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

This study guide follows the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (YEC11), Issue 2, June 2018. It covers section 3.3.5 Government intervention, item 1, on product markets (points a to f). The specification labels Units 1 and 2 as International AS (IAS) and Units 3 and 4 as the extra International A2 (IA2) content. This topic sits in Unit 3, Business behaviour, so it is IA2 content for the full International Advanced Level only, not for IAS alone.

All figures are invented and illustrative. Firms and countries are made up, and currency units are “cu”. Do not quote any number here as real data.

Related pages: the Edexcel economics hub, the printable checklist, the revision notes, the practice set, the Unit 1 guide to taxes, subsidies, price controls and government failure and our free 10-minute diagnostics. Wage controls and other labour-market tools belong to the separate labour-market unit, so they are not repeated here.

What the specification asks for

Reference	You must be able to
1a	Explain the case for government intervention
1b	Explain measures to control monopolies and mergers
1c	Explain measures to promote competition and contestability
1d	Explain measures to protect suppliers and employees
1e	Assess the impact of each measure on price, profit, efficiency, quality and choice
1f	Evaluate the limits to intervention

1a: The case for intervention

Markets with little competition tend to give firms power over price. A firm with market power restricts output to raise price, which lowers allocative efficiency (price above marginal cost). Without rivals it may also let costs drift, so productive efficiency suffers. Externalities and public goods (Unit 1) are further grounds. Other reasons: protecting small suppliers and workers from powerful buyers or employers, and keeping essentials affordable.

Running example: Firm M, the only supplier of piped gas in Country A. Demand is P = 100 - Q, marginal cost is 10 cu and fixed costs are 800 cu.

1. Profit maximising: marginal revenue is 100 - 2Q. Set it equal to 10, so Q = 45 and P = 55.
2. Profit = 55 x 45 - (800 + 10 x 45) = 2,475 - 1,250 = 1,225 cu.
3. Efficient output has P = MC: Q = 90 and P = 10.
4. Deadweight loss = 0.5 x (90 - 45) x (55 - 10) = 1,012.5 cu.

In words, with price up the side and output along the bottom, marginal revenue lies below demand, cuts marginal cost at 45 units, and the price is read up from demand. The welfare loss is the triangle between demand and marginal cost from 45 to 90 units.

Because fixed costs are large, average cost falls up to output 90 (it is 18.9 cu there). One firm serving the market is cheaper than two, which is why the state regulates rather than breaks the firm up.

1b: Controlling monopolies and mergers

Price regulation. The regulator caps price. Setting it at marginal cost (10 cu) is efficient but Firm M would lose its 800 cu fixed costs. A cap equal to average cost works better. Solve 100 - Q = 10 + 800/Q, so Q squared - 90Q + 800 = 0 and Q = 80 (the smaller root, 10, is not used). Then P = 20 cu, average cost = 10 + 800/80 = 20, profit is zero and the deadweight loss falls to 0.5 x (90 - 80) x (20 - 10) = 50 cu.

A common form is a price cap that rises each year by the inflation rate minus an efficiency factor X. With inflation 4% and X = 1.5%, the cap rises 2.5%, from 20 to 20.5 cu. In real terms the price falls by about 1.4%, so the firm keeps the profit only if it cuts costs faster. That is an incentive to be productively efficient.

Profit regulation. The regulator limits the rate of return on capital. Capital employed is 5,000 cu and profit is 600 cu, a return of 12%. If 8% is allowed, permitted profit is 400, so 200 is excess. Sales of 100 units mean prices fall 2 cu per unit, or a rebate is paid. Weakness: the firm may overstate its capital or costs to look less profitable.

Quality standards. A capped price invites cost cutting, so rules set minimum standards such as waiting times, supply interruptions or safety. They protect consumers, though meeting them raises costs.

Performance targets. Penalties and rewards link to results. Suppose late deliveries must stay under 5% and revenue is 10,000 cu, with 1% of revenue per percentage point. At 8% late, the penalty is 3 x 1% x 10,000 = 300 cu. At 3% late, a reward of 2 x 1% x 10,000 = 200 cu applies.

Referral to regulatory authorities. Complaints or suspected abuse go to a specialist body, which investigates, orders changes, issues fines or sets price caps. It brings expertise, but cases are slow.

Merger legislation. Laws let authorities review, block or attach conditions to mergers and takeovers, often when the combined market share passes a set size. Firms with shares of 30% and 25% would combine to 55%, which an invented 40% threshold would send for review.

Worked example: a merger with cost savings. Demand is P = 100 - Q. Before: competitive, with marginal cost 40, so Q = 60 and P = 40. After: one firm with marginal cost 30. Monopoly output solves 100 - 2Q = 30, so Q = 35 and P = 65.

• Consumer surplus: before 0.5 x 60 x 60 = 1,800; after 0.5 x 35 x 35 = 612.5, a fall of 1,187.5.
• Profit after: (65 - 30) x 35 = 1,225.
• Total surplus after: 612.5 + 1,225 = 1,837.5, slightly above 1,800.

Total surplus edges up because of the cost saving, yet consumers lose heavily (price up 62.5%). The verdict depends on whether authorities weigh consumers or total surplus, and on whether the savings are real.

1c: Promoting competition and contestability

A market is contestable when entry and exit are cheap, because sunk costs are low. Even a single firm then holds its price down, since a rival could enter and leave (“hit and run”).

