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UK regulation


Neo-Classical theory

As Adam Smith noted in the late 18th Century, '..people of the same trade seldom meet together...without..the conversation ending in a conspiracy against the public, or in some contrivance to raise prices.' (Wealth of Nations, 1776). This view dominated Classical and Neo-Classical  theory for 150 years. The Neo-Classical analysis of firms is deeply rooted in the belief that monopolies are inherently harmful, and that a merger between competitive firms will reduce competition and increase monopoly power. The Neo-Classical view was that monopolies would cause a misallocation of scarce resources, with prices rising well above competitive prices. In short, regulatory authorities should be suspicious of the motives behind meetings of firms, alliances and formal mergers, and closely monitor and control the anti-competitive behaviour of monopolies.

The modern approach

The modern view is more pragmatic, and recognises that monopolies and mergers should be judged on a case by case basis, and it should not be assumed that they are against the public's interest. The modern approach accepts that monopolies can create economic benefits as well as costs, including the benefits of economies of scale, innovation and dynamic efficiency, and export earnings.

Relevant legislation

The Competition Act 1998

The Competition Act 1998 prohibits a number of activities by firms, including:

  1. The formation and operation of cartels.

  2. The abuse of a firm’s dominant position on a national or local level.

  3. Concerted practice, such as firms colluding instead of competing. For example:

  • Fixing price, such as a number of book publishers fixing the minimum resale price of books sold by separate book stores, or raising price together, or fixing output.

  • Fixing terms of business, such as agreeing to the same delivery times or terms of payment.

  • ‘Carving up’ a market, which means that firms agree to split up a market and not compete in the different sectors of the market.

The Enterprise Act 2002

This Act amended the Competition Act and strengthened the power of the regulators, especially in terms of detecting and punishing abuse of market dominance and cartel-like behaviour. The main provisions of the Act were:

  1. Assessment of mergers to be less influenced by politicians and more independent

  2. New powers for regulators to investigate markets, such as the power to use covert surveillance.

  3. Criminalisation of cartels, with the UK regulators becoming tougher than those in the EU.

  4. Disqualification of directors for breach of the competition rules.

  5. Consumer groups can complain about uncompetitive practices.

There was a shift of emphasis from considering the public interest criteria to a more narrow concern regarding the effect of behaviour on competition.

Enterprise and Regulatory Reform Act 2013

This Act established the new Competition and Markets Authority (CMA) which was launched on 1st April 2014. The CMA will combine the current competition and consumer protection function of the Office of Fair Trading (OFT) and the Competition Commission (CC).

Regulatory structure in the UK

In the UK, the regulation of firms and promotion of competition is undertaken by the Department for Business, Innovation and Skills (BIS), the Office of Fair Trading (OFT), and the Competition Commission.

The Department for Business, Innovation and Skills (BIS)

The Department for Business, Innovation and Skills (BIS) was created in 2009 with the merger of the Department for Business, Enterprise and Regulatory Reform (BERR), and the Department for Innovation, Universities and Skills (DIUS).

The main objectives of BIS are:

  1. To promote free and fair markets, with increased competition

  2. To increase productivity and improve skills

  3. To promote science and innovation, and promote the commercial exploitation of knowledge

  4. To create the right conditions for business success

  5. To improve economic performance of the UK regions, and to reduce the gap in growth rates between the regions

The Office of Fair Trading (OFT)

The OFT is an independent body whose main role is to try to ensure that markets work effectively. As its name suggests, it looks at unfair and uncompetitive trading. It has separate divisions (offices) that regulate the privatised utilities, including Ofgem, Ofwat, and Ofcom. It is the main referring body, referring cases to the Competition Commission.

The OFT’s main objectives are:

  • To identify and put right trading practices which are against the consumer’s interests.

  • To regulate the provision of consumer credit.

  • To investigate anti-competitive practices, including restrictive practices, such as manufacturers forcing retailers to fix a minimum price.

  • To investigate abuse of market power, when a firm has a dominant position, and cartel-like behaviour.

  • To help promote market structures which encourage competitive behaviour.

It can impose fines of up to 10% of turnover when necessary, and in 2004 the OFT gained new powers to use covert surveillance to investigate anti-competitive practices.

The sub-offices

The OFT’s sub-offices were established to regulate the privatised utilities and encourage competition.

The Competition Commission

In terms of mergers, the Commission must assess whether a merger will reduce competition. After investigating it may recommend that the merger:

  1. Goes ahead

  2. Is prohibited

  3. Is allowed to go ahead, but with modifications

In deciding which option to implement, the Commission will consider whether, after the merger, competition is maintained.

The Competition and Markets Authority (CMA)

Launched in April 2014, the CMA is now the UK's leading competition regulator, combining the competition elements of the OFT and Competition commission.

Policy towards mergers

In the UK mergers are assessed in terms of the specific circumstances of each case.

Substantial Lessening of Competition (SLC)

There are several considerations when making an assessment of a merger - the most important of which is whether there will be a substantial lessening of competition (SLC). This refers to the potential loss of competition which may result from a merger.

