Unit 3: Government Regulation

Regulation of Markets

The government may wish to regulate monopolies to protect the interests of consumers. For example, monopolies have the market power to set prices higher than in competitive markets. The government can regulate monopolies through price capping, yardstick competition and preventing the growth of monopoly power.

Why the Government Regulates Monopolies

1. Prevent Excess Price. Without government regulation, monopolies could put prices above. This would lead to allocative inefficiency and a decline in consumer welfare.
2. Quality of service. If a firm has a monopoly over the provision of a particular service, it may have little incentive to offer a good quality service. Government regulation can ensure the firm meets minimum standards of service.
3. Monopsony power. A firm with monopoly selling power may also be in a position to exploit monopsony buying power. For example, supermarkets may use their dominant market position to squeeze profit margins of farmers.
4. Promote Competition. In some industries, it is possible to encourage competition, and therefore there will be less need for government regulation.
5. Natural Monopolies. Some industries are natural monopolies – due to high economies of scale, the most efficient number of firms is one. Therefore, we cannot encourage competition and it is essential to regulate the firm to prevent the abuse of monopoly power.

How the Government Regulate Monopolies

1. Price Capping by Regulators RPI-X
For many newly privatised industries, such as water, electricity and gas, the government created regulatory bodies such as:

• OFGEM – gas and electricity markets
• OFWAT – tap water.
• ORR – Office of rail regulator.

Amongst their functions, they are able to limit price increases. They can do this with a formula RPI-X

• X is the amount by which they have to cut prices by in real terms.
• If inflation is 3% and X= 1%
• Then firms can increase actual prices by 3-1 = 2%

If the regulator thinks a firm can make efficiency savings and is charging too much to consumers, it can set a high level of X. In the early years of telecom regulation, the level of X was quite high because efficiency savings enabled big price cuts.

RPI+/- K – for water industry

In water the price cap system is RPI -/+ K.

K is the amount of investment that the water firm needs to implement. Thus, if water companies need to invest in better water pipes, they will be able to increase prices to finance this investment.

Advantages of RPI-X Regulation

1. The regulator can set price increases depending on the state of the industry and potential efficiency savings.
2. If a firm cuts costs by more than X, they can increase their profits. Arguably there is an incentive to cut costs.
3. Surrogate competition. In the absence of competition, RPI-X is a way to increase competition and prevent the abuse of monopoly power.

Disadvantages of RPI-X Regulation

1. It is costly and difficult to decide what the level of X should be.
2. There is danger of regulatory capture, where regulators become too soft on the firm and allow them to increase prices and make supernormal profits.
3. However, firms may argue regulators are too strict and don’t allow them to make enough profit for investment.
4. If a firm becomes very efficient, it may be penalised by having higher levels of X, so it can’t keep its efficiency saving.

2. Regulation of quality of service

Regulators can examine the quality of the service provided by the monopoly. For example, the rail regulator examines the safety record of rail firms to ensure that they don’t cut corners.
In gas and electricity markets, regulators will make sure that old people are treated with concern, e.g. not allow a monopoly to cut off gas supplies in winter.

3. Merger Policy

The government has a policy to investigate mergers which could create monopoly power. If a new merger creates a firm with more than 25% of market share, it is automatically referred to the Competition Commission. The Competition commission can decide to allow or block the merger.
More on mergers.

4. Breaking up a monopoly.

In certain cases, government may decide a monopoly needs to be broken up because the firm has become too powerful. This rarely occurs. For example, the US looked into breaking up Microsoft, but in the end the action was dropped. This tends to be seen as an extreme step, and there is no guarantee the new firms won’t collude.

5. Yardstick or ‘Rate of Return’ Regulation

This is a different way of regulating monopolies to the RPI-X price capping. Rate of return regulation looks at the size of the firm and evaluates what would make a reasonable level of profit from the capital base. If the firm is making too much profit compared to their relative size, the regulator may enforce price cuts or take one off tax.
A disadvantage of rate of return regulation is that it can encourage ‘cost padding’. This is when firms allow costs to increase so that profit levels are not deemed excessive. Rate of return regulation gives little incentive to be efficient and increase profits. Also, rate of return regulation may fail to evaluate how much profit is reasonable. If it is set too high, the firm can abuse its monopoly power.

6. Investigation of Abuse of Monopoly Power.

In the UK, the office of fair trading can investigate the abuse of monopoly power. This may include unfair trading practises such as:

• Collusion (firms agree to set higher prices)
• Collusive tendering. This occurs when firms enter into agreements to fix the bid at which they will tender for projects. Firms will take it in turns to get the contract and enable a much higher price for the contract.
• Predatory pricing (setting low prices to try and force rival firms out of business)
• Vertical restraints – prevent retailers stock rival products
• Selective distribution For example, in the UK car industry firms entered into selective and exclusive distribution networks to keep prices high. The competition commission report of 2000 found UK cars were at least 10% higher than European cars

Related Exam Question:

Jun 2009 Unit 3, Q11 - The rail industry