Our government plans to introduce a competition bill this year. The proposition that competition almost always benefits the consumer is well accepted by economists. They instinctively love competition and hate monopolies and cartels. Such sentiments are not ideological, but based on their training, economic reasoning, and scientific evidence accumulated over two centuries. On most counts, economists should be a government’s natural ally in favor of a competition bill. Yet they are not agreed on the need for a competition law.
To begin with one cannot assume that a competition law necessarily promotes competition. A distinction has to be drawn between supporting competition and favoring a competition law. The case for such a law must rest on sound economic reasoning and solid empirical evidence.
Two Views of Market Power
The rationale for enacting this law is based on the assumption that an unregulated market is monopoly prone. Advocates see it as a necessary government step to foster competition in the marketplace, to create a level playing field, and to protect consumer interests. An implicit requirement for this view is the belief that firms can develop and maintain monopoly power relatively easily.
This theory, which Professor Harold Demsetz calls the “self-sufficiency theory”, sees market concentration, large capital requirements, intensive advertising, predatory pricing, and collusive practices – like bid rigging, price fixing, and market allocation – as competitive tactics used by big companies against defenseless smaller ones. This view dominated the economics profession from 1925 up to the 1970s. It is also the popular view that is etched into the public’s mind and is beloved by most policy makers.
The “self-sufficiency theory” is often colorfully equated with an ocean of large fish rapaciously consuming smaller fry, until only one or a few remain. The implied message is clear – the only businesses that survive long term are large, aggressive companies which achieve their dominance by deploying lethal competitive tactics. Market competition is akin to swimming with sharks; and is thus monopoly prone.
This equation, however, fails to consider the single most important fact about competition in the real world – that the right to use lethal competitive tactics is not monopolized by big incumbent companies. Newer, younger and more competitive fish are born every day and are not averse to challenging the dominance of larger ones. It is not unusual for small companies to grow into large threatening corporations, as Microsoft has discovered, and as Google and Apple will one day inevitably realize. The market is a competitive place and a breeding ground for competitive new firms, just as the water is a breeding ground for young fish.
The notion that markets are competitive-prone, as opposed to monopoly- prone, is an old idea and can be traced back to Adam Smith. Demsetz calls Smith’s 18th century view the “interventionist theory”. According to this “theory”, monopolistic power originates from government intervention and not from the competitive tactics of businessmen attempting to dominate the market. The latter is the focus of “self-sufficiency theory”. The former claims that without the help of government to control competition, big business cannot wield significant monopolistic power. The coercive power of government is used to establish and police legal barriers to competition and is deployed punitively against offenders.
The “interventionist theory” views the regulation of businesses, the enforcement of licensure, the control of prices, the legal restrictions imposed on entry and on the use of competitive tactics, the granting of franchises, and the creation of public monopolies as the origin of far more significant monopolistic powers. Smith’s old view has been revived since the 1970s, and I believe that its explanatory power is considerable when applied to Hong Kong and elsewhere. Smith’s view is better received on the Mainland than in the capitalist economies.
The two theories, however, lead to very different opinions on how we should deal with monopolistic power. Should we try to reduce the degree of government intervention, or should we try to restructure industries and modify the competitive tactics used by firms? Those who advocate the “self-sufficiency theory” will answer this question by seeking more intervention, while those who see the source of monopoly in government intervention will seek to limit the role of government in the economy.
Adam Smith on Market Power
Adam Smith first showed that the pursuit of self interest, through competition in the market, leads to the greatest benefit for all. Smith wrote, “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” In competing with each other to serve the consumer, the butcher, the brewer, and the baker, out of their own interest, struggle to keep prices low and consumer satisfaction high.
Smith’s praise for competition in the market place, or what he famously called the “invisible hand”, is accompanied by a severe criticism of the businessmen of his day; a criticism that I believe remains valid today. He observed that “people of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” The propensity for conspiracy, to avoid competition, and to cartelize is one of his most penetrating observations of human nature.
Would Smith have supported the enactment of a competition bill to limit and outlaw the competitive behavior of the businessmen of his day? Reading his writings, I am convinced that he would not. And the reason is that our venerate professor feared that effective competition will be harmed if the government is invited to play an even larger role. He said, “But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies, much less to render them necessary.”
The government in Smith’s time granted franchises, protected industries and crafts, and extended patronages to all types of activity in order to give legitimacy to precisely the kind of (mercantilist-like) competitive tactics that assemblies of businessmen conspire to do. For Smith, it would be ironic indeed to encourage government and to give it additional powers to police such (mercantilist-like) competitive tactics which it has sanctioned in the first place.
Although Adam Smith believed that businessmen liked to conspire, he also thought it would be difficult for them to do so successfully without the help of government. What drove them to conspire in the first place was self interest. Yet it is self interest that tempts them to betray each other. For Smith, the invisible hand also exerted a powerful influence and acted to constrain such (mercantilist-like) competitive tactics.