There are considered to be three main categories where a merger can lead to a lessening of competition:

Unilateral effects

Unilateral effects arise when a single combined firm is able to raise prices in a profitable way given the lessening of competition that follows the removal of a rival. The closeness of the firms as substitutes for each other will clearly have a bearing on the assessment of unilateral effects.

Co-ordinated effects

Co-ordinated effects occur when several firms are more likely to jointly increase their price. For example, firms may carve-up a market in a geographical way, and with less competition raise their price. In this instance production may be limited or innovation stifled. Tacit collusion is example of a co-ordinated effect.

Vertical effects

Finally, vertical effects are associated with vertical integration and may arise when a merger strengthens the ability of the merged firm to exert its power in the market.

The counterfactual situation

In deciding whether a merger will lead to a substantial lessening of competition the OFT or CC will consider the likely foreseeable competitive situation that would have arisen if the merger had not gone ahead – called the counterfactual. For example, it may be likely that a new firm would have entered the market were it not for the merger. It is also possible that one of the merged firms may have left the market had the merger not gone ahead. The authorities (the OFT and CC) may also consider, as part of the counterfactual analysis, whether a different bidder would have come forward.

Regulation of privatised utilities

Nationalisation

Between the 1930s and 1950s, most of the public utilities in the UK, such as gas, water, and electricity, were taken over by the state via a process called nationalisation.

The main motive for nationalisation during this period was to ensure a coordinated approach to production and supply to ensure economic survival and efficiency in the face of war, and post-war reconstruction.

However, by the late 1970s it was becoming apparent that these utilities were suffering because:

  1. They were being managed ineffectively and inefficiently. The principal-agent problem is highly relevant to public sector activities. The managers of the utilities were not required to meet any efficiency objectives of the state, and there was growing criticism because these industries were protected from competition, and hence had become increasingly ‘X’ inefficient.

  2. The nationalised industries had no power to raise capital on the open market. If they needed funds for investment, they would have to compete with other government spending departments, like education, health, and defence.  This is one reason why there was considerable under-investment in these industries.

To resolve these problems and to generate revenue for the government,  many State-owned industries during the 1980s were sold off to the private sector through a process called privatisation.

Privatisation and regulation

The major privatisations in the UK were gas, electricity, oil, telecoms, and coal. However, many of the privatised utilities are also natural monopolies. With a natural monopoly, the role of the regulator is to act as a surrogate competitor to the privatised, natural monopoly. In doing this the regulator can make up for the missing contestability found with natural monopolies.

Regulatory options

Regulators have a number of options, including:

Price capping

Regulators can set price controls and formulae, often called price capping. This means forcing the monopolist to charge a price below profit maximising price. For example, in the UK the RPI – ‘X’ formula has been widely used to regulate the prices of the privatised utilities. In the formula, the RPI (Retail Price Index) represents the current inflation rate. ‘X’ is a figure which is set at the expected efficiency gain which the regulator believes would have existed had the firm operated in a competitive market. However, there is a dilemma with price controls – price-capping results in lower prices, but lower prices also deter entry into the market. In the case of water supply, Ofwat, the regulator, was more generous given the need for capital investment in infrastructure.

The formula for water is RPI + K + U, where K is the price limit, and U is any unused 'credit' from previous years. For example, if K is 3% in 2010, but a water company only 'uses' 2%, it can add on the unused 1% to K in 2011. Regulators may remove price caps if they judge that competition in the market has increased sufficiently, as in the case of OFCOM who removed BT's price cap in 2006.

On disadvantage of the price-cap formula is that price limits only apply to variable charges, and do apply to connect charges or other fixed charges

Rate-of-return regulation

An alternative to price-cap regulation is rate-of-return regulation. Rate of return regulation, which was developed in the USA, is a method of regulating the average price of private or privatised public utilities, such as water, electricity and gas supply. The system, which employs accounting rules for the calculation of operating costs, allows firms to cover these costs, and earn a ‘fair’ rate of return on capital invested. The ‘fair’ rate is based on typical rates of return which might be expected in a competitive market.

However, rate-of-return regulation is often criticised because, unlike in an actual competitive market, a reduction in costs will not improve its situation, and hence there is little incentive to control costs. In fact, it will be to the advantage of the monopolist to allow costs to inflate because prices will then be allowed to rise. This would not happen in a competitive market because demand would form a constraint against such price rises.

A further general weakness is that regulators are unlikely to have perfect knowledge about the costs of production of the monopolist, and cannot make an effective judgement about whether the costs are being controlled effectively, or not.

Windfall taxes

Regulators could chose to impose a windfall tax on excessive profits, which would encourage the monopolist to reinvest its profits, rather than distribute them to shareholders. This tax would not alter the output of the firm; hence consumers would not suffer from falling output.

Yardstick competition

Regulators can introduce yardstick competition, such as setting punctuality targets for train operating companies (TOCs) based on the best-performing European train operators. It is also possible to split up a service into regional sections to compare the performance of one region against another. This is applied in the UK to both water and rail.

