C O M P E T I T I O N I N T H E E C O N O M I C S Y S T E M

223

comes from the central economic problem facing society, that is, the problem of the utilization of knowledge which no one individual possesses. Furthermore, this economic problem always arises due to changes occurring in the economy. Hayek (1978) sums up his position as follows:

the point to keep constantly in mind is that all economic adjustment is made necessary by unforeseen changes; and the whole reason for employing the price mechanism is to tell individuals that what they are doing, or can do, has for some reason for which they are not responsible become less or more demanded. (p. 261)

Such change brings with it certain opposition. Competition is generally seen to benefit the consumer and indeed some producers, but it also introduces new ways of doing things that are better than current methods, the ‘old’ being replaced by the ‘new’. With such displacement comes changing fortunes of those involved. Competition brings with it increased rewards for some and diminished reward for others. As explained in relation to trade in Chapter 5, such diminished rewards form the basis on which competition is usually opposed.

6 . 5 W H E N M A R K E T S F A I L

The portrayal and outcomes of competition describe how the self-motivated actions of consumers and producers leads to production and consumption of goods and services in an efficient, effective manner, given the incentives generated by the prices of goods and services. However, there are some events that occur that can interfere or even prevent this outcome – markets can sometimes fail.

Market failure occurs when economic resources are not allocated efficiently caused by the price system working imperfectly.

6.5.1WHY MARKETS MAY FAIL

The principal types of market failures are public goods, externalities, natural monopolies and monopoly power and information asymmetries. These are important in the context of policy as they provide the rationale underlying much of the government intervention in markets that we observe.

Public goods

Public goods (introduced in Chapter 1) are generally available to all, such that it is difficult if not impossible to exclude any person, even if they have not paid for

224	T H E E C O N O M I C S Y S T E M

the good, from consuming it. Markets often fail to encourage private firms from supplying such goods.

Externalities

As outlined in Chapter 4, an externality may result from a production or consumption process that affects some individual(s) not directly involved in the process.

Positive externalities are private timber forests providing scenic benefits to all or immunization against contagious diseases in a community. Negative externalities are pollution from a factory harming local farmers or cigarette smoke reducing the enjoyment of a meal by another person.

Often, the prices of products do not fully reflect the true costs including the external effects of their production. It is the negative externalities that economists are mostly concerned with as they reduce the economic welfare of producers and/or consumers.

Natural monopoly and monopoly power

Monopoly power, or substantial power over price, is closely associated with the natural monopoly case such that a lower level of output may be produced and a higher price charged than in a more competitive market. These negative aspects can be sustained due to barriers to entry in the market, which facilitates the redistribution of income away from consumers and towards producers, thus harming consumer interests. Monopoly power also provides firms with the opportunity of engaging in anti-competitive practices, either on their own against other producers or potential producers or against consumers, which effectively means raising prices above competitive levels.

Information asymmetries

Information asymmetries exist when one party has more information than another party in an exchange agreement.

Information asymmetries usually arise where a producer has more information on a product or service than consumers who are open to potential exploitation, usually in the form of high prices and/or poor quality. The functioning of competitive markets depends on the ability of consumers to adequately judge competing products. A

C O M P E T I T I O N I N T H E E C O N O M I C S Y S T E M

225

lack of information naturally impedes this. If firms have market power they may have few incentives to produce relevant information for consumers or the information may be of such a technical nature that few consumers would be properly able to interpret and use it. The information asymmetry problem is most pronounced for experience goods as against search goods.

Experience goods are goods where their quality attributes can only be assessed through trial (or experience) whereas the quality of search goods can be gained before purchase.

The resulting problems are of inefficiency and welfare loss.

6.5.2IMPLICATIONS OF MARKET FAILURE

One implication of market failure is the redistribution effects from producers to consumers. Society may also suffer a deadweight loss, as considered earlier in Figure 6.5. This is particularly damaging since potential benefits are lost to the economy. By preventing such a loss someone in the market place would gain. In Figure 6.7 panel A we have a market performing efficiently where price and quantity emerge from the interaction of demand and supply as P E and Q E. If the quantity of output is limited below its free-market level (for example, because producers can set high prices as fewer goods than the equilibrium quantity may be sold due to distribution agreements) to Q L, consumers pay higher prices at P H. At a higher price, consumer surplus falls and producer surplus rises but we see that some of the original surplus is no longer part of consumer or producer surplus – this is a deadweight loss shown as a triangle in Figure 6.7 panel B.

A					B
							Consumer
P					P			Deadweight
		Consumer					surplus
								loss
		surplus
			S		P	H			S
P	E				PE
		Producer		D			Producer		D
		surplus					surplus
		QE	Output				QL QE	Output

F I G U R E 6 . 7 D E A D W E I G H T L O S S

226	T H E E C O N O M I C S Y S T E M

Preventing or correcting market failures can create positive economic benefits and can provide a justification for government involvement in the market. In an extreme case market failures can prevent a market from existing at all – hence the provision of public goods.