Government Can Entrench Market Power
A cartel can successfully set a higher price if, and only if, it can secure an agreement among members to lower total production, and to agree to share that lower production amongst themselves. After the agreement has been struck, each member still has a very strong incentive to clandestinely sell more than their agreed output, i.e. to cheat on the cartel. For a cartel agreement to stick, resources must be spent on policing the arrangement and on disciplining offenders.
Cartels are inherently unstable. The most important reason for this is the entry threat of new firms. Cartelized industries, by definition, set higher prices and earn higher profits. This inherently lucrative situation attracts new players. And before devising an appropriate response strategy, the cartel must first ascertain whether the potential player is threatening a bona fide entry or is merely trying to extort payment from the cartel. Deciphering motives are notoriously difficult and can be costly. To survive, a cartel must either prevent entry, or bribe the new entrant to join.
Preventing entry is costly. Cartel members must agree to invest resources to discourage the new player and agree on how to share that cost. Each additional new member also requires another costly redistribution of the share of production. These are non-trivial tasks and many enjoy being free-riders.
To sustain its monopolistic power an industry must be able to restrict, or retard, the expansion of new productive capacity. Government can offer industry much greater powers of coercion to accomplish this than can be supplied by industry itself. It can restrict competitive entry brutally through the use of licensure and quotas, which, by convenience and out of necessity, specifically penalize prospective entrants.
Government can regulate competition in a more subtle manner through imposing health standards, environmental standards, labor standards, safety standards, etc. that impact incumbent firms and prospective firms differentially. US President Obama introduced last year a cap and trade scheme for environmental pollution permits, but chose to give these permits to incumbent firms for free. New entrants, however, had to pay the market price. The policy tilted the playing field and compromised industry competition.
Professor George Stigler inspired an enormous amount of work on the public regulation of industry. Stigler’s work demonstrated that government regulatory bodies are usually captured by the powerful industries they seek to regulate. As a consequence, these public bodies are transformed from pro-competitive agencies into anti-competitive ones. More and more research findings now show that US and European regulatory bodies have fallen victim to this fate. Economists today are more skeptical of the benefits of having regulatory bodies to foster competition.
Are the courts a better alternative institution for enforcing competition? The US makes extensive use of the courts to enforce Antitrust Law. Professor Paul Rubin’s work on the value of Antitrust Law in the US is particularly illuminating. His work examined 23 antitrust cases in the US. These were examined critically in 37 economics studies.
From the perspective of an economist antitrust cases have several possible outcomes. A case may be “justified” if the behavior challenged is indeed anticompetitive, or may be “unjustified” if the behavior is actually pro-competitive. The plaintiff, which is usually the government, may win or lose in each sort of action whether the case is “justified” or “unjustified.”
A plaintiff victory in a “justified” case, and a defendant victory in an “unjustified” case, are correct outcomes. Rubin discovered that the number of cases that had correct outcomes were 9 and 2, respectively, out of the 23 cases. In other words, of the 23 cases only 11 were correctly adjudicated by the court. The probability of getting it correct was less than 50%. This is truly a miserable record. It sends a totally confused signal as to what constitutes anti-competitive behavior. Industry simply will not know what the law stands for. Such confusion will surely harm industry performance. In the absence of confusion, compliance costs would already be high, but they are now exacerbated because industry fails to understand what the law wants.
Outcome by Cases Justified Case Unjustified Case Totals
Plaintiff Victory 9 (39%) 7 (30%) 16 (69%)
Defendant Victory 5 (22%) 2 (9%) 7 (31%)
Totals 14 (61%) 9 (39%) 23 (100%)
The true record is even more discouraging because the appropriate remedy might not have been granted. For example, in correct situations where the plaintiff wins a justified case, or when the defendant wins an unjustified case, the granted remedy might have been ineffective. An ineffective remedy would send another wrong signal further confusing industry.
In all these cases huge legal expenditures were incurred. When all costs and mistaken effects are added up, they amount to more harm than benefit. Competition law is falling out of favor with economists who have read the research closely, but Hong Kong is rushing into it this year.
Harold Demsetz, “Two Systems of Belief about Monopoly”, in Industrial Concentration: the New Learning, Little Brown, 1974.
Paul Rubin, “What Do Economists Think About Antitrust? A Random Walk down Pennsylvania Avenue,” in F S McChesney and W F Shughart II, ed., The Causes and Consequences of Antitrust, University of Chicago Press, 1995, pp. 33‑62.
George Stigler, “The Theory of Economic Regulation”, Bell Journal of Economics, Spring, 1971, pp. 3-21. Reprinted in George Stigler, ed., Chicago Studies in Political Economy, University of Chicago Press, 1988.
Shuli Hu, “Price Control and Champing at a Monopoly Bit,” A Century Weekly Editorial, 01.14.2011. http://english.caing.com/2011-01-14/100216964.html