St. Michael, Earl of Bensalem.

POLICIES WHICH A UK GOVERNMENT COULD USE TO CONTROL THE ACTIVITIES OF OLIGOPOLISTS

An oligopoly is a market structure with a few dominating firms. A firm inside this is called an oligopolist. Oligopolists are generally not liked by governments because unlike perfect competition, oligopolists are assumed to have a price making ability whereas in perfect competition, the consumer sets the price of the market the firms involved are thus price takers.

P1 P2

Q1

Q2

(Diagram from the Internet, I cant draw on the computer.) In the above diagram, the oligopolistic firms in the market will produce at MC=MR, the profit maximising output. (The assumption is that all firms want to maximise their profits and using price making ability they can). However allocative efficiency only occurs when MC=AR, i.e. supply=demand, and as you can see, oligopolist firms are not producing at Q2, the allocative efficiency optimum, instead they are producing at Q1, the profit maximising optimum. (Allocative efficiency is when the market produces the optimum amount of what consumers which to buy.)The distance between Q1 and Q2 is the amount of allocative inefficiency happening in the market. Now if you contrast this to firms in a competitive market, then these oligopolistic firms will be no longer be allowed to exploit the consumer with their producer surplus and supernormal profits (the black box), rather they would be forced to charge the consumer at P2 and not at the oligopolists P1 since that would now be the new equilibrium. Many governments see charging at P1, Q1 as uncompetitive if the allocative optimum is producing at P2, Q2, therefore they can use government policy to change it. The other problem that governments like to address is that of the anti-competitive behaviour of oligopolies in restricting output, their supernormal profits but also the fact that can be involved in predatory pricing (a barrier to entry in the market in that they can undercut firms, increase market share and then raise prices later with more market power). It is these characteristics of allocative inefficiency and the anti-competitive behaviour (supernormal profits, predatory pricing) associated with oligopolies which are the main reason for government control in markets. However oligopolies can be good in that markets with viable and long run economies of scale (savings due to size), oligopolies can exploit this advantage whilst other types of firms cant. This is because they have the money to be able to expand in size and be profitable in this exercise whilst small individual firms cant afford the financial risks involved. For example the supernormal profits they earn can be spent on research and development which 1 E-mail; smebthewizard@outlook.com Twitter; @SMEBtheWizard

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St. Michael, Earl of Bensalem. can create new, innovative products (improving allocative efficiency) whilst also using it to reduce their own costs (improving productive efficiency). (Of course without these supernormal profits, the firms would not be able to conduct this research since research carries a lot of risk and costs a fortune.) Naturally governments have to do something to encourage this innovation and stop their exploitation. A policy to stop exploitation would include regulation whilst to encourage they could try and make the market more contestable. Regulation is part of a set of government command and control policies. Essentially regulation is just laws and legalisation designed to stop anti-competitive actions by firms and usually included consequences for firms that break them, i.e. fines. A form of regulation could be merger restricting policies which bar firms from joining together whilst they could also be used to ban them from colluding together. This should mean that the firms cant use their joint market power to influence the market at large thus protecting consumers from any possible exploitation. (The assumption that firms wouldnt charge at P2 since they would lose customers and thus receive lower profits, however if they had more market power then they would charge P2 since lower profits wouldnt happen). Different countries have different types of regulation. The British approach is investigating merger applications on requests made to the Office of Fair Trading (OFT) and then reviewing, expanding the investigation with the Competition Commission (CC) who then investigate and deal with the problem if necessary. What this allows is for a thorough examination of the system whilst it allows for recommendations to be made and adhered to. However in light of the BSKB bid where News Corporation captured the OFT and tried to bypass the CC, regulatory capture (where regulators act for the producers whilst not protecting the exploitation of consumers) is rife. The European approach is policing oligopoly and anti-competitive behaviour in that they investigate whether firms existing are exploiting and then fine them. For example Microsoft has been fined billions of euros for preventing other internet software packages. Of course this administration cost that is again expensive, time consuming and can also lead to regulatory capture However in America, the policy used is generally trust busting whether the government can break trusts. (Trusts are generally oligopolies or monopolies). An example is Standard Oil, which was broken down from a 95% monopoly to smaller firms. However this still leads to concentrated market power since wealthy individuals will still end up dominating the market but now with oligopolies and not monopolies.

