Edexcel A-Level Economics · Revision notes

3.6.1 Government intervention

Firms with market power can raise prices, restrict output, reduce choice and pay their suppliers and workers less than they would in a competitive market. Governments intervene to limit this. This topic covers the four areas of intervention in the specification: controlling mergers, controlling monopolies, promoting competition and contestability, and protecting suppliers and employees. Whether that intervention works is covered in 3.6.2 The impact of government intervention.

Why governments intervene

A profit-maximising monopolist produces where marginal revenue equals marginal cost. Compared with a competitive market, price is higher and output is lower.

The problems with market power

• Allocative inefficiency. Price is above marginal cost, so consumers who value the good above its cost of production do not buy it. There is a welfare loss.
• Productive inefficiency. The firm may not produce at the lowest point on its average cost curve.
• X-inefficiency. Without the pressure of competition, costs may be higher than necessary.
• Less choice and lower quality for consumers.
• Monopsony power. A dominant buyer can push down the prices paid to suppliers or the wages paid to workers.

Evaluation: Market power can bring benefits too, such as economies of scale and supernormal profits that fund research and development. Intervention therefore tries to limit the harm without losing these gains.

In the UK, the main body is the Competition and Markets Authority (CMA), set up in 2014, alongside industry regulators such as Ofgem (energy), Ofwat (water), Ofcom (communications and post) and the Office of Rail and Road.

Government intervention to control mergers

A merger between two firms in the same market (horizontal integration) can reduce the number of competitors and increase market power. The CMA can investigate mergers that involve large firms or that would give the merged firm a large share of supply in the UK.

How merger control works

1. Phase 1. The CMA carries out an initial review to decide whether the merger may lead to a substantial lessening of competition.
2. Phase 2. If it may, the CMA carries out a more detailed investigation, looking at the effect on prices, choice, quality and innovation.
3. Decision. The CMA can clear the merger, clear it subject to conditions, or block it.

Possible remedies

• Blocking the merger outright.
• Requiring the sale of part of the business, such as some stores or brands, so that competition is maintained.
• Behavioural conditions, such as promises to keep prices down or to supply rivals on fair terms.

UK examples

• In 2019, the CMA blocked the proposed merger of Sainsbury's and Asda, concluding it would lead to higher prices and lower quality for shoppers.
• In 2023, the CMA initially blocked Microsoft's takeover of Activision Blizzard over concerns about competition in cloud gaming, then cleared a restructured deal in which the cloud gaming rights were sold to another firm.

Merger control must weigh the loss of competition against possible gains, such as economies of scale that could lower costs and prices.

Government intervention to control monopolies

Some industries are natural monopolies.

Key idea: Because fixed costs are very high, as with water pipes, the electricity grid or rail track, one firm can supply the whole market at a lower average cost than two or more competing firms. Breaking up the monopoly would raise costs, so instead the government regulates it.

Price regulation

The regulator sets a limit on how much the firm can raise its prices. In the UK this has often taken the form of an RPI minus X price cap.

• RPI is the rate of inflation, measured by the Retail Prices Index. Many regulators now use CPI or a related measure instead.
• X is a percentage set by the regulator, reflecting the efficiency gains it expects the firm to make.
• If inflation is 3% and X is 1%, the firm can raise its prices by no more than 2% a year.

The cap gives the firm an incentive to cut costs. If it cuts costs faster than X, it keeps the extra profit until the next review. Regulators such as Ofwat review price limits every five years.

Where large investment is needed, the formula can be RPI plus K, where K allows prices to rise faster than inflation to pay for investment. This has been used in the water industry.

Profit regulation

The regulator limits the rate of return the firm can earn on the capital it has invested. Prices are set so that the firm covers its costs plus a fair return. This prevents excessive profits, but gives the firm little incentive to control costs, because higher costs can be passed on in higher prices. It may also encourage firms to over-invest in capital to increase the profit they are allowed to earn.

Quality standards

A monopoly facing a price cap could protect its profits by cutting quality. Regulators therefore set minimum standards, such as the reliability of supply, the cleanliness of drinking water, or how quickly complaints are dealt with. Firms that fall short can be fined or required to compensate customers.

Performance targets

Regulators set targets that firms must meet, often with financial penalties for missing them. Examples include punctuality targets for train operators, targets to reduce leaks and pollution incidents for water companies, and delivery targets for Royal Mail, which has been fined by Ofcom for missing them.

Problems with regulating monopolies

• Asymmetric information. The firm knows far more about its costs than the regulator, making it hard to set the right price cap.
• Regulatory capture. Over time, the regulator may come to act in the interests of the firms rather than consumers.
• Cost of regulation, both for the regulator and for firms in meeting its requirements.

