One of the oldest subjects in economics is the vast and enormously complex field of industrial organization – competition, monopoly and cartel. In my previous article, I introduced two theories on the cause of monopoly power – the “self-sufficiency theory” and the “interventionist theory”.  The first believes that markets are monopoly prone, that firms maintain their monopoly with ease, and that it’s therefore necessary for government to pro-actively foster competition through enacting and enforcing a competition law.

The second theory was advanced by Adam Smith, who claimed that by erecting barriers to entry governments caused monopolies and cartels. These   were seen as inherently unstable and difficult to maintain, as long as they could be effectively challenged by new competitive firms. However, if government regulation prevented this then it would inadvertently protect the monopolies.

The empirical work conducted on competition and competition law since the 1970s has led to a major revival of Smith’s theory. Economists now believe “interventionist theory” offers a more potent explanation of monopoly power than “self-sufficiency theory”. Unfortunately public policy decisions have remained stuck in pre-1970s thinking.

It is fair to say at the outset that both theories shed light on monopolies.

The great strength of the “self-sufficiency theory” lies primarily in identifying the strategies adopted by firms to exercise monopolistic power. It does not tell us how monopolies can succeed in the first place or how monopolization can be maintained in the face of new challengers, who utilize identical tricks. By focusing on the tricks, the theory resorts to competition law to control the behavior of monopolies and restore competition.

The strength of the “interventionist theory” is its deep understanding of human nature and the behavior of businessmen. It recognizes the futility of regulating and controlling the self-interested behavior of firms.  Businessmen, constrained in the market place, habitually attempt to capture regulators and controllers in the political and legal arenas, and the odds of winning this more difficult political and legal competition favor large incumbent firms, rather than smaller new challengers.

And that is why Smith places his faith in the market, rather than government, to be the best friend of small new firms. The criteria for success in the market place are the ability to compete successfully through efficiency, innovation, and by imitating and improving upon the monopolistic practices of large incumbent firms.

The purpose of any public regulation of industry, including the adoption of a competition law, is to protect the consumer. It is often assumed that intentions and consequences will coincide. George Stigler in 1971 argued that the consequence, as opposed to the stated intention, of public regulation has been to advance industry interests at the expense of the consumer. The public regulation of industry substitutes economic decisions with political choices that reflect the relative strengths of organized groups. Industry incumbents have the greatest stake in the outcome of public regulation, and are willing to devote considerable resources to ensure that their interests are protected. The incentives of consumers, impartial outsiders, bureaucrats and politicians to defend public interests are typically no match for industry incumbents. The outcome of political choice almost always favors industry rather than the consumer, even in democracies.

It is therefore unsurprising to me that the strongest and most vocal critics of a competition law in Hong Kong are the small and medium enterprises. They know they have much more to fear and lose from such a law, as their competitive advantage in today’s market place will be of little use in tomorrow’s political and legal arenas.

Which Theory Matters

The government’s choice between the two theories is an important one as they have different policy implications. The two theories also apply a different calculus on the social cost of monopolies.

According to the “self-sufficiency theory” the major loss to society from monopolies stems from raising prices and lowering output. When this happens two things occur.  First, producers benefit at the expense of consumers resulting in an income redistribution effect. However, if this was the only problem it could be easily remedied through a levy on the monopolies’ income, rather than by regulating them. This was considered by Harold Demsetz as a more efficient solution.

Second, a monopoly’s underproduction of output results in a sub-optimal use of resources, or waste. There is too little production of the monopoly output and too much production of other products. The sub-optimal use of resources is a loss to society because it is a wasteful allocation of these resources. According to the “self-sufficiency theory” this loss, known to economists as a “deadweight social welfare loss”, is the irremediable wrong of monopolistic power. In other words, this is the evil that needs to be corrected. For decades economists held this view and the public was persuaded.

Arnold Harberger estimated the social cost of monopolies from the sub-optimal or wasteful use of resources for the US. To his surprise he found that it was at most one-tenth of 1% of GDP. This was incredibly low and trivialized the issue of monopolistic power. It made a mockery of the economists’ and public’s concern about monopoly power and competition law. They appeared to be irrelevant for public policy.

In contrast, the social loss from monopolies is much larger according to the “interventionist theory”. In addition to the social loss from the sub-optimal or wasteful use of resources, there are other losses. If monopolies are created with the aid of government a firm would be willing to invest resources to garner such aid. This investment could lead to legal political lobbying and campaigns, or in illegal bribes. The amount a firm is willing to spend might be almost as large as the gains from the monopoly. Maintaining the monopoly after it has been created requires continuous expenditure to counter the constant challenges from other firms.

There may be more than one aspiring firm competing for government aid. The total expenses invested by all such firms in securing a monopoly and countering similar efforts by others may actually be greater than the total private gain from the monopoly itself. These sums are necessarily much larger than the social losses considered by the “self-sufficiency theory”. Economists have referred to the behavior of securing government aid as “rent-seeking” and the associated social losses as the dissipation of economic rents.

