COMPETITION LAW

THE THEORY OF COMPETITION

It is important to distinguish the meaning of competition from the function it is

to fulfil.

Competition means a struggle or contention for superiority. In the commercial

world, it means a striving for the customer and the business at the market place.

According to Neo-classical economic theory consumer welfare is maximised in

conditions of perfect competition. Under perfect competition economic
resources are allocated between different goods and services in precisely the
quantities which consumers wish their desires being expressed by the price they
are prepared to pay in the market. This is termed as Allocative Efficiency.

Apart from allocative efficiency many economists and non-economists think that
under perfect competition goods and services will be provided at the lowest cost
possible which means that as little of the societys wealth is used in the
production process as necessary and this is termed as Productive Efficiency.

There are further desirable effects that follow from perfect competition. The
price at which goods or services is sold never rises above the marginal cost of
production. In this case costs for this purpose include a sufficient profit margin
to encourage the producer to invest his capital in the industry in the first place
but no more than that.

Monopolists on the other hand flee from the constraints of competition may be
high cost producers. In the competitive market, it is said that producers will
constantly innovate and develop new products as part of the continuing battle of
striving for consumer business. Thus competition may have the desirable
dynamic effect of stimulating important new technological research. These
beneficial effects would flow from a state of perfect competition if such a state
could ever exist.

What perfect competition means is that on any particular market, there is a very
large number of buyers and sellers all producing identical or similar products and
that consumers have perfect information about market conditions. Also that
resources can freely flow from one area of economic activity to another and that
there are no barriers to entry which might prevent the emergence of new
competition nor barriers to exit which might hind firms wishing to leave the
industry.

Of course a market structure satisfying all these conditions is unlikely if not

impossible. But what the theoretical model shows is that in perfect competition
any producer will be able to sell his products on the market only at the price
which the market is prepared to bear. In this situation the producer is said to be
the price taker with no capacity to affect the price by his own unilateral action
because it depends on the market.

The consumer is said to be sovereign

Allocative efficiency is achieved under perfect competition because the producer

assuming he is acting rationally and has the desire to maximise his profits will
expand his production for as long as it is privately profitable to do so. As long as
he can earn more by producing one extra unit of whatever he produces than it
costs to make it, he will do so. Only when the cost of a further unit exceeds the
price he would obtain from it will he cease to expand production.
Productive efficiency is achieved because a producer is unable to sell above cost,
if he did so his customers would immediately desert him and he will not of
course sell below cost because he will not make a profit. If he charges above
cost other competitors would move into the market in the hope of profitable
activity. They would attempt to produce on a more efficient basis so that they
could earn a greater profit.

In the long run the tendency of this will be to force producers to incur the lowest
cost possible in order to be able to earn any profit. Eventually the point will be
reached where price and the average cost of producing goods necessarily
coincide and this will mean that price will never rise above cost. If on the other
hand price were to fall below cost, there would be an exit of capital from that
industry and as the output would therefore decrease price would be restored to
a competitive level.

MONOPOLIES

Monopoly is the extreme opposite to perfect competition. They exist when there
is only one supplier for a particular product and there is no close substitute for
that product.

Under conditions of monopoly the situation is different. The Monopolist is in a

position to affect market price since he is responsible for all of the output and
since it is the aggregate output that determines price through the relationship of
supply to demand he will be able to increase price by reducing the volume of his
own production.

Furthermore again assuming a motive to maximise profits, the monopolists will

see that he will be able to earn the largest profit if he refrains from expanding
his production to the maximum possible. The results will be that output is lower
than could be the case in perfect competition. Thus the consumer will be
deprived of goods and services that they would have been prepared to pay for at
the market price.

There is therefore allocative inefficiency because societys resources are not

being distributed in the most efficient way possible. This inefficiency is made
worse by the fact that consumers deprived of the monopolised product that they
would have bought will spend their money on products which they wanted less.
The extent of this allocative inefficiency is sometimes referred to as the Dead
Weight Loss attributable to monopoly.