Government intervention to promote competition and contestability

Rather than controlling firms with market power directly, the government can make markets more competitive, or more contestable. A contestable market is one with low barriers to entry and exit.

Key idea: Even if there are few firms, the threat of new entrants forces existing firms to keep prices close to average cost.

Enhancing competition through promotion of small business

More small firms means more competitors and more potential entrants. The government supports small firms through:

• Start-up loans and help with access to finance, since small firms often find it harder to borrow.
• Lower taxes, such as relief from business rates for small premises and a lower rate of corporation tax on small profits.
• Advice and support for new businesses.

Deregulation

Deregulation removes legal barriers to entry, such as licences or legal monopolies, so that new firms can enter a market.

• Bus services outside London were deregulated in 1986.
• Royal Mail's legal monopoly on delivering letters was removed, opening the market to competitors.
• Airline routes within Europe were opened up to competition in the 1990s, helping the growth of low-cost airlines.

Deregulation increases contestability, but some rules exist to protect safety, consumers or the environment, so removing them can have costs.

Competitive tendering for government contracts

The government invites private firms to bid for the right to supply a service, such as refuse collection, school meals, hospital cleaning or running a rail route. The contract goes to the firm offering the best value. Even where only one firm provides the service, competition for the contract can drive down costs. The risks are that firms cut quality to win contracts, and that contracts are hard to monitor.

Privatisation

Privatisation is the transfer of a state-owned firm to the private sector, usually by selling shares. Major UK privatisations included BT in 1984, British Gas in 1986, the water companies in 1989, the railways in the 1990s and Royal Mail in 2013.

• The profit motive gives the firm an incentive to cut costs and improve efficiency.
• If it is combined with deregulation, new competitors can enter the market.
• But a state monopoly may simply become a private monopoly, which is why many privatised industries need a regulator.

Government intervention to protect suppliers and employees

Restrictions on the monopsony power of firms

A monopsony is a single dominant buyer. It can use its power to push down the prices it pays suppliers or the wages it pays workers.

• Suppliers. The large supermarkets buy from thousands of farmers and food manufacturers. The Groceries Supply Code of Practice requires them to deal fairly with suppliers, for example by not changing agreements without notice, and the Groceries Code Adjudicator enforces it.
• Employees. A dominant employer in a local labour market can pay a wage below what workers would earn in a competitive market and employ fewer workers. A minimum wage can limit this power. Set at the right level, it can raise both wages and employment in a monopsony labour market.

Nationalisation

Nationalisation is the transfer of a private firm into public ownership. The government may nationalise a firm to protect jobs, to keep an essential service running when a private firm fails, or to stop a monopoly exploiting consumers, suppliers and workers.

• Northern Rock was taken into public ownership in 2008 to protect savers and the banking system.
• Several rail operators have been brought into public ownership, beginning with the East Coast main line in 2018, and the government has committed to bring passenger rail services back into public ownership as contracts expire.

A nationalised firm does not face the profit motive, so it may be less efficient, and its losses fall on taxpayers.

Key terms

Common mistakes

• Confusing RPI minus X with a fixed price. The cap limits the annual change in price, not the price level itself.
• Getting the arithmetic wrong. With inflation of 4% and X of 1.5%, prices can rise by up to 2.5%, not fall.
• Assuming privatisation always increases competition. Without deregulation or regulation, a state monopoly may become a private monopoly.
• Confusing monopoly and monopsony. A monopoly is a dominant seller. A monopsony is a dominant buyer, of goods from suppliers or of labour from workers.
• Treating all mergers as harmful. Some mergers bring economies of scale that lower costs, which is why the CMA can clear mergers subject to conditions.
• Forgetting the regulator's information problem. Regulators know less about costs than the firms they regulate, which limits how well any of these tools work.

How this has been examined

In the Edexcel papers indexed on this site, this topic has appeared in five formats:

• 15-mark "Discuss" data response — asked once (2019)
• 12-mark "Discuss" data response — asked twice across 2 series (2018 to 2024)
• 10-mark "Assess" data response — asked twice across 2 series (2018 to 2020)
• 8-mark "Examine" data response — asked once (2017)
• 2-mark "Explain" data response — asked once (2022)

Where this goes next

The market structures that create the need for intervention are covered in 3.4.5 Monopoly, 3.4.6 Monopsony and 3.4.7 Contestability, and the efficiency concepts used to judge them in 3.4.1 Efficiency. Mergers and integration are introduced in 3.1.2 Business growth. The effects of these policies on prices, efficiency, choice and quality, and their limits, are evaluated in 3.6.2 The impact of government intervention. Privatisation and competition policy also appear as supply-side policies in 2.6.3 Supply-side policies.