Smith is much more critical of the detrimental effects of monopolies because he sees them as causing a greater social loss than the mere sub-optimal use of resources.

Research on Competition in Hong Kong

Research on monopolistic practices in Hong Kong is not extensive, the Consumer Council being the most important source. Its website lists a total of 14 businesses that were studied for alleged monopolistic practices. They covered (1) banking, (2) broadcasting, (3) telecommunications, (4) private residential property, (5) motor gasoline, diesel and LPG markets, (6) water heating and cooking fuel, (7) retail food stuffs and household necessities, (8) EPS debit card network payment system, (9) shipping line agreements, (10) beauty industry, (11) textbooks, (12) lift maintenance, (13) live pig pricing, and (14) soft drinks supply in schools.

This research provides the primary intellectual justification for government to foster competition. The studies are very much inspired by the “self-sufficiency theory” and lead naturally to a demand for a competition law, but almost all the studies were undertaken 10 years ago. I conjecture either the interest in competition studies has fallen, or it has become more difficult to identify new targets. I have no way of telling whether the former is true. If the latter is correct then monopolistic practices, to the extent that they exist, are to be found primarily in the areas mentioned. This would be great news if it were indeed the case as it would probably suggest a fairly clean bill of health for competition in Hong Kong.

While I have not studied all these cases in any great depth, a moment’s reflection would suggest that the overwhelming proportion of the aforementioned businesses have been either directly or indirectly regulated by government. With entry limited from the outset it is impossible to conclude whether the alleged monopolistic practices are the result of market competition or of government regulation. A closer, detailed analysis is needed.

Take an easy example; the textbook market is heavily regulated by the Education Department, presumably to ensure the standards of students’ books. Yet the enormous cost of textbooks can be blamed on this cumbersome regulation and its uncertain outcome, which deters new suppliers from entering the market. Only established providers, familiar with the review procedures, survive.

Many years ago, when my son was studying in primary school, I went shopping for textbooks for him. At a local bookstore I found, to my horror and surprise, a Chinese language textbook that described a happy gathering celebrating Mid-Autumn Festival. The family saw not only the Moon, but also Venus, Jupiter, Mercury, Mars, and Saturn as they looked out the window. A benign view is to believe that the author was approved for her Chinese writing rather than her poor knowledge of basic astronomy.

I bought the textbook and sent it to the then Secretary of Education. I subsequently learned from those knowledgeable of the industry that some textbook providers hire poorly qualified authors to save on the total cost of production caused by the cumbersome and uncertain regulatory process. Perhaps parents and students may get cheaper and better textbooks if the Education Department stopped vetting them altogether. I am quite confident, in the age of internet blogging, that quality and affordable textbooks would be available if the market was allowed to function properly.

Government Regulation in Hong Kong

What are the most important sources of monopoly power in Hong Kong? They are to be found where government intervention has occurred. I shall discuss only a few significant ones that are, or have been, severely affected by inadequate competition. These include (1) public monopolies, (2) cartels, (3) licensing, (4) government franchises, and (5) public regulation.

(1) Publicly created monopolies include the stock exchange, postal service, water supply, and the like. By far the most important ones are health, housing, and education. Over time these areas are likely to become an increasingly important part of the economy.

The Hospital Authority is a near monopoly provider of hospital services, controlling some 90% of beds in the territory. The government is considering establishing some new private hospitals, but the limited scale and distant time horizon for this make any effective competition a remote possibility. Public hospitals should compete with each other but this would demand changes in the government’s regulatory framework.

The Housing Authority provides homes to some 50% of domestic households. The dominance of government in this sector has created enormous inefficiencies and inequities and is the root cause of popular discontent. However, its history is too long and complicated to be pursued here.

In education, government and aided schools constitute 87% and 75% of all primary and secondary schools in the territory. Aided schools are not strictly government operated, but since more than 90% of their funding is government-based, they are heavily regulated to the point of almost being indistinguishable from government schools. In the past the lack of competition in this area has been reinforced by policies that prohibit local private schools from charging higher tuition fees to improve the quality of education. This limits the ability of private schools to compete effectively against aided and government schools.  Competition comes only from the international sector and the English Schools Foundation.

Under the stewardship of Antony Leung, Arthur Li and Fanny Law direct subsidy scheme schools appeared and these have gradually provided some limited competition. On the other hand parents who can afford higher tuition fees and overseas schooling are voting with their feet en masse. Unless greater competition is introduced, the quality of education will inevitably decline regardless of the funding invested.

(2) Historically, rice importation was a well-known government-supported cartel. Although this has now ended, in the past the government pressed importers to stockpile rice to stabilize the supply and insulate it from world market conditions.  Rice importers naturally agreed in exchange for a system of licenses issued by government making them the only legitimate importers of rice. This helped cartelize the industry and remove the threat of new entrants. Throughout most of the post-war years Hong Kong’s rice importers maintained a steady supply for the population, but prices were generally 10% higher than rice of the same grade in Macau, where no such cartel existed. Today rice is no longer a significant imported commodity.

