Is the Competition Commission meeting its objectives in the UK retail grocery market?
Is the Competition Commission meeting
its objectives in the UK retail grocery
market?
A theory-based assessment
Stephen Watts
Edited by Hedley Stone
5/10/2009
Introduction
This project is about the economic debate around the control of monopoly power in
the UK. More specifically, its purpose is to assess the effectiveness of the
Competition Commission in identifying and tackling the abuse of monopoly power in
the UK retail grocery market through an examination of the design and impact of a
report published in 2008. I have selected the retail grocery market as there is a
recent competition report on it and it is a sector where a lot of information is in the
public domain.
In my analysis, I consider the theoretical basis of the report and will attempt to use
measures such as the Lerner Index, the Herfindahl-Hirschman Index and the
Cournot model to estimate monopoly power within the industry. I begin with a brief
review of the literature contained within DD309, go on to review other economic
literature on the theory surrounding monopolies and the abuse of monopoly
power.and then analyse how that theory has been applied in the report to the supply
of groceries in the UK market. Finally, I look at how the report has impacted on
developments within the grocery sector.
Literature Review
Within the static neoclassical model, perfect competition delivers normal profits to
firms and maximises consumer welfare such that the outcome is Pareto efficient – it
is not possible to make someone better off without making someone worse off.
Perfect competition by definition requires an indefinitely large number of consumers
and producers such that no one has any influence over the market price Reality of
course is far removed from this, but in a competitive environment you would expect
price competition to lower prices to the benefit of consumers at the expense of
producer profits.
At the other extreme of the neoclassical school is another static model, namely that
of a monopoly. In its purest sense it is where one supplier supplies the whole market
and in doing so is able to enjoy monopoly or ‘supernormal’ profits. For a monopoly to
be effective it will need barriers to entry or else its supernormal profits will attract
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other firms into the market. The more a firm can prevent other firms from entering the
market the more freedom it will have to exercise monopoly power. Often, the
competition authorities will be able to legislate to remove such entry barriers, but it
will be impossible to inject competition into a natural monopoly. A natural monopoly
occurs in an industry when the economies of scale are such that a single firm can
supply the market at lower average cost than a number of smaller firms (Costello
and Mackinosh 2006). A good example of a natural monopoly is a distribution
network with declining average costs over the range of output required. In this
situation the introduction of competition by the regulator will be pointless as
eventually, once again, one firm will dominate the market and regulation of that
market will be the only option.
Natural monopolies aside, most cases that the competition authorities have to
consider will lie somewhere between the two extremes outlined above. The role of
the competition authorities is to set the rules of the game; preventing firms from
getting too much monopoly power or, if that is unavoidable, to make sure the
benefits of the monopoly are targeted towards improving the welfare of consumers.
(Régibeau 2009)
The work of Mason and Bain has laid the foundations of the neoclassical analysis of
the impact of competition on the profitability of firms. The basic idea is that the
economic performance of an industry is a function of the conduct of buyers and
sellers which, in turn, is a function of the industry’s structure (Mason, 1939; Bain,
1956).
Industry structure includes such variables as the number and size of buyers and
sellers, technology available, degree of product differentiation, extent of vertical
integration and level of barriers to entry. This in turn impacts on firm conduct which
includes capacity installation and utilisation, promotion and pricing policies, inter-firm
competition or co-operation and research and development. Economic performance
is measured in terms of welfare maximisation (Scherer, 1980).
There are several ways of measuring market power. One way to measure the
degree of monopoly power within the industry would be the Lerner Index, which
seeks to measure the degree to which the price can be raised above the marginal
cost and is expressed as:
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The Herfindahl-Hirschman Index (HHI) measures market power indirectly by
measuring concentration in the industry. That is, it measures market power through
its link with market structure. The index sums the square of the market share for
each firm in the industry. We can relate the HHI to the Lerner Index by dividing by
the price elasticity of demand such that
The more price inelastic the demand for the goods (the closer the value of ε is to
zero) the higher the Lerner Index and the more ability there is to raise the price
above the marginal cost. (Regibeau 2009)
As mentioned above, the essential link between structure and performance is
barriers to entry and without them monopoly profits cannot be maintained. Barriers to
entry are defined by Bain as:
“the advantage of established sellers in an industry over potential entrant
sellers, these advantages being reflected in the extent to which established
sellers can persistently raise their prices above a competitive level without
attracting new firms to enter the industry” (Bain, 1956).
The concept of barriers has been further developed by Caves and Porter to include
mobility barriers. These are barriers that exist to existing firms in the market place
rather than to new entrants. These may explain why some firms in the industry do
better than others (Caves and Porter 1977).
In contrast to the static neoclassical model Schumpeter takes a dynamic approach
arguing that the monopoly profits that firms might be able to earn in concentrated
markets enables them to innovate in a way that they might not be able to if the
market was competitive. In other words rather than a sign of inefficiency monopoly
profits are the reward for previous innovation and the source of funds for future
innovation (Schumpeter 1987).
