Is Competition Always Beneficial To Consumers?

Introduction

The economists have always advocated governments to deregulate and privatize most industries to stimulate competition and maximize productivity and efficiency gains, as well as benefiting consumers in terms of more choice and lower price. However, is that firms in competitive industries always good for consumers? There are lots of debates about this issue and it’s impacts on societies has significant importance for policy makers. Here, I would like to analysis in detail both the advantages and disadvantages of competition from a theoretical economist’s perspective to more practical ones.

Theoretical perspective

Firstly, I would explain why academic economists always favour high competition by comparing the theory of perfect competition and monopoly. In the perfect competition, firms are price takers who face very close substitutes, both consumers and suppliers have perfect information and firms could enter or exit a market freely in the long run. E.g. agricultural industries almost satisfy these conditions. In short run, profit-maximizing firms set price equals to marginal costs of production, i.e. the benefit for consumers of purchasing the product is the same as the cost of producing the last unit of output. Over the long run, if there are positive economic profits in an industry, it will attract more suppliers to enter the market freely. Then more competition drives the price down until there is only normal profit in the market and no firm are willing to enter or exit the industry. So, the marginal cost is equal to the long run average total cost and the price. Therefore, there is allocative efficiency in both short run and long run. Overall, more competition maximize social welfare which provides consumers more choices, lower prices and higher output. In addition, the desires for survival stimulate firms to control cost of production through investment in technology and innovation. (Robert H. Frank, 5th edition).

In contrast, there are only a few firms with no close substitutes for monopolies. For