Benefits of Product Market Competition

National Training Workshop on Competition Policy and Law

Gerald Gregory(CUTS Fellow)

Summary

Competition ensures allocative efficiency so the right goods are produced in the right quantity at the right price, at any one point in time

Competition ensures productive efficiency at the firm and industry level and so maximises the level of productivity in an economy

Competition can be a driver of innovation which leads to productivity growth over time

Increases in productivity lead to higher output from the same input, so it is the most direct route to inflation free economic growth and higher standards of living

Therefore sound competition policy is essential to economic development

Allocative efficiency

When competition is restricted, 'monopoly' prices are significantly above marginal cost

Consumers willing to pay above marginal cost but below monopoly price are not supplied leading to loss of welfare associated with a sub-optimal allocation of resources

Competition drives price down towards marginal cost so these consumers are supplied leading to an increase in welfare

Competition maximises welfare by ensuring allocative efficiency – the right goods are produced in the right quantity at the right price at any one point in time

Consumer Benefits

As well as increases to total welfare through increased allocative efficiency, competition benefits consumers by lowering prices (which transfers surplus from producers to consumers)

The UK Office of Fair Trading measures the consumer benefits of its interventions annually and finds that its interventions have saved on average £409m per year in the period 2006-2009

In the same period the average annual expenditure of interventions (mergers, competition law enforcement, market investigations) was £53m

So the consumer benefit-cost ratio of the UK competition authority is 8:1

Wider benefits could be even larger given the deterrence effect of competition law enforcement dynamic welfare gains from new products

Productive efficiency – firm level

Within monopoly firms managers have little incentive to be cost efficient in production

This managerial slack is removed by competition as it creates incentives to maximise productive efficiency:

- There is greater opportunity for owners to compare and monitor managerial performance

- Cost-reducing improvements in productivity could generate a larger increase in revenue in a competitive environment

- A higher probability of bankruptcy forces managers to work harder to avoid bankruptcy

Productive efficiency – industry level

Competition brings about a Darwinian process of 'survival of the fittest' where only the strong survive

Less efficient firms are weeded out from more efficient firms with labour and capital being reallocated from shrinking/exiting firms to entering/growing firms

These changes to composition in an industry due to firm dynamics raise productive efficiency across the industry

The reallocation of labour and capital between firms is essential to the process and so well functioning labour and capital markets are very important

Innovation

'Breaking new ground' through process and product innovations leads to productivity growth

But there are differing theories on whether competition promotes innovation:

- Schumpeter (1942) argued competition is not good for innovation; if firms make no private gain post-innovation because it is competed away they will have no incentive to undertake R&D (also large firms have more internal financing)

- Arrow (1956) suggested that the greater pre-innovation rents the lower the net gain resulting from innovation; firms facing competition might be expected to have stronger incentives to undertake R&D

Innovation (continued)

Aghion, Harris, Howitt and Vickers (2000) found an inverted-U relationship between product market competition and innovation

- At low levels of competition innovation is low due to lack of incentive (Arrow effect)

- At medium levels of competition as firms try to escape competition by innovating

- At high levels of competition innovation is reduced as the potential gains are reduced by the high number of potential imitators (Schumpeter effect)

Other studies have found a more definite positive relationship between competition and innovation

Evidence competition enhances productivity

There is a strong evidence base backing the theory that competition enhances productivity

Nickell (1996) looked at a sample of 676 UK firms over 1975-86 that competition and found competition was associated with higher productivity growth rates

Disney et al (2000) looked at 143,000 UK firms and found competition was associated with higher productivity levels as well as higher growth rates

There is also a significant amount of evidence to suggest international competition drives domestic productivity growth

Evidence interventions enhance productivity

A 2004 study by the Centre for Competition Policy, University of east Anglia assessed the benefits from competition using illustrative cases in the UK

The breaking of a price-fixing cartel in the replica football kit market by the OFT led to price reductions of 15%

The ending of Resale Price Maintenance on books led to price decreases and increases in productivity

The liberalisation of European air routes by the European Commission facilitated the emergence of an entirely new business model in the form of low cost airlines

Evidence competition drives economic growth

If evidence suggests competition positively affects productivity at the firm and industry level then a positive relationship between competition and aggregate economic growth can be assumed

However, only a few studies have attempted to test this because of measurement difficulties

Dutz and Hayri (1999) found their index of pro-competitive policy had a positive effect on the growth rate of GDP per capita in a cross-section of countries

Some studies find evidence that competition resulting from openness to trade positively impacts on economic growth

Recap

Competition improves allocative efficiency and while bringing about consumer benefits

Competition reduces 'slack' so that firms are as efficient as possible

Selection through 'survival of the fittest' ensures industry level efficiency

Competition generally promotes innovation which leads to productivity growth

As competition leads to productivity growth, it is a driver of economic growth and living standards

Policy makers must ensure a sound competition regime is in operation as part of any development strategy

Thank you for your attention!geraldgregory@hotmail.co.uk