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AS Market Failure

Competition, Monopoly & Allocation of Resources

In this note we consider the nature of competition within different industries. You will find during your study of economics that no two markets are ever the same because they all have different market structures. The market for airline travel is very different from the market for coal or the market for clothing on the high street. At AS level you need to understand what is meant by monopoly power in a market and also consider some of the costs and benefits of markets and industries where one or more firms have market power.

An introduction to market structures

A market structure is the characteristics of a market which can affect the behaviour of businesses within the market and also influence the outcome of a market in terms of economic efficiency and the welfare of consumers.

Some of the main aspects of market structure are listed below:

• The number of firms in the market and extent of overseas competition
• The market share of the largest firms
• The nature of production costs in the short and long run e.g. the ability of businesses to exploit economies of scale
• The extent of product differentiation i.e. to what extent do the businesses in the market try to make their products different from those of competing firms?
• The price and cross price elasticity of demand for different products within the market
• The number and the power of buyers of the industry’s main products
• The turnover of customers (also known as “market churn”) – this is a measure of the percentage of consumers who switch suppliers each year and it is affected by the degree of brand loyalty and the effects of advertising and marketing.

The market for detergents

The market for detergents and fabric conditioners is dominated by two producers, Proctor & Gamble and Unilever. The total value of the market for clothes-washing detergents and laundry aids was worth around £1.42 billion in 2005 with 75 per cent of this market being taken up by sales of detergents. Proctor & Gamble and Unilever account for 84 per cent of the market with the remaining market share being taken mainly by the own-label sales of the major supermarkets.

Some of the features of this market are as follows:

• Demand for liquid detergents has a low income elasticity of demand but the demand for ancillary products such as fabric conditioners is more income elastic
• Heavy spending on advertising and marketing by each of the two major players
• Investment in research and development to change the formulations in the detergents and to expand the number of brands available. Investment has also focused on creating new products such as stain removers, fresheners and creation of more environmentally-friendly products
• Many consumers in the market are brand-loyal, especially older people

The market for gas and electricity supplies

The market for gas supply in the UK was privatised in 1986 with the market for electricity generation and distribution also transferred to the private sector of the economy a few years later. Over the years the years there have been important changes in the market share of the leading electricity distribution companies and domestic gas suppliers with the former state monopolies losing much of their dominance over this time. The most recently available market share data is shown in the table below.

The UK energy market is split into three elements. Suppliers sell electricity and gas to final commercial, industrial and household consumers. Distributors are companies responsible for getting energy to users e.g. by building and maintaining the infrastructure of pipes and cables in the road and in installing meters. Thirdly, the generators are responsible for generating the energy used in homes, offices, shops and factories.

The retail market for energy is competitive because all users are now able to change their gas or electricity supplier. That said, although suppliers are competing with each other for customers, many people do not switch their suppliers even when they might be able to make savings on their gas or electricity bill. One reason is that people do not find it easy to get accurate information about what the differences are between these competing suppliers.

The industry regulator OFGEM believes that the opening up of the market to competition (and subsequent changes to market structure) has worked well over the last fifteen years. They claim for example that in March 2006, 900,000 customers responded to a series of gas and electricity price rises by switching their energy supplier. Their energy-watch web site is designed to improve flows of information for consumers so that more of them can switch supplier.

The gas and electricity supply industry is best described as an oligopoly since virtually the whole market is taken by the six leading businesses. But the market is competitive because consumers have a real choice about who will sell them their energy. The market share of new entrants into the industry since privatisation is now above 40 per cent for both gas and electricity. British Gas has seen a steady and persistent decline in its share of the gas market and by March 2006 this was down to 52 per cent compared to 63 per cent in the winter of 2002.

What is a monopoly?

There are several meanings of the term monopoly:

• A pure monopolist in an industry is a single seller. It is quite rare for a firm to have a pure monopoly – except when the industry is state owned and has a legally protected monopoly position. The Royal Mail used to have a statutory monopoly on delivering household mail. But this is now changing as the industry is being opened up to fresh competition.
• A working monopoly: A working monopoly is any firm with greater than 25% of the industries' total sales. In practice, there are many markets where businesses enjoy some degree of monopoly power even if they do not have a twenty-five per cent market share. In the UK market for breakfast cereals for example, Kellogg’s had a 39 per cent share of a market where total sales were 31.2 billion in 2005. Cereal Partners (Nestle) took 17 per cent of the market and Weetabix secured 15 per cent. 
• An oligopolistic industry is characterised by the existence of a few dominant firms, each has market power and which seeks to protect and improves its market position over time.
• In a duopoly, the majority of market sales are taken by two dominant firms. A good example of this is the market for razors in the UK – one dominated by Gillette and also is Schick (the manufacturers of the Wilkinson Sword brand). Gillette has approximately 70% of the global shaving market.