A government can control the behaviour of producers and consumers through ‘indirect command’ where they provide incentives by making certain activities more or less rewarding. Government involvement can take the form of intervention in the market, either as a direct supplier of a good or service, or as a policy instrument to force a positive outcome arising from a market failure. For example, governments will usually provide public goods such as national defence and security and also may provide the goods associated with natural monopoly characteristics, such as in the utilities industry where governments have in the past supplied electricity, gas, telecommunications, water, etc.

Less direct government involvement arises in attempts to reduce the impact of other types of market failure.

•To reduce information asymmetries governments can introduce regulations compelling producers to release accurate and affordable information in the form of standardized product labelling, setting minimum safety and health standards or banning false or misleading advertising.

•Governments can also step into the market, in the form of regulation, to reduce welfare losses arising from negative externalities.

•To reduce monopoly power and reduce the effects of anti-competitive practices, the government can introduce a specific legal instrument in the form of competition law, to enforce standards and a policy of competition in the economy.

6 . 6 G O V E R N M E N T R E G U L A T I O N O F C O M P E T I T I O N

Across Europe, governments’ role in reducing monopoly power and in anticompetitive practices has evolved substantially over recent decades, particularly from the 1980s on. One traditional response – for governments to step in and take ownership of natural monopolies and to impose strict regulations on business activities – was considered to be an efficient method until the realization emerged that it may also generate significant costs. This conclusion arose from:

C O M P E T I T I O N I N T H E E C O N O M I C S Y S T E M

227

•weighing up of the costs versus the benefits of regulations;

•comparing whether the restrictions imposed under regulation were proportionate to the potential harm done in their absence;

•examining whether there was a more efficient way of achieving the goals of regulation.

Furthermore, it was possible in some circumstances that governments’ regulations might harm consumers. This occurs if business interests are put ahead of consumer interests and if there is a weak consumer voice. Both of these can result in regulatory capture.

Regulatory capture occurs where regulations set up to protect consumers – to lead to greater competition and lower prices – become captured by the industry for the benefit of producers in that industry. This happens where producers can convince the government or a regulator to introduce rules favouring producers.

Furthermore, the notion of a natural monopoly and the role of governments in running such enterprises began to change. Advances in technology and the development of financial markets, for example, both helped to change the perception of natural monopolies. No longer were such industries considered to be optimal if operated by one firm and instead many were broken up into small sub-industries. For example, in the electricity market, four sub-industries were developed comprising:

•generation: the production of electricity by either hydro, nuclear or fossil fuels, for example;

•transmission: the transfer of electricity from the generation site through the national grid to different parts of the country;

•distribution: the transfer of electricity from the national grid to local grids and sub-stations;

•supply: the transfer of electricity to homes and industries.

The idea then was to introduce competition into as many of these sub-industries as possible. Generation and supply were sub-industries where competition was seen to be possible whereas transmission and distribution were considered to have natural monopoly-type characteristics. Hence, it did not make economic sense to have duplicate transmission and distribution networks when the product could be transferred more efficiently through just one.

228	T H E E C O N O M I C S Y S T E M

When introducing different competitors in rail transport, it would not make economic sense to have separate tracks and stations for each train operator. If this were to happen, hundreds of train stations would be scattered around the country, along with thousands of miles of train track. Exactly the same scenario applies to gas, water and other utility industries.

In addition, governments also reconsidered their ownership of certain industries, driven in some cases by EU policy. Moves towards privatization were not only an attempt to bring the benefits of competition to industries, including improving efficiency, but also to reduce bureaucracy and political interference.

Privatization: the sale of government-owned businesses (and associated assets) in whole or in part to the private sector. Examples include electricity, gas and telecommunications industries.

Governments’ entire industry philosophy changed, becoming broadly less interventionist in industry with a redirection of their efforts to other policy issues. The idea was to introduce competition where competition was possible and to have regulation where it was not. Such regulation could take the form of access/price regulation so that competitive supply industries could gain access to a product at a ‘fair’ price and then sell it on to the end user for a ‘reasonable’ profit where the relevant regulator would decide on the interpretation of fair and reasonable.

Many regulations no longer serving their purpose – either because they were outdated, or had been captured by industry – encouraged a process of deregulation or re-regulation of private industry – where old rules were abandoned or amended to reflect current market conditions. At the same time the EU pushed for greater liberalization of markets as part of its drive for a single European market. The result was a changing competitive landscape in many industries including airlines, utilities and some professional services.

Market liberalization: reducing barriers to the free movement of goods and services to encourage entry by new competitors.

With liberalized markets came government competition policy to ensure a fair and level playing field for all competitors. Broad-based competition policy is seen as less burdensome than industry regulations in attempting to create a well-functioning marketplace.