In general terms, however, the effects of merger and collusive regulation is that allocative efficiency should improve since the firm now produces at Q2. This is because the firm will not be able to charge at the profit maximising level (by law), and instead it will have to charge at supply=demand, the allocatively optimum level in order to make its profit. However it will not lead to long run productive efficiency since the firm would not be allowed to merge and thus gain from any long run economies of scale. (The assumption is that there are always long run economies of scale). The fact that the oligopolistic firms would not be able to gain from these economies of scale is because of there being no opportunity to reduce admin costs and also the increased efficiency of research and development (since duplication of innovation would be nonexistent), which mainly arise form successful mergers. This loss of potential increased productive 2 E-mail; smebthewizard@outlook.com Twitter; @SMEBtheWizard

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St. Michael, Earl of Bensalem. efficiency will mean that the higher cost of production for both firms will remain, and that the ability of the joint firm competing overseas is still limited. For example if the meagre of EADS and BAE was completed then they would have jointly competed against American competition, a much stronger base than if they were both singular firms. Also other drawbacks include the need for regulators to check and analyse whether or not the regulation is working and also whether it is being adhered to. A problem also lies in these regulators in that they could be captured, in that the regulators work in the interests of the oligopolists and not the consumer, a process called regulatory capture. For example, Ofwat has suggested to water firms to deal with leakages in their pipes, this should improve allocative efficiency since the waste of water should be reduced. However these can be largely ignored since the oligopolies want to maximise profits which can mean offloading the costs onto the consumer whilst keeping wasteful, inefficient firms in the market. The lengthy time and costly delays in investigating any problems has meant that most regulation is ineffective since the regulation was not fully enforced onto the producer and the producer was not changed in the way it should have. This is called government failure, whereas governments have made the situation worse by interfering, in this many cases, the administration and bureaucracy costs involved lead to the result of nothing being changed in the market and market failure increasing as a consequence.

For existing oligopolies other government policy may be used. For example, the removing of barriers to entry, where as governments remove the obstacles allowing others to compete in a market. It is part of free market, contestable market theory which at the centre assumes that markets need not face competition but the threat of potential competition instead. An example would be limiting the number of patents granted and changing the way patents are issued i.e. not patenting rectangles as seen recently in the tablet market. The theory is that if you allow more firms to compete and by removing enough barriers to entry (an example would be patents that stop the production, creation and selling of tablets). Then the impression of an artificial perfectly competitive market is created since firms inside the market are fearful of potential outside competition (and reduced profits). So if the existing firms collude and charge higher price or prices over the equilibrium level (supply=demand) then this gives off signals that abnormal profits can be made. Abnormal profits are extra profits made above normal profit, normal profit being the minimum level of profits needed to keep the firm competing in the market. Existing oligopolies colluding would now face the prospect of competition and the effect should mean that these existing firms have the incentive of being more productively and allocatively efficient since they dont want to be kicked out of the market and lose their profit from this market. They would be allocatively efficient since they would lower their prices and expand their output to willing buyers reducing their producer surplus and creating more consumer surplus. (As if they did not, outside firms or entreputional individuals, would join the market and take away their profits 3 E-mail; smebthewizard@outlook.com Twitter; @SMEBtheWizard

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St. Michael, Earl of Bensalem. and market share.) The productive efficiency comes from the need to lower average costs since if they couldnt then they wouldnt be able to produce goods at the right price, without losing customers and profit. This should lead to an increase in research and development spending, further improving the dynamic efficiency of the firm, of which was a direct result from this need to reduce the average costs. This may improve employment, since more research workers and managers are needed, whilst building up the oligopolist to compete on an international scale with its reduced average costs. Ofcourse it is worth noting that an overhall of patent regulation might reduce research since firms will not want to pay for others to steal their hardwork but if patents are issued properly then this will not be the case. However this is theory, and in practise the effectiveness of reduced barriers to entry may be limited due to any sunk costs involved. Sunk costs are costs that can not be retrieved when leaving the market and as such many firms, large or small, would not risk millions of pounds competing in a market that they do not understand. Examples include equipment and fixed costs. In reality, governments have overcome this by giving out subsidies (to encourage production by other firms) though a lot of these are politically motivated whilst being expensive as well as wasteful. They could wasteful in that the money could be misused, not used or generally they could go to firms that dont need it.

Oligopolies are good because of the price stability and the fact that supernormal profits can fund innovation that can improve the allocatively and productive efficiency of markets. However they do tend to exploit the consumer and be anticompetitive. So therefore the UK government could use American style merger regulation to stop the creation of oligopolists (or monopolies) in the first place, European style regulation to exploitation or continue the British approach of investigation. However government failure resulting from regulation is a major problem whilst the main problem of contestable market theory is sunk costs, which can be largely overcome by subsidies given to firms to pay for research and development or possible expansion whilst regulatory capture is not exactly controllable. Therefore I would advise the government to allow oligopolies to compete but to make sure that use their supernormal profits efficiently, allocatively and productively, by breaking down the barriers to entry to promote the aspect of potential competition. This use of contestable market theory would help improve consumer welfare and happiness, the true role of government.

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