How monopolies can develop

Monopoly power can come from the successful organic (internal) growth of a business or through mergers and acquisitions (also known as the integration of firms).

Horizontal Integration 
This is where two firms join at the same stage of production in one industry. For example two car manufacturers merge, or a bank successfully takes-over another bank. A good recent example in the UK is the merger between Safeway and Morrisons to create the UK’s fourth largest national food retailer. Another example came in July 2004 with the merger between Travel Inn and Premier Lodges to form Premier Travel Inn. And in August 2005, German sports goods firm Adidas announced an agreement to buy US rival Reebok for £2.1bn.

Vertical Integration     
This is where a firm develops market dominance by integrating with different stages of production in the industry e.g. by buying its suppliers or controlling the main retail outlets. A good example is the oil industry where many of the leading companies are explorers, producers and refiners of crude oil and have their own retail networks for the sale of petrol and diesel and other products.

• Forward vertical integration occurs when a business merges with another business further forward in the supply chain
• Backward vertical integration occurs when a firm merges with another business at a previous stage of the supply chain

Case Study: Building a Monopoly Position

Tesco has built a monopoly position in the UK food retailing industry and is now increasing its share of the non-food retail sector. What are the costs and benefits of Tesco’s dominance?

Market share in the UK retail grocery industry for the 12 Weeks to 18 June 2006

The Internal Expansion of a Business 

Firms can generate higher sales and increased market share by expanding their operations and exploiting possible economies of scale. This is internal rather than external growth and therefore tends to be a slower means of expansion contrasted to mergers and acquisitions.  To go back to our previous example, US computer giant Dell succeeded in raising total sales revenue by 58 per cent over the last five years.

Preventing competition - barriers to entry

Barriers to entry are the means by which potential competitors are blocked. Monopolies can then enjoy higher profits in the long run as rivals have not diluted market share. There are several different types of entry barrier – these are summarised below:

• Patents: Patents are legal property rights to prevent the entry of rivals. They are generally valid for 17-20 years and give the owner an exclusive right to prevent others from using patented products, inventions, or processes. The owners of patents can sell licences to other businesses.

• Advertising and marketing: Developing consumer loyalty by establishing branded products can make successful entry into the market by new firms more expensive and less successful. Advertising can also cause an outward shift of demand and also make demand less sensitive to price

• Brand proliferation: In many industries multi-product firms engaging in brand proliferation can give a false appearance of competition to the consumer. This is common in markets such as detergents, confectionery and household goods – it is non-price competition.

Monopoly, market failure and government intervention

Should the government intervene to break up or control the monopoly power of firms in markets? This debate about the benefits and costs of government intervention revolves around the advantages and disadvantages of businesses holding monopoly power.

A monopolist is able to enjoy and exploit some power over the setting of prices or output. But be careful of stating that monopolists can “charge any price that they like”! A monopolist cannot, charge a price that the consumers in the market will not bear! In this sense, the price elasticity of the demand curve acts as a constraint on the pricing power of the monopolist.

The economic and social costs of monopoly

The main case against a monopoly is that these businesses can earn higher profits at the expense of allocative efficiency. The monopolist will seek to extract a price from consumers that is above the cost of resources used in making the product. And higher prices mean that consumers’ needs and wants are not being satisfied, as the product is being under-consumed. Under conditions of monopoly, consumer sovereignty has been partially replaced by producer sovereignty.

In the diagrams above we contrast a market where demand is price inelastic (i.e. Ped <1) with one where demand is more sensitive to price changes (i.e. Ped>1). The former is associated with a monopoly where consumers have few close substitutes to choose from. When demand is inelastic, the level of consumer surplus is high, raising the possibility that the monopolist can reduce output and raise price above cost thereby operating with a higher profit margin (measured as the difference between price and average cost per unit).

One way of showing the loss of economic welfare that comes from monopolistic firms exploiting their power is to use supply and demand analysis and the concepts of consumer and producer surplus. If a monopoly reduces output from the equilibrium at Q1 to Q2 then it can sell this at a higher price P2. This results in a transfer of consumer surplus into extra producer surplus. But because price is now about the cost of supplying extra units, there is a loss of allocative efficiency. This is shown in the diagram by the shaded area which is not transferred to the producer, merely lost completely because output is lower than it would otherwise be in a competitive market.

