Pearson Edexcel International Advanced Level Economics: Competition policy (YEC11) – Revision Notes

These notes condense section 3.3.5 Government intervention, item 1 (product markets, points a to f), of the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (YEC11), Issue 2, June 2018. The specification labels Units 1 and 2 as International AS (IAS) and Units 3 and 4 as International A2 (IA2). This topic is in Unit 3, Business behaviour, so it is IA2 content for the full International Advanced Level only.

For full explanations and worked examples, read the study guide. Then try the practice set. Other links: the Edexcel economics hub, the printable checklist and our free 10-minute diagnostics. Every number below is made up for illustration (“cu” means currency units).

Key definitions

Term	Meaning
Market power	Ability of a firm to set price above marginal cost
Allocative efficiency	Price equals marginal cost
Productive efficiency	Output at the lowest average cost
Natural monopoly	One firm serves the market at lower average cost than two could
Contestable market	Entry and exit are cheap (low sunk costs), so rivals can threaten a firm
Monopsony	A single (or dominant) buyer
Privatisation	Transfer of state-owned assets to private owners
Nationalisation	Transfer of private assets to state ownership
FDI	Foreign direct investment: a firm from one country setting up or buying operations in another
Regulatory capture	The regulator comes to act in the interests of the industry it regulates

The measures in one table (1b to 1d)

Group	Measure	How it works	Main weakness
Control monopolies and mergers	Price regulation	Cap on price, often inflation minus X	Cap too low harms quality and investment
	Profit regulation	Limit on rate of return	Firm may overstate capital
	Quality standards	Minimum service levels	Higher costs
	Performance targets	Rewards and penalties	Targets can be gamed
	Referral to regulators	Expert investigation and remedies	Slow, costly
	Merger legislation	Review, block or condition deals	Judging future effects is hard
Promote competition	Grants, tax incentives	Lower entry costs for small firms and FDI	Cost to taxpayers
	Deregulation	Remove entry limits	Standards may fall
	Privatisation	Profit motive	Private monopoly
	Competitive tendering	Firms bid for public contracts	Quality risk if price only
	Trade liberalisation	Remove tariffs and quotas	Job losses in weak sectors
Protect suppliers and employees	Local sourcing	Buy a share at home	Higher costs
	Employment legislation	Rules on safety, hours, dismissal	Labour costs rise
	Entry barriers for foreign firms	Quotas, licences	Less choice, higher prices
	Monopsony limits	Minimum buying price or code	Needs enforcement
	Nationalisation	State ownership	Cost and weak incentives

Method in steps: evaluate a measure

1. Name the problem (market power, high barriers, weak supplier or worker).
2. State the measure and how it works on price, cost or entry.
3. Trace the effect on price, profit, efficiency, quality and choice.
4. Say who gains and who loses.
5. Apply a limit from 1f (capture, information gaps, resources, power).
6. Judge, with a condition: “It works if… because…”.

Small worked reminders

Monopoly welfare loss (demand P = 100 - Q, marginal cost 10, fixed cost 800). Marginal revenue 100 - 2Q = 10 gives Q = 45 and P = 55. Efficient output is 90. Loss = 0.5 x 45 x 45 = 1,012.5 cu.

Average-cost cap. Solve 100 - Q = 10 + 800/Q: Q = 80, P = 20, profit zero, loss 50 cu. A cap at marginal cost (10) leaves a 800 cu loss.

Price cap with X. Inflation 4%, X = 1.5%: the cap rises 2.5%. The firm gains only by cutting costs faster.

Merger test. Compare the cost saving with the price rise. Competitive price 40 and cost 40, then a merged firm with cost 30 sets 65 and sells 35: consumer surplus falls from 1,800 to 612.5, while total surplus rises from 1,800 to 1,837.5.

Monopsony. Supply P = 4 + 0.2Q, marginal revenue product 40 - 0.2Q. Competition: 90 units at 22. Monopsony: 60 units at 16. A floor at 18 gives 70 units.

Contestability. Payback = sunk cost / annual profit. A grant cuts sunk cost and shortens payback.

Impacts (1e) in one table

Measure	Price	Profit	Efficiency	Quality	Choice
Price or profit regulation	Down	Down	Allocative up	Risk of fall	Little change
Quality standards, targets	May rise	Down	Mixed	Up	May fall
Merger control	Lower than if unchecked	Lower	Blocks dominance, may lose savings	Protects	Protected
Grants, deregulation, liberalisation	Down	Down for incumbents	Up	Often up	Up
Privatisation	Depends on competition	Up	Often up	Mixed	Up if rivals follow
Local sourcing, entry barriers	Up	Up for protected firms	Down	Mixed	Down
Monopsony limits	Higher for suppliers	Down for buyer	Closer to competitive	Little change	Little change
Nationalisation	Set by state	Often down	Mixed	Mixed	May fall

Every arrow needs a reason. For example, profit falls under a cap because price falls toward average cost, while quality may fall because the firm cuts costs to protect its margin.

