MRG - Inadequate Competition Lesson

Inadequate Competition Lesson

A market failure is a situation where an unfettered market fails to allocate resources efficiently. This means the price mechanism, which generally leads to allocative efficiency, is not able to allocate resources in such a way as to maximize the net total benefit to society. In these cases, government intervention usually occurs to correct the market failure. The four categories of market failures this module will address include inadequate competition, externalities, public goods, and income distribution.

Market Failures Video

View the video below to learn more. To make the video full screen, click the double arrows at the bottom right corner of the object.

Inadequate Competition

As discussed in previous modules, all market structures outside of perfect competition result in some amount of inefficiency. If you remember, that inefficiency was expressed as the deadweight loss to society. The deadweight loss was the result of a lack of competition (which is centered around oligopoly and monopoly) that resulted in too little of the good being produced and sold for a price that was too high. When we consider "too little being produced", what does that mean? It means that the firm is producing less than the socially optimal quantity which is found where marginal benefit (demand curve) and marginal cost (supply curve) are equal. Furthermore, in these instances, price is not equal to marginal cost, so the price being charged for the product, while found on the demand curve, is not the optimal price. Society would rather see more of the good produced and sold such that price = marginal benefit = marginal cost. In the case of firms operating in structures outside of perfect competition, this would not lead to profit maximization. Therefore, being allocatively efficient is not a goal of monopolistic competitors, oligopolistic competitors, and monopolies. Since these forms of lesser competition produce inefficient outcomes, the government has intervened to ensure that competition is safeguarded to a degree that protects the consumer and society. Keep in mind, however, that these markets do have positive attributes – namely, product differentiation and economies of scale. Product differentiation is good for the consumer because it results in a variety of goods/services to choose from. Economies of scale are positive because it results in lowered production costs as the size of a firm grows.

Antitrust Video

View the video below to learn more about antitrust. To make the video full screen, click the double arrows at the bottom right corner of the object.

Herfindahl-Hirschman Index

While some of the legislation discussed above restricts mergers, they are allowed to happen under the right circumstances. However, the goal of the Department of Justice is to ensure that mergers do not significantly lessen competition in a market. To that end, the DOJ employs the use of the Herfindahl-Hirshman Index, a commonly used measure to determine market concentration.

The index is based on the two market structure extremes – perfect competition and monopoly. In perfect competition, the number of firms is so vast and their relative size to the market is so small, that each firm has a negligible impact on the market. In terms of market shares controlled by any given firm in this market structure, the firms would have shares very close to 0. For a monopoly, the opposite is true. A monopoly is the single producer of a good in a particular market. In essence, the monopoly is the market. That means a monopoly controls 100% of the market share. Firms operating in monopolistic competition and oligopoly will fall somewhere between these two extremes in terms of market shares controlled.

To calculate the HHI, each firm's market share is squared and then added together to get a total HHI value. Rephrased, the HHI is the sum of the squares of each firm's market share in a particular industry. The maximum value of the HHI is 10,000. This would represent a market which is controlled by a monopoly (remember, a monopoly controls 100% of the market, so 1002 = 10,000). Below are the following types of mergers:

• Small Change in Concentration: Mergers involving an increase in the HHI of less than 100 points are unlikely to have adverse competitive effects and ordinarily require no further analysis.
• Unconcentrated Markets: Mergers resulting in unconcentrated markets are unlikely to have adverse competitive effects and ordinarily require no further analysis.
• Moderately Concentrated Markets: Mergers resulting in moderately concentrated markets that involve an increase in the HHI of more than 100 points potentially raise significant competitive concerns and often warrant scrutiny.
• Highly Concentrated Markets: Mergers resulting in highly concentrated markets that involve an increase in the HHI of between 100 points and 200 points potentially raise significant competitive concerns and often warrant scrutiny. Mergers resulting in highly concentrated markets that involve an increase in the HHI of more than 200 points will be presumed to be likely to enhance market power. The presumption may be rebutted by persuasive evidence showing that the merger is unlikely to enhance market power.  SOURCE:  Information based on Horizontal Merger Guidelines published by the Department of Justice and the Federal Trade Commission on August 19, 2010.

Mergers

View the video below to learn more about mergers. To make the video full screen, click the double arrows at the bottom right corner of the object.

Regulating Natural Monopolies

In some instances, monopolies can make economic sense. These are referred to as natural monopolies. The existence of natural monopolies is directly related to the costs of operating a business. In past modules, the focus has been mainly on variable and marginal costs. In the case of natural monopolies, fixed costs are responsible for making the determination that a market is best served by a monopoly.

Why Fixed Costs?

In certain markets, the start-up cost for establishing a firm is so great that it acts as a significant barrier to entry. The fixed costs are so expensive because of the amount of capital that the business must purchase to produce the good/service. Once the investment in those huge fixed costs is made, any expansion in output will decrease ATC for the natural monopolist. Examples of this are found in the markets for utilities (electricity, water, etc). Let's consider the time, expense, and effort needed to establish a power company. Power lines must be buried, poles and cables run, and power grids must be established. These steps are very costly. What would society gain by promoting competition in a market such as this? Consider your own home. Would it be better off if there were two options for electrical power? The answer is no. As long as the lights come on when you flip the switch, you are happy. That line of reasoning is the basis for allowing natural monopolies to exist. Encouraging multiple power providers to go to the expense of burying lines, running cables, and establishing power grids yields no real gain to the consumer – and it would waste those resources that could otherwise be used elsewhere.

So, in some instances, monopolies can be justified. However, we must not forget that if left to their own devices, they will behave as monopolies do…producing too little and charging a price that is too high. The government allows the natural monopoly to exist, but it will regulate the business to protect the consumer from being harmed.

Regulation

The video below highlights some of the options in terms of regulatory steps the government can take.  To make the video full screen, click the double arrows at the bottom right corner of the object.

IMAGES CREATED BY GAVS (Image 1 from freepik.com and modified by GAVS)