The objection to monopoly does not stop there, there is also the problem that
productive efficiency may be lower because the Monopolist is not constrained by
competitive forces to reduce costs to the lowest possible level. Instead the firm
becomes inefficient, resources are used to make the right product but less
productively than they might be. Management spends too much time on the golf
course, outdated industrial processes are maintained and a general laziness
creeps into the organisation. Furthermore the monopolist may not feel the need
to innovate because he does not experience the constant pressure to go on
attracting customers. Thus it has been said that the greatest profit of the
Monopolist is the quiet life he is able to enjoy.

Another objection to the monopolist is that since he can charge what he likes, he
is the price maker and wealth is transferred from the consumer to him and this
may be particularly true where he is able to discriminate between consumers
charging some more than others. Moreover it has been argued that the very
prospect of earning large monopoly profits can encourage firms to misallocate
resources and this induces wasteful expenditure. In attempts to acquire a
monopoly position which is a loss to society at large.
QUESTIONING THE THEORIES

We have said that the theory of perfect competition is only a theory and that
such conditions are extremely unlikely. Between the market structure of perfect
competition and monopoly, there are many intermediate positions. Many firms
will sell products which are slightly different from their rivals or will command
some degree of consumer loyalty which means that an increase in price will not
necessarily result in a massive loss of business. In such a situation there is said
to be monopolistic competition. This means that on the one hand the producer
enjoys some monopolistic power in respect of products differentiated from that
of others but on the other hand that the consumers loyalty to a particular brand
is not endless and that he will switch to a competitors brand if the price rises
too greatly. It is also unlikely that a customer will have such complete
information of the market that he will immediately know that a lower price is
available elsewhere for the product he requires. Yet the theory depends on
perfect information being available to the consumer. In the same way monopoly
in its purest sense is extremely rare and a point may come when even a firm
which produces the entire output of one particular product will find that it has
raised prices so high that consumers cease to buy.

Monopoly power does not exist in relation to a product but in relation to a

relevant product market. This definition of relevant product market must meet
two criteria

1. It must be sufficiently narrowly drawn to exclude non-substitutes.

2. It must be sufficiently broadly drawn to include all substitutes.

Much more likely is the situation where one firm dominates a market without
having a complete monopoly. That firm may be able to behave in a manner
similar to the monopolist. But the complex economic problem is to establish at
what point a firm has the requisite degree of power to be able to do so.
Apart from the fact that perfect competition and pure monopoly are unlikely,
there are other problems with the theory itself. It depends on the notion that
all business people are rational and that they always attempt to maximise profit
but this is not necessarily the case.

Directors of a company may not think that earning fast profits for the
shareholders is the most important consideration they have. They may be more
interested to see the size of their business grow or indulge themselves in the
quiet life that monopolists may enjoy.

Critique of the Theories of perfect competition

Another problem with the theory of perfect competition is the assertion that
costs are kept at an absolute minimum which is not necessarily correct. It may
be correct as far as the private costs of the developer are concerned but it does
not take into account the social costs or externalities as they are known which
arise from society at large; from for example the air-pollution that a factory
causes or the injuries caused to workers because of cheap machinery used which
does not include satisfactory safeguards against injury.

It has been argued that competition law should not concern itself with those
social costs and that this is a matter best left to specific legislation on issues
such as conservation, the environment, health and safety at work. It would also
wrong to suppose that the monopolist does not produce social costs but none the
less it is reasonable to sceptical of the argument that in perfect competition
costs will be inevitably kept at a minimal level. So given these doubts it might
be wondered whether a pursuit of an ideal is worthwhile at all.

There are further problems; if perfect competition cannot be achieved then

alternative model is needed to explain how imperfect markets work or should
work. In particular it will be necessary to decide how monopolistic or dominant
firms should be treated and an adequate theory will be needed to deal with
oligopoly which is a common industrial phenomena which exists where a few
firms between them supply most of the products within the relevant market
without any of them having a clear advantage over the other.

Some economists have argued that the most common market form is oligopoly
and therefore competition policing ought to be designed around an analytical
model of this phenomenon rather than on the theory of perfect competition.

QUESTIONING THE THEORY OF COMPETITION:

A Case for Monopoly?