Evaluation toolkit

• Size: is the cap or grant large enough to matter?
• Time: entry, tendering and liberalisation take years; a cap acts at once.
• Information: does the regulator know the true costs?
• Winners and losers: consumers, workers, local suppliers, taxpayers and the firm often gain and lose in different ways.
• Alternative: compare with no action and with a different tool.

Must-know distinctions

• Privatisation changes ownership; deregulation removes rules. A privatised firm can still be tightly regulated.
• Price regulation (sets price) versus profit regulation (sets return on capital).
• Allocative efficiency (price = marginal cost) versus productive efficiency (lowest average cost).
• Protecting suppliers and workers versus promoting competition: one can reduce the other, since barriers to foreign firms cut rivalry.
• Total surplus versus consumer surplus when judging a merger.
• A limit on intervention weakens a policy; it does not show that doing nothing is better. Compare both outcomes.

Limits to intervention (1f)

Limit	One-line chain
Regulatory capture	Regulator depends on firm, caps set loosely, firm keeps excess profit
Information gaps	Firm knows costs better, reports high, cap too generous
Inadequate resources	Low detection, expected fine below gain, rule-breaking pays
Lack of regulatory power	Cannot compel data or fine, firm ignores the regulator

Quick self-test

1. Define a contestable market and name one measure that makes a market more contestable.
2. Last year’s regulated price was 40 cu. Inflation is 3% and X is 2%. Calculate the new cap, and say what happens to the real price.
3. A utility has capital of 2,000 cu and profit of 260 cu. The allowed return is 10%. Calculate the actual return and the excess profit.
4. A council’s in-house cost for a service is 80 cu. The winning bid is 68 cu. Calculate the saving in cu and in percent.
5. A good has a world price of 25 cu and a 40% tariff. Calculate the domestic price and the percentage fall when the tariff is removed.
6. A firm needs 500 units of a component. Imports cost 6 cu and local supply costs 9 cu. A rule requires 30% to be local. Calculate the extra cost, in cu and percent.
7. Define monopsony and give one restriction on monopsony power.
8. A cartel gains 120 cu. The probability of detection is 0.3. Calculate the smallest fine that makes the expected penalty exceed the gain.
9. A start-up has sunk costs of 80 cu and annual profit of 20 cu. A grant covers 25% of the sunk costs. Calculate payback before and after.
10. The state sells a firm for 500 cu. It earned 20 cu a year from the firm. It can borrow at 6%. Is the state better or worse off each year, and by how much?
11. Name two measures that tend to raise price and reduce choice.
12. Explain one way regulatory capture reduces the effectiveness of a price cap.

Answers

1. A market where entry and exit are cheap because sunk costs are low. Examples: grants for small firms, deregulation or trade liberalisation.
2. 40 x (1 + 0.03 - 0.02) = 40.4 cu. Inflation is 3% and the price rises 1%, so the real price falls by about 1.9%.
3. 260/2,000 = 13%. Permitted profit is 200, so excess profit is 60 cu.
4. 80 - 68 = 12 cu, which is 15%.
5. Domestic price 25 x 1.4 = 35 cu. Removal gives a fall of 10/35 = 28.6%.
6. Cost = 350 x 6 + 150 x 9 = 3,450 against 3,000, so 450 cu or 15% more.
7. A single or dominant buyer. Restriction: a minimum buying price, or a code of conduct on payment terms.
8. Fine x 0.3 > 120, so the fine must exceed 400 cu.
9. Before: 80/20 = 4 years. Grant = 20 cu, so (80 - 20)/20 = 3 years.
10. Interest saved = 6% x 500 = 30 cu. The state loses 20 of income, so it is 10 cu a year better off, before any efficiency change.
11. Local sourcing rules and barriers to the entry of foreign firms (also quotas).
12. The regulator relies on the firm’s data and staff links, so it sets the cap too high. The firm keeps excess profit and has little pressure to cut costs.

Where marks are usually lost

• Using the same answer for every measure (“it lowers price”) with no mechanism.
• Setting a regulated price at marginal cost for a natural monopoly without noting the loss.
• Forgetting to compare the cost saving of a merger with its price effect.
• Treating privatisation and deregulation as the same thing.
• Writing a list of limits without applying one to the case.
• Ignoring time: entry, tendering and trade liberalisation take years to work.
• No judgement: evaluation stops at “it depends” without saying on what.
• Quoting the right percentage with the wrong base, such as dividing by the new price instead of the old.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics (YEC11), Specification, Issue 2, June 2018, Pearson Education Limited. This page covers section 3.3.5 item 1 of Unit 3.