although the SCP model has been questioned and criticised. A basic model of structure- conduct performance should be explained as part of the answer to (B) and developed with reference to static and dynamic efficiency Structure of an industry (market characteristics) The share of the largest firms (i.e. as measured by the concentration ratio) The nature of costs in both the short and long run (i.e. ratio of fixed to variable costs, prevalence of sunk costs) The degree to which the industry is vertically integrated (ownership of different stages of the supply chain) The extent of product differentiation Conduct (behaviour) How does the structure of an industry affect the pricing, output, R & D and other strategies of firms in the market? Dominant firms? Anti-competitive pricing (collusion) and non-price competition? How do businesses interact with each other in their price, output, advertising and R&D decisions Do businesses behave strategically to retain profits by deterring entry of new suppliers in the long run? Performance (economic outcomes) Trends in real price levels and corporate profitability (excessive profits?) Spending on research and development / technological development Page 3

4 Does the structure and conduct of an industry give rise to outcomes that are perceived to be economically and socially efficient? Consumer surplus and equity Market structure and economic efficiency Trends towards greater consolidation and consolidation in an industry can lead to the development of monopoly power where firms have the market power to keep price above cost and earn supernormal profits in the long run (a loss of allocative efficiency) On the other hand, some industries have a cost structure where there is huge potential for increasing returns to scale to be exploited (i.e. economies of scale lower LRAC improvements in productive efficiency). Some industries might be characterised as natural monopolies. Vertical integration gives a business control over the supply of inputs and retail and distribution channels might be used as an instrument to exert monopoly power over other firms in the market Conduct and economic efficiency Monopoly diagram might have already been used in part (a) perhaps a chance to use a diagram showing the effects of price collusion by firms operating in an oligopoly Individual Firm Industry MC MC (industry) AC P(cartel) MR Demand Quota Firms Output Industry Output Industry Output Highly concentrated markets often do exhibit some implicit forms of price collusion and other forms of anti-competitive practices which reduce consumer welfare The competition authorities in recent months and years have made many investigations about the conduct of firms within specific industries some of these might be used as illustrative examples: Investigation into new car prices (a joint inquiry by the Competition Commission and (initially) by the Office of Fair Trading Aggressive selling of extended warranties to consumers for electrical goods / consumer durables The extent of choice and competition in the retail beer market Page 4

5 Car servicing and repairs excessive pricing and poor quality Unfair terms in consumer contracts such as penalty clauses in mortgage contracts and notice clauses in mobile phone contracts Barriers to entry are critical to the issue of the conduct of businesses in a market. If the entry and exit costs into and out of an industry are low, a market becomes more contestable and this should impact on the price and output behaviour of the existing suppliers in the industry Performance and economic efficiency This is the third part of the traditional assessment of markets by the Competition Authorities and here there are clear links to both static and dynamic efficiency Is there a trend within a market for falling prices over time? (Perhaps due to increasing competition, the exploitation of economies of scale or higher productivity arising from technological advancements) What rates of profit are achieved by existing firms? Are profits deemed to be excessive? (Very difficult to quantify) Perhaps suggesting supernormal profits from an abuse of a dominant market position How much is spent on research and development within an industry? Do new products come into the market to meet changing consumer needs and wants? Are there improvements in non-price factors? (The quality of service, number of customer complaints) The Feedback Critique The traditional view is that there is a simple line of causation from the structure of a market through to the conduct of businesses within it and finally to performance indicators. The feedback critique argues that there is no simple line of causation this is illustrated in the flow diagram below Market Structure Conduct Performance The Feedback Critique Conduct can affect market structure (e.g. merger and takeover activity) Market performance can affect conduct as well as market structure For example, aggressive take-over activity by one or more businesses within a market must eventually impact on the concentration ratio in an industry. This is something the Competition Commission must take into account when deciding whether or not to block a merger or a takeover on competition grounds. Page 5

6 Equally a firm might build a dominant market position by simply out-performing other competitors it achieves lower costs; it develops successful products that meet consumer needs and wants better than the existing products; it invests sufficiently in research and development to win patent races and bring new products to the market for which it has some legal protection from competition. We must also remember as part of the evaluation that the performance of firms within a market depend crucially on their business objectives. The Competition Commission can no longer take as given the assumption that businesses are simple profit-maximizers. The structure-conduct-performance approach to investigating industries still has some intrinsic value and there are clear links to whether or not markets and industries come close to achieving economic efficiency in the long run Page 6