Forcing competitive tendering

In an attempt to make public utilities and government departments more efficient - especially local government - compulsary competitive tendering (CCT) was introduced in the UK during the 1980s. This initiative forced publicly funded organisations to seek bids from a range of suppliers, hence introducing competition into purchasing process. The objective was to cut costs and improve efficiency in the supply of public services.

Critics have argued that while competitive tendering may have increased efficiency in many areas, quality may have been driven down, and additional costs may have been generated, including additional transaction costs.

Transaction costs

For example, if four private firms bid for a contract to supply a public organisation (firms A - D), against an existing firm, E, and firm B wins the bid, the losing bidders have incurred many costs in pursuing the bid. These costs including legal costs, and other managerial costs incurred in constructing an submitting the bid. In addition, the 'losing' incumbent will incur exit costs, such as redundancy payments. It may be that the net cost savings in terms of supply costs are much smaller and possiblly non-existent when all the transaction costs are included.

Predatory pricing

There are also concerns that firms may make very low bids in an attempt to pursue a predatory pricing strategy. Once rivals have been driven out of the market, the incumbent can raise price and extract short-term super normal profits.

Unbundling

Effective regulation may also involve bringing down barriers to entry, such as forcing the incumbent to allow potential rivals to have access their network or infrastructure. This is referred to as opening-up or unbundling their infrastructure.  The is common practice in the communication industry where incumbents may have significant market power over the use of the network they own.

Limiting integration

Prohibiting further mergers and acquisitions (M&A) - to stop the level of concentration in the industry increasing.

Re-nationalisation

Bringing them back under public control - re-nationalisation. This would force them to move from profit maximisation to sales maximisation.

Self-regulation

In some industries, the regulator might allow self regulation. Certain industries may be allowed to self regulate by establishing a code of conduct by which industry members agree to abide. In 2002, the main UK supermarkets established a voluntary code of conduct following criticism by the Competition Commission in 2000. Critics argue that self-regulation is unlikely to provide sufficient incentive for firms to behave responsibly.

Having a licensing system, such as with the train operating companies (TOCs) and Royal Mail for letter post. Licenses can be extended or withdrawn, subject to the performance of the licence operator.

Criticisms of regulation

Since the Competition Act (1998) and the Enterprise Act (2002) regulators have had more power to act against abuses of monopoly power.

However:

Very few mergers are actually investigated each year. Since the Enterprise Act (2002), not a single major cartel has been investigated by the OFT (2008).

Despite heavy fines, covert collusion is difficult to prove. New powers have been given to the regulators to undertake covert surveillance of firms to establish whether collusion is taking place.

Tacit collusion is almost impossible to prove. Statistical techniques could be used to establish correlations between price movements in ‘theory’ and in practice.

The problem of ‘cheating’ or ‘finding loopholes’, such as getting round the regulations by moving into an adjacent market. For example, a large grocery retailer moving into the ‘convenience’ store market could be seen as a way of circum­venting competition policy.

A major criticism is that ‘single’ markets are inadequately defined. For ex­ample, in 2004 the OFT allowed Tesco to purchase Adminstore (the owners of Cullens, Europa and Harts) because it regarded ‘convenience stores’ to be a separate market from grocery stores. This gave Tesco 6% of the convenience food market as well as 26% of the grocery market. While Tesco argued that the two markets are quite distinct, critics, like the Forum for Private Business, argued that the markets are almost indistinguishable and that Tesco should not have been allowed to enter the convenience food market.

The problem of regulatory capture

One particular criticism of regulation in general is that it is subject to regulatory capture – where the regulator is captured or hijacked by the regulated. This occurs because the regulated subject regulators to intense pressure, often through the lobbying system. Two processes increase the likelihood of regulatory capture – firstly, the increased exposure of regulators to the regulated encourages them to ‘see things from their perspective’ and develop an understanding of and empathy towards the regulated. This removes their impartiality and weakens their ability to regulate. Secondly, the regulated develop a deep understand of the details of the regulation and can learn how to ‘play the system’. Large corporations can allocate vast sums to developing strategies to deal with the regulators. In wider terms, regulatory capture is seen as a form of government failure, and is often seen as evidence that government regulation is not the most effective method of achieving competition and efficiency.

Two examples in the UK have been frequently cited. Firstly, it is claimed that banking regulators, including the FSA and the Bank of England have been perpetual victims of regulatory capture by the banking industry, and that, furthermore, having ‘got out of control’ the banks wayward behaviour has played a large part in the recent financial crisis. Even the Bank of England Governor, Sir Mervin King, has accepted that the complexity and weight of regulation makes it difficult for regulators to operate effectively. The second more recent example is the alleged capture of the tax authorities (HMRC) by the UK’s mobile phone giant, Vodafone, who apparently negotiated a £6b tax reduction, reducing their tax bill for 2009-10 from £7b to £1b.

 

See also:

EU Competition Policy

Contestable market theory

Banking regulation

Financial crisis

Transfer pricing