Chapter 8 Competition, Market Failure and Gov’t Intervention

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Chapter 8

Competition, market failure & government

intervention

CHAPTER 8 COMPETITION, MARKET TERVENTION

88 www.studyinteractive.org

CHAPTER CONTENTS

LEARNING OUTCOMES -------------------------------------------------- 89

BUSINESS INTEGRATION ----------------------------------------------- 90

MEASURES OF MARKET CONCENTRATION ---------------------------- 91

MEASURING MARKET CONCENTRATION 91

MONOPOLIES, COLLUSION AND COMPETITION POLICY ------------ 93

EXTERNALITIES ---------------------------------------------------------- 96

GOVERNMENT INTERVENTION ----------------------------------------- 98

INDIRECT TAXATION AND SUBSISIDIES ---------------------------- 100

GOVERNMENT REGULATION ------------------------------------------- 102



LEARNING OUTCOMES

(a) Explain market concentration and the factors giving rise to differing levels of

concentration between markets, including acquisitions and combinations.

(b) Identify the impacts of the different forms of competition on prices, output

and profitability.

(c) Explain the main policies to prevent abuses of monopoly power by firms.

(d) Explain market failures and their effects on prices, efficiency of market

operation and economic welfare.

(e) Explain the likely responses of government to market failures.



BUSINESS INTEGRATION

The four quadrants represent the potential directions of growth for a firm.

Forms of growth

The above strategies may be achieved through either organic growth or merger &

acquisition. The below diagram illustrates the growth options available to a miller

(producer of flour used for making bread)

BAKERY

MILL MILL DELICATESSEN

FARMER

a) Forward vertical integration;

b) Horizontal integration;

c) Backward vertical integration;

d) Conglomerate diversification.

Market Penetration

Product Development

Market Development

Diversification

Current New

Current

New

PRODUCTS

MARKETS

(a)

(c)

(d) (b)



MEASURES OF MARKET CONCENTRATION

The relevance of market concentration enables a greater understanding of the

determinants of price.

As market concentration increases, this limits the availability of substitutes and

therefore reduces price elasticity of demand.

With an inelastic demand curve firms look to increase prices in the knowledge

that the overall reduction in demand will be less than in proportion to the increase

in price, resulting in increased profits!

Measuring market concentration

There are two main methods available to measure market concentration:

1. Market concentration ratio (may need to calculate in the exam);

2. Herfindahl index (may need to calculate in the exam);

1. Market concentration ratio

A simple percentage of overall output in a given industry, is calculated for the

top four or five firms typically.

2. Herfindahl index

The Herfindahl index provides a more accurate representation of market

concentration than that of the market concentration ratio.

Rather than considering the top four/five firms in an industry, all firms are

included. However, in order to emphasise differentials, the market

percentage share of each firm is squared and then an overall market total

calculated.



Exercise 1

The following table shows two markets, each with six firms operating. The

respective market shares are shown in descending order.

Firms Market A %

share

Market B %

share

Market B

1 40 60

2 20 10

3 20 10

4 10 10

5 5 5

6 5 5

Total -

Complete the above table calculating market concentration based on a four

firm ratio, and based on the Herfindahl index.

Note: Using the Herfindahl Index the output will vary between 0 (perfect

competition) and 10,000 (pure monopoly).



MONOLPOLIES, COLLUSION AND COMPETITION POLICY

Market structure spectrum

Monopoly

A monopoly exists when there is a sole supplier within a given industry. For a

monopoly to exist there must be no close substitutes along with barriers to entering

the market.

As a consequence of there being no close substitutes, demand tends to be relatively

inelastic. The monopolist faces the entire market demand curve, in the absence of

regulation, will produce a level of output that maximizes profits.

Illustration

Barriers to entry

1. Product differentiation

2. Exclusive control

3. Economies of scale

4. High start-up costs

5. Cartel agreements

6. Geographical barriers

Monopoly Duopoly Oligopoly Monopolistic Perfect competition

$

Quantity

D0

Competitive

supply

Monopolistic supply

P1

P2

Q2 Q1 Z

Profits gained

Profits lost



Collusion practices

Collusion involving a formal agreement among competing firms, where there is a

small number of sellers distributing a homogenous product may be defined as a

cartel.

