OxfordAQA International AS and A-level Economics: Competition policy, regulation (9640)

This guide is aligned to the OxfordAQA International AS and A-level Economics (9640) specification, version 1.2. It covers sections 3.3.3.11 (competition policy) and 3.3.3.12 (public ownership, privatisation, regulation and deregulation of markets). Section 3.3 forms part of the extra International A2 content, taught in Unit 3. All numbers below are invented and fictional.

Related pages: revision notes, practice questions, the course hub and the checklist. To check your starting level, use the free diagnostics.

What you must be able to do

Section	Outcome
3.3.3.11	Prevention of dominant firms abusing monopoly power
3.3.3.11	Regulation of mergers and takeovers
3.3.3.11	Policies on restrictive practices; consumer protection
3.3.3.11	Measures to promote competition and reduce entry barriers
3.3.3.11	Price and profit controls
3.3.3.11	Arguments for competition policy, and its limitations and costs
3.3.3.12	Case for and against public ownership
3.3.3.12	Case for and against privatisation
3.3.3.12	Arguments for and against regulation and deregulation
3.3.3.12	Regulatory capture

Why governments act: the case for competition policy

Competition policy is government action that stops firms using market power against consumers or rivals. The argument for it is that a firm with market power can restrict output and raise price, so allocative efficiency falls and some consumer surplus becomes either profit or deadweight loss. Without rivals, it also has less pressure to cut costs or innovate.

The limitations matter just as much. Policy has costs: running an authority, legal fees for firms and delays. Authorities lack full information, so they may block a beneficial merger or miss a harmful one. Size can bring economies of scale, so punishing size can raise costs. Firms may also respond by moving activity abroad.

Abuse of dominant position

A dominant firm is not illegal by itself. Policy targets abuse. Typical abuses:

• Predatory pricing: selling below cost to push out a rival, then raising price.
• Exclusive dealing: forcing retailers to stock only the dominant firm’s goods.
• Tying: making the purchase of one product depend on buying another.
• Refusing to supply a rival that needs an essential input.

Remedies include fines, orders to stop the conduct and, in extreme cases, breaking the firm up. The hard part is proof. Low prices help consumers today, so an authority must show that prices are below cost and that the intent and effect is to eliminate competition.

Regulating mergers and takeovers

A merger joins two firms; a takeover is when one firm buys another. Horizontal mergers join rivals, vertical mergers join firms at different stages of supply, and conglomerate mergers join firms in unrelated markets. Authorities mainly worry about horizontal mergers because they directly cut the number of competitors.

One screening tool is the n-firm concentration ratio, which adds up the shares held by the n biggest sellers.

Worked example 1: a merger in the flour market

Country A’s wholesale flour market (illustrative) has five firms with shares of 30%, 25%, 20%, 15% and 10%.

• Four-firm concentration ratio before: 30 + 25 + 20 + 15 = 90%.
• The firms with 20% and 15% propose to merge, giving 20 + 15 = 35%. The market now has four firms: 35%, 30%, 25%, 10%. The four-firm ratio is 100%, and the largest firm has risen from 30% to 35%.

The merged firm claims its unit cost will fall by 8%, from an index of 100 to 92. The saving is 8 index points (take price as an index of 100 too, for simplicity). If it passes on half, price falls by 0.5 × 8 = 4 points, to 96, a 4% fall. If it passes on none, price stays at 100 and the gain goes to profit. The authority therefore asks what the pass-through is likely to be. Strong remaining rivals and low entry barriers make high pass-through more likely.

Possible decisions: allow, allow with conditions (for example selling some plants to a new entrant), or block. Evaluation points: the quality of the cost evidence, how contestable the market is, whether the merger is needed to compete with foreign rivals, and the cost of mistakes in each direction.

Restrictive practices and consumer protection

Restrictive practices are agreements that limit competition: price fixing, market sharing, bid rigging and agreements to limit output. A cartel is a group of firms that cooperate in this way. Policy usually bans them and punishes them with fines related to turnover, damages claims and, in some countries, prison for individuals. Leniency schemes reward the first member to report the cartel, which makes members distrust each other.

Consumer protection covers rules on misleading advertising, product safety, unfair contract terms and rights to refunds. It helps where consumers cannot judge quality, a form of imperfect information.

Worked example 2: would the cartel still pay?

Three bakery chains in Country A (illustrative) fix prices; their combined turnover is 200m a year. Raising prices earns the cartel 20m extra profit a year. It runs for 4 years, so total gain = 20 × 4 = 80m. The maximum fine is 10% of annual turnover, so fine = 0.10 × 200 = 20m. The probability of detection is 0.3.

• Expected fine = 0.3 × 20 = 6m.
• Expected fine (6m) is far below the gain (80m), so the cartel pays.
• To deter, expected fine must reach the gain: fine = 80 / 0.3 = 266.7m, which is 133% of turnover.

Conclusion: fines alone deter weakly when detection is unlikely. This supports leniency schemes (raising the probability of detection), damages claims and personal penalties. The model ignores reputation damage and legal costs, which also deter.

Promoting competition and reducing entry barriers

Measures include removing licences and legal monopolies, making it easier to switch supplier, requiring incumbents to share essential networks on fair terms, limiting long exclusive contracts, cutting planning delays, and opening public contracts to competitive tendering. Competitive tendering means firms bid for the right to run a service for a period. Reducing sunk costs and the information advantage of the incumbent makes a market more contestable, because the threat of entry disciplines existing firms even when few firms operate.