(3) Licensing is a pervasive form of regulation and its most pernicious effect is to facilitate cartelization. The most damaging economic effects are in the area of occupational licensing. Medicine and law are the most well-known.   Over the past decade, licensing arrangements have expanded rapidly in many occupations. Accidents and malpractices cannot be entirely prevented in any line of business, but they have been turned into opportunities to lobby government for protection and cartelization. While this may improve the standard of services, it also means higher prices and less competition. It is difficult to imagine how Hong Kong can emerge as a high value-added service hub if its professions are highly cartelized.

(4) Franchises apply to a variety of private enterprises that impose restrictions on entry. The most obvious include electricity and commuter transportation. The granting of franchises has been justified by the presence of scale economies.  But this is odd since natural monopolies do not need franchise protection. The case of town gas supply in Hong Kong illustrates the point. New entry into the industry has not occurred even though the existing company has not been granted a franchise. The franchises of the bus and electricity companies are territory based so the economies of scale argument hardly hold up as both territories are of differing sizes.

(5) Public regulation of industry is best illustrated in the case of the Interest Rate Agreement. This was established ostensibly to protect depositors from the banks’ “reckless” competition for deposits by raising interest rates.  In setting low deposit rates banking businesses appeared to be highly profitable because of the large differential between deposit and loan rates. Some of these higher profits were dissipated through non-price competition, for example, through over-branching. Since the Agreement did not restrict entry, the main long term effect probably made banking moderately more profitable for smaller banks, but protected the market position of banks with large deposit bases. As they were forced to compete on economically inefficient non-price measures, society as a whole suffered. Small retail depositors received low interests rates, while large depositors could keep their money in assets not covered by the Agreement. The Agreement is no longer in effect.

Competition in Hong Kong

Hong Kong’s service sectors are by and large quite competitive. Empirical evidence shows that average firm size has fallen over time and market competition is likely to have become keener. The only exception is the retail business, where branding matters greatly. Franchised chain hotels, supermarkets and department stores have grown much larger – these and other retail outlets often have vast economies of scale due to their inventory, distribution, and information management systems. The decline of the neighborhood “mom and pop” store is a universal phenomenon reflecting the growing economies of scale in this industry and has nothing to do with market power. For example, in many smaller US towns the only store is Wal-Mart, but few think of Wal-Mart as having market power in the US.

Allegations have been made in Hong Kong that some of the pricing and sales strategies of supermarkets appear to reflect market power. Such reasoning is economically flawed. Incumbent firms do not have an exclusive right in deploying these strategies. Any new entrant is free to imitate them and to further improvise. One should not be surprised that in a city economy like Hong Kong, the level of market concentration in retail business is higher in some industries.

Declining Firm Size in Hong Kong (Average number of employees per firm)

1982 1987 1997 2008
Manufacturing 19.8 18.6 11.6 11.6
Wholesale 5.3 4.5 3.3 3.8
Retail 3.7 3.5 4.6 4.7
Import-Export 6.5 6.2 5.3 5.8
Restaurant 23.1 22.6 20 20.2
Hotels & Boarding Houses 28.6 23.5 32.2 37.5
Financial Services 8.2 10.9 11.5 10.9
Business Services 11.4 9.8 6.4 9
Transport 3.8 4.1 5.4 7.3

Source: HKSAR Census and Statistical Department, Annual Surveys

Liberalizing many regulated industries and professions, and privatizing or corporatizing government-provided services, will enhance competition in many areas of Hong Kong’s growing service economy. It would be a serious mistake if our efforts to promote competition in Hong Kong were directed at preventing market driven mergers and acquisitions, and forcing markets to become artificially less concentrated. Prohibiting firms from adopting competitive pricing and retailing strategies by claiming they seek to increase their market share fails to appreciate that this approach is available to all.

What one must guard against is using the coercive power of government to regulate industries in favor of incumbents, erecting barriers to entry, protecting cartels, and preserving monopolies. There is no reason to presume that Hong Kong’s markets are monopoly prone, except in those areas where government has intervened to limit entry.

The government should rethink its position on introducing a competition bill that fails to address the real issues of monopolistic power and exempts those sectors where competition is weak or absent. Government effort should not focus on alleged monopolistic practices adopted by firms in industries, where entry is free and market competition has become keener as average firm size has fallen over time.

References:

Arnold C. Harberger, “Monopoly and Resource Allocation”, American Economic Review, Vol. 44, No. 2, May Proceedings, 1954, pp. 77-87.

http://www.jstor.org/stable/pdfplus/1818325.pdf?acceptTC=true

Harold Demsetz, “Why Regulate Utilities?” Journal of Law and Economics, Vol. 11, No. 1, Apr., 1968, pp. 55-65

http://www.jstor.org/stable/pdfplus/724970.pdf

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