Another line of inquiry considers whether perfect competition would be

beneficial anyway. It may have some attractions but does it necessarily offer
society the best economic policy? one of the arguments against the notion of
perfect competition relates to scale. In some industries products can be
produced very cheaply and the market for them may be large so that there is no
difficulty in the way each producer expanding output to the point at which
marginal costs and marginal revenues intercept and disposing of the entire
amount produced. In reality this is not always the case, considerable capital
investments may be needed to produce some goods and the size of the market
may be small in relation to the cost of production. In some markets a profit can
be made only by a firm supplying at least one quarter or one third of the total
output. It may even be that the minimum efficient scale of operation is
achieved only by a firm with a market share exceeding 50% so that the monopoly
may be seen to be a natural market condition. Where the scale is of such
importance to the market it is absurd to attempt to achieve perfect competition
which would destroy the efficiency of production at the appropriate level.
OPTIONS

Where the minimum efficient scale is very large in relation to total output, a
separate question arises as to how industries can be made to operate in a way
that is beneficial to society as a whole. One of the solutions may be
Nationalisation.

1. Nationalization

2. Bureaucratic Regulations being introduced while leaving the producers

in the private sector; let the private sector do it then we regulate
them

3. Firms should be allowed to bid for a franchise to run the industry in

question for a set period of time at the end of which there would be a
further round of bidding. In other words there will be periodic
competition to run the industry although no actual competition within
it.

Whatever the solution to the problem of natural monopoly, the point at this
stage is simply that efficiency of scale presents difficulties for the theory of
perfect competition. Equally it might be that social or political value judgments
lead to the conclusion that competition is inappropriate in a particular economic
sector. For example in the US, Agriculture is an obvious example and the
legislator has tended to view that agriculture possesses special features entitling
it to protection from the potentially ruthless effects of the competitive system
and especially outside foreign competition.
Another example is the labour market which is not fully exposed to the
competitive process and there is a tendency to refrain from insisting that
professionals should engage in price competition in advertising.

Another line of argument is that in some circumstances restriction of

competition can have negatively beneficial results which can manifest
themselves in various ways. For example the suggestion that firms which are
forced to put down costs to the minimum because of the pressures of
competition will be negligently on safe cheques. This is particularly true of the
transport sector where fears have often been expressed that safety has been
subordinated to the profit motive.

Another example which is more important in practice is that two or more firms
acting together and restricting competition between themselves may be able to
develop new products or to produce goods on a more efficient scale. For
example in the pharmaceutical industry the benefits to the public at large may
be considerable.

These examples suggest that a blanket refusal to allow restrictions of

competition may deprive the public of substantial advantages.

Another objection is that the notion of striving for superiority may be considered
ethically unsound. One of the arguments is that cutthroat competition means
that firms are forced to charge lower prices until in the end the vicious cycle
leads them to charge below marginal costs in order to keep customers at all.
The inevitable results will be insolvency.

Competition is also thought to be undesirable because of the wasteful effects for

example the consumer may be incapable of purchasing a tin of beans in one
supermarket because of fear that at the other end of town there is a competitor
who is offering the product more cheaply. He will waste his time which is a
social cost and money in shopping around. Meanwhile competitors will be
wasting their own money by paying advertising agencies to think up more
expensive and elaborate campaigns to promote their products. It has been
argued that this type of conventional competition leads to chronic waste in
which everybody loses and attention should be focused not on the supposed evils
of say for example cartelizaton in the petroleum industry but rather on the
freedom of firms to exit from an industry if and when they see an opportunity to
operate more profitably on another market (contestable markets).

A more serious practical objection to promoting competition is that it is often

contrary to the general thrust of industrial policy in many countries. The
suggestion has been made that in conditions of perfect competition firms will
innovate in order to keep or attract new customers. However governments often
encourage firms to collaborate where these would lead to economies of scale or
to more efficient research and development. And therefore in practice is seems
that the innovator, the entrepreneur and the risk taker may require some
immunity if they are to indulge in expensive technological projects and this is
recognised in the law of Intellectual Property Rights which provides incentives to
firms to innovate by preventing the appropriation of the commercial ideas which
they have developed. Thus owners of copyrights patents, registered designs and
other related rights are given exclusive rights to exploit the subject matter of
their innovation for a certain number of years. This is recognition of the fact
that in some circumstances competition suppresses innovation and an indication
that it is not realistic to pursue the ideal of perfect competition.