In most economies cartels are illegal, however do exist on a global level since

international laws are inadequate insofar as brining about prosecutions.

The formation of a cartel relies upon:

(a) Firms in the cartel must be able to control supply to the market.

(b) The firms must agree on a price and on the output each should produce.

(c) There should be barriers against new suppliers entering the industry.

The success of a cartel will depend on:

The number of producers in the market comprising the cartel.

Availability of substitutes.

The ability to restrict supply.

Price elasticity of demand.

The ability of producers to agree on their share.

Arguments for monopolies

Arguments against monopolies



Approaches to competition policy

Overall the aim of competition policy is to prevent undesirable outcomes that

typically derive from the abuse of market power.

Vs

Rules

Approach

Discretionary

Approach



EXTERNALITIES

An externality is a cost or benefit that is not reflected through prices. It is

incurred by a party who was neither the buyer nor the seller of the goods or

services that gave rise to the externality.

The cost of an externality is a negative externality or external cost, while the

benefit of an externality is a positive externality or external benefit.

Discussion 1

Discuss and categorise the following as to whether they give rise to positive or

negative externalities.

Pollution

Vaccination



The below diagram illustrates the notion that the free market would determine

equilibrium at point Py,Y.

In the absence of government intervention a polluting factory would not factor in

the full social costs of production when deciding what level of output to produce.

Were a tax to be imposed on output, such that the tax revenues raised go towards

off-setting any environmental damage, this would cause the supply curve to shift

left, which in turn would reduce overall output, leading to a more socially desirable

outcome at Px, X.

$

Quantity

D0

S1

Py

Px

X Y

S0



GOVERNMENT INTERVENTION

Public goods

The definition of a public good derives from the following criteria:

Excludable Non-Excludable

Diminishable Private goods Common goods

Non-Diminishable Club Goods Public goods

Exercise 2

Categorise the following according to the above table: Lighthouse, Club Sandwich,

Internet, Fish Stocks.

Excludable Non-Excludable

Diminishable

Non-Diminishable

A common mistake when classifying public goods is to confuse those goods

Eg Healthcare (National Health Service in the UK). Healthcare is both excludable

and diminishable.



Merit goods and de-merit goods

Merit goods provide positive externalities, whilst de-merit goods provide negative

externalities.

Governments therefore attempt to increase the consumption of merit goods whilst

discouraging the consumption of de-merit goods.

Crucially, merit goods differ from public goods insofar as they could be supplied by

the free market, however despite perfect knowledge, consumers would buy a sub-

optimal quantity.

Merit Good

De-merit Good

Discussion 2

What measures might a government undertake to encourage education and

discourage smoking?



INDIRECT TAXATION AND SUBSISIDIES

Indirect taxes

Indirect taxes are levied on expenditure on goods or services, as opposed to direct

taxation which is applied to incomes.

Indirect taxes may be used to improve the allocation of resources when there are

damaging externalities, causing the supply curve to shift to the left as previously

discussed.

Exam questions often pick up on the notion of who the tax burden will affect the

most, producer or consumer. This will depend on the relative elasticity of

demand and supply. Consider the following extremes as to who incurs the tax

burden.

Demand more inelastic than supply

Demand is more elastic than supply

D0

S0

$ S1

Qty

D0

S0

$ S1

Qty



Subsidies

A subsidy is the payment to the supplier of a good by the government.

Reasons for government subsidy payments may include:

To encourage the production of a good.

To keep prices at a socially acceptable level.

To protect a vital industry.

The impact of a subsidy mirrors that of an indirect tax.

Beware of the relative elasticity of demand and supply when interpreting the overall

impact from a subsidy.

$

Quantity

D0

S0 S1

P1

P2

Q0 Q2

P0

Subsidy



GOVERNMENT REGULATION

Governments intervene in microeconomic matters when market forces do not

produce the outcomes they desire. Two further forms of intervention include:

Privatisation

Over the past twenty years there has been a trend away from state intervention,

with the growth of the private sector. s included:

Deregulation allowing private firms to compete with state owned companies.

Contracting out of government work previously done by government

employees.

Outright sale of businesses to private shareholders.

Public private partnerships (PPP)

As discussed in chapter 1, Public Private Partnerships are a form -way-

combining the benefits of state provision and private sector funding.

Chapter 8 Competition, Market Failure and Gov’t Intervention

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