• Tax incentives and grants for small businesses and FDI (foreign direct investment). Lower taxes or grants cut entry costs. Example: a start-up has sunk costs of 120 cu and earns 30 cu a year. Payback takes 4 years. A grant of 30% (36 cu) cuts it to (120 - 36)/30 = 2.8 years. A small firm taxed at 10% rather than 20% on 50,000 cu of profit keeps 5,000 cu more. FDI brings capital, techniques and rivals.
• Deregulation. Removing licences or legal limits on entry (for example a cap on taxi permits) lets more firms in. Prices may fall, but safety and quality rules may weaken.
• Privatisation. Sale of state-owned assets to private owners gives a profit motive. Suppose a firm sold for 900 cu used to pay the state 60 cu a year. Interest saved at 5% is 45 cu, so the state is 15 cu a year worse off. The gain must come from efficiency, and a private monopoly may replace a state one.
• Competitive tendering for public sector contracts. Firms bid to supply a service. Four bids for a cleaning contract currently costing 125 cu in-house: 120, 112, 105 and 98. The lowest saves 27 cu (21.6%). A weighted score can include quality: 60% on price score (lowest bid divided by bid x 100) and 40% on a quality score. With quality scores of 90, 80, 70 and 50, the scores are 85.0, 84.5, 84.0 and 80.0, so the dearest bid wins. Price-only tendering would pick the weakest quality.
• Trade liberalisation. Removing tariffs and quotas exposes domestic firms to imports. If a 20% tariff on a world price of 50 cu is removed, the domestic price falls from 60 to 50, down 16.7%. With price elasticity of demand of -1.2, quantity rises 20%. Domestic firms that cannot match the price may shut.

1d: Protecting suppliers and employees

• Local sourcing of raw materials and components. Rules require firms to buy a share locally. If a firm needs 1,000 units, imports cost 8 cu and local items 10 cu, a 40% rule raises cost from 8,000 to 8,800 (up 10%), while local suppliers gain 4,000 cu of sales. It guards jobs but raises costs and may invite retaliation.
• Employment legislation to protect workers from exploitation. Rules on safety, hours, contracts and dismissal raise labour costs but cut the risk of abuse, improve morale and may raise productivity.
• Barriers to entry of foreign firms. Quotas, licences or ownership caps protect new domestic firms. Infant industry case: costs of 70 cu against a rival’s 50 fall 8% a year, so after 4 years they are 50.1 and after 5 years 46.1. Protection must last about 5 years, and weak firms may never catch up.
• Restrictions on the monopsony power of firms. A monopsony is a single powerful buyer. Farmers’ supply is P = 4 + 0.2Q and the processor’s marginal revenue product is 40 - 0.2Q. Competition gives Q = 90 and P = 22. The monopsonist’s marginal cost of buying is 4 + 0.4Q, so Q = 60 and P = 16, with farmers’ price 27% lower and output 33% lower. A minimum buying price of 18 raises the quantity to 70, because supply at that price is 70 and the processor still values the last unit at 26. Price and quantity both rise, so this improves on the monopsony result.
• Nationalisation. The state takes ownership. It can protect jobs and essential services and pursue wider aims than profit. Cost: compensation, say 10 million shares at 12 cu, or 120 million cu. If the business then earns 6 million a year (5%), that beats borrowing at 4% (4.8 million) but not at 6% (7.2 million). Risks: weak cost control and political interference.

1e: Impact on price, profit, efficiency, quality and choice

Measure	Price	Profit	Efficiency	Quality	Choice
Price or profit regulation	Down	Down	Allocative up, productive depends	Risk of fall	Little change
Quality standards, targets	May rise	Down	Mixed	Up	May fall (weak firms exit)
Merger control	Lower than unchecked	Lower	Blocks dominance, may lose savings	Protects	Protected
Entry grants, deregulation, trade liberalisation	Down	Down for incumbents	Up	Often up	Up
Privatisation	Depends on competition	Up	Often up	Mixed	Up if competition follows
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

Direction depends on how strong the measure is. Give a reason for each arrow.

1f: Limits to intervention

• Regulatory capture. The regulator comes to serve the firm, through staff exchanges, lobbying or reliance on its data, so caps are set loosely.
• Asymmetric information. The firm knows its costs better. Suppose Firm M reports fixed costs of 1,064 cu instead of 800. The average-cost cap gives Q = 76 and P = 24. True average cost is 10 + 800/76 = 20.5, so the firm gains 264 cu, exactly the overstated 264 of fixed cost.
• Inadequate resources. Too few inspectors mean low chances of detection. A cartel gains 350 cu. A 200 cu fine with 40% detection has an expected cost of 80, so the cartel is worth joining. To deter it the fine must exceed 350/0.4 = 875 cu, or detection must rise.
• Lack of regulatory power. The regulator cannot compel data, enforce fines or act against firms operating abroad.

A strong answer weighs the cost of failing to act against the cost of acting badly.

Common errors

• Treating a price cap as always good: set too low, it harms quality and investment.
• Setting a regulated price at marginal cost for a natural monopoly and ignoring the fixed-cost loss.
• Assuming a merger always harms consumers, or never does, without comparing cost savings with the price rise.
• Describing privatisation as the same as deregulation.
• Listing limits without applying one to the scenario.

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.