Higher costs – loss of productive efficiency:

Another possible cost of monopoly power is that businesses may allow the lack of real competition to cause a rise in production costs and a loss of productive efficiency. When competition is tough, businesses must keep firm control of their costs because otherwise, they risk losing market share.  Some economists go further and say that monopolists may be even less efficient because, if they believe that they have a protected market, they may be less inclined to spend money on research and improved management. These inefficiencies can lead to a waste of scarce resources.

The potential benefits of monopoly

The possible economic benefits of monopoly power suggest that the government and the competition authorities should be careful about intervening directly in markets and try to break up a monopoly.
Market power can bring advantages both to the firms themselves and also to consumers and these should be included in any evaluation of a particular market or industry.

1. Research and Development Spending

Huge corporations enjoying a high level of profits are well placed to allocate some of their profits to fund capital investment spending and research and development projects. The positive spill-over effects of research can be seen in a faster pace of innovation and the development of improved products for consumers. This is particularly the case in industries such as telecommunications and pharmaceuticals. This can lead to gains in dynamic efficiency and social benefits (i.e. positive externalities). The table below provides data from the 2005 UK research and development survey. The top firms are all household names, large scale businesses, and operating in industries and sectors where research spending is hugely important in being competitive against global competition.

2. Exploitation of Economies of Scale

Because monopoly producers often supply goods and services on a large scale, they may achieve economies of scale – leading to a fall in average costs. Lower costs will lead to an increase in profits but the gains in productive efficiency might be passed onto consumers through lower prices. 

3. Monopolies and International Competitiveness

One argument in support of businesses with monopoly power is that the British economy needs multinational companies operating on a scale large enough to compete in global markets. A firm may enjoy domestic monopoly power, but still face competition in overseas markets. Two good examples of these are UK Coal and Corus, the UK-Dutch owned steel manufacturer.

Government intervention in markets – an introduction to UK competition policy

Competition policy involves the regulation of markets so that consumer welfare is protected and improved. It operates in different ways – three of the main competition bodies are the Competition Commission, the Office of Fair Trading and the European Union Competition Authority.

• The Competition Commission carries out inquiries into matters referred to it by the other UK competition authorities. Their main concern is to investigate mergers and takeovers to examine if these mergers will have a negative effect on overall competition. For more details go to their web site: www.competition.gov.uk

• The Office of Fair Trading reports on allegations of anti-competitive practices including claims of collusive behaviour where businesses are thought to be engaging in price-fixing. Their web site is at www.oft.gov.uk

• The European Competition Authority monitors competition in the European single market. They examine anti-competitive behaviour, mergers and takeovers between European businesses and investigate state aid to struggling businesses to make sure that subsidies do not reduce or distort competition. Their web site is at http://europa.eu.int/comm/competition/index_en.html

• Utility regulators monitor the industries that were privatised during the 1980s and 1990s. The regulators have used the power to introduce and review price capping and they have also have sought to bring fresh competition into markets. Competition was introduced into the telecommunications in 1984; in Gas from 1996-98 and in Electricity from 1998.

Another key role for the regulatory agencies is to monitor the quality of service provision and improve standards for consumers. Examples of utility regulator web sites can be found by using the following links:

OFGEM:           www.ofgem.gov.uk/ofgem/index.jsp
OFWAT:           www.ofwat.gov.uk/
OFCOM:           www.ofcom.org.uk/

• Technological change – e.g. the rise of e-commerce and the internet
• Globalisation – e.g. fresh low-cost competition from emerging market economies such as China and India
• Deliberate government policies (in the UK and the European Union) to open up markets and give new businesses the right to compete (e.g. in the markets for postal services, car retailing and telecommunications)

Deregulation of monopoly
An important government policy towards markets where monopoly power exists is to open up markets and encourage the entry of new suppliers into a market where there was monopoly power in the past – a process called de-regulation.
Examples of this in the UK include the opening up of markets for household energy and the introduction of competition into Postal Services.
The expansion of the European Union Single Market has accelerated the process of market liberalisation. The Single Market seeks to promote four freedoms – namely the free movement of goods, services, financial capital and labour. In the long term we can expect to see the microeconomic effects of the EU Single Market working their way through many British markets and industries and the general expectation is that competitive pressures for all businesses working inside the European Union will continue to intensify.