Limits: some barriers are natural (high fixed costs), and entry may fail if new firms cannot match the incumbent’s costs.

Price and profit controls

These apply mainly where competition is unlikely, such as a natural monopoly: a market where one firm’s long-run average cost is lowest because fixed costs are very large.

Price cap. The regulator sets the maximum average price rise as inflation minus X, where X is an efficiency target. If a firm beats X, it keeps the extra profit; this gives an incentive to cut costs.

Worked example 3: a five-year price cap

Let X = 2.5. A regulated utility in Country B (illustrative) starts at a price index of 100. Annual inflation is 3.0%, 4.5%, 2.0%, 3.5% and 1.0%.

Year	Inflation (%)	Allowed change (%)	Price index
1	3.0	0.5	100.50
2	4.5	2.0	102.51
3	2.0	-0.5	102.00
4	3.5	1.0	103.02
5	1.0	-1.5	101.47

Prices in the economy generally rise by a factor of 1.030 × 1.045 × 1.020 × 1.035 × 1.010 = 1.1477, so a general index of 114.77. The utility’s real price index is 101.47 / 1.1477 = 88.4. In real terms its price has fallen by about 11.6%.

Weaknesses: the regulator needs a good estimate of X. If X is too tight, the firm may cut quality or investment; if too loose, profit is excessive.

Rate-of-return (profit) control. The regulator limits profit to a set return on capital employed. If capital is 500m and the allowed return is 8%, allowed profit is 40m. The firm gains by raising capital, because at 600m allowed profit rises to 48m. This encourages over-investment and gives little reward for cutting costs.

Worked example 4: pricing a natural monopoly

Demand is P = 20 − 0.1Q. Fixed cost is 400 and marginal cost is constant at 4 (illustrative units).

• Unregulated profit maximiser: marginal revenue = 20 − 0.2Q. Setting MR = MC: 20 − 0.2Q = 4, so Q = 80 and P = 12. Profit = (12 − 4) × 80 − 400 = 240.
• Marginal cost pricing (P = 4): Q = 160. Revenue just covers variable cost, so the firm loses its fixed cost of 400. It needs a subsidy.
• Average cost pricing: P = 4 + 400/Q, so 20 − 0.1Q = 4 + 400/Q. This gives 0.1Q² − 16Q + 400 = 0, and the larger root is Q = 129.0 with P = 7.10. The firm breaks even.

Average cost pricing is the practical compromise: lower price and higher output than the unregulated monopoly, with no subsidy.

Public ownership

Public ownership means the state owns the firm or industry (nationalisation).

For: natural monopolies can be run without profit-seeking; external benefits and merit goods can be provided where private firms would underprovide; strategic industries stay under national control; the state can take a long-term view and protect jobs.

Against: weak profit incentive can mean higher costs and low innovation; political goals can override efficiency; losses fall on taxpayers; the government has less information than the managers; capital is competed for within the government budget.

Privatisation

Privatisation means moving state-owned assets into private hands by sale. For: stronger profit incentive and cost pressure, access to private capital, sale proceeds, less political interference and a chance to introduce competition. Against: a private monopoly may replace a public one, people may lose out when unprofitable services close, assets may be sold too cheaply, and the state gives up future income.

Worked example 5: was the sale price too low?

A state-owned port (illustrative) earns 60m profit a year and is sold for 900m. The price is 900 / 60 = 15 times annual profit. The government uses the receipts to cut debt that costs 4% a year, saving 0.04 × 900 = 36m. It gives up 60m, so the net loss is 60 − 36 = 24m a year. The sale is justified only if efficiency gains, quality, investment or new competition outweigh this (or if a higher price could have been obtained, which makes the loss smaller).

Regulation, deregulation and regulatory capture

Regulation is rules enforced by an authority on prices, quality, entry or conduct. For: protects consumers where competition is weak, handles externalities and information gaps, and offers a route for private ownership of natural monopolies. Against: compliance costs, slow decisions, and the regulator’s information gap. Deregulation removes rules to encourage entry and cut costs. For: lower prices, more choice, less red tape. Against: lower safety or quality, firms exploit consumers, and weak oversight can allow short-term risk-taking.

Illustration: after a bus market in Country C (illustrative) is deregulated, average fare falls from 12.00 to 10.20, a fall of 15%, and passenger trips rise from 40,000 to 46,000, a rise of 15%. Price elasticity of demand = +15% / -15% = -1.0, so revenue barely changes (480,000 falls to 469,200), and any gain to consumers has to be weighed against reduced service on quiet routes.

Regulatory capture is when a regulator ends up serving the industry it oversees, not the public. Causes: the industry has the information and the money to lobby; regulators and firms swap staff; and the regulator relies on the firm’s data. Consequences: lenient price caps, weak enforcement and entry barriers that protect incumbents. Remedies: rotate staff, publish evidence, independent appeals, and bring in outside expertise.

Common errors

• Treating all large firms as illegal. Policy targets abuse, not size.
• Saying a price cap fixes the price. It limits the average rise.
• Forgetting that privatisation without competition just creates a private monopoly.
• Describing capture without saying who gains and who loses.
• Giving one-sided lists. Judge which effect is larger and why, and under what conditions.

Official syllabus

OxfordAQA International AS and A-level Economics (9640) Specification, version 1.2, OxfordAQA. First teaching September 2020; International AS exams from May/June 2021; International A-level exams from May/June 2022.