A last point which should be made with regard to objections to competition is

that the competitive process contains an inevitable paradox. Some competitors
win by being the most innovative. The most responsive to customers wishes and
by producing in the most efficient way possible, thereby succeeding in seeing off
its rivals. It would be strange if that firm is condemned for being a monopolist.
WORKABLE COMPETITION

This discussion on the theory shows that the issue is not as simple and one must
decide whether competition has any properties sufficiently beneficial to justify
its protection. The conclusion would seem to be that notwithstanding the doubts
expressed sufficient benefits may be expected to flow from competition to
warrant some system of control. In particular monopoly does seem to lead to a
restriction in output. There is a greater incentive to achieve productive
efficiency in a competitive market and competition is likely to leave the
consumer with a greater degree of choice. However if perfect competition is not
attainable the question arises as to whether there is any other economic model
to which it could be reasonable to aspire to.

Some economists have settled for the theory of workable competition, they
recognise the limitations of the theory of perfect competition but nonetheless
consider it worthwhile seeking the best competitive arrangement that is
practically attainable. Again what is workable competition and what it should
consist of has caused some theoretical difficulties. However a workable
competitive structure might be expected to have a beneficial effect on conduct
and performance and therefore be worth striving for and maintaining. If it is
accepted that workable competition is desirable then a competition law
designed to protect it will need to deal with four problems:

1. To prevent firms entering into agreements which has the effect of

restricting competition either between themselves or between
themselves and third parties and which do not have any beneficial
features.
 2. It will need to control attempts by Monopolists or dominant firms to
abuse their position and prevent new competition emerging.

3. It will need to ensure that workable competition is maintained in

oligopolistic industries.

4. It will need to monitor mergers between independent undertakings,

the effect of which maybe to concentrate the market and diminish the
competitive pressure within it.

CONTESTABLE MARKETS

In recent years some economists have advanced a theory of contestable markets

upon which competition will be forced to ensure and optimal allocation of
resources provided that the market on which they operate is contestable i.e. a
market where barriers to entry and exit are reduced. In a perfectly contestable
market entry into the industry is relatively free and exit is costless. The
emphasis on exit is important as firms should be able to leave an industry
without incurring a loss if and when opportunities to profit within it disappear.

A perfectly contestable market need not be perfectly competitive. This means

that the theory can accommodate much more real business behaviour than the
theory of perfect competition. Even an industry in which only two or three firms
are operating may be perfectly contestable where there are no barriers to entry
or exit.

THE ROLE OF POLICY DIRECTION IN COMPETITION LAW

If the sole function of competition law was the maximisation of consumer

welfare by achieving most efficient allocation of resources and by reducing costs
as far as possible the formulation of legal rules and their application would be
relatively simple. In reality however, many different policy objectives have been
pursued in the name of competition law many of them which are not rooted in
the notion of consumer welfare strictly speaking. Some of them are even
contrary to the pursuit of allocative and productive efficiency. It is important to
note that competition policy does not exist in a vacuum. It is an expression of
the current values and aims of society and it can change depending on the
political thinking because views change overtime, competition law is often
infused with tension and furthermore different systems of competition law
reflect different concerns.

Several objectives have been ascribed to competition law.

1. Its essential purpose should be to protect the consumer not in the

sense of maximising consumer welfare but in the more specific sense
of safeguarding individuals against the power of monopolists or the
anti-competitive agreements made by independent firms. Monopolies
can earn huge profits and there is an argument for preventing the
accumulation of wealth at the consumers expense.

2. Competition law should be applied in such a way as to protect the

small firms against more powerful rivals. The competition authorities
should ensure that the small businesses are given a chance to succeed.

3. Competition law may be used as an instrument of other policies.

4. There is the issue of competition outside the borders of the country

i.e. International Trade issues and the internal barriers to trade. Firms
should be able to outgrow their national markets and operate on a
more efficient scale throughout the region or the world. The positive
role that competition law can play is that it can be modelled in such a
way as to encourage inter-country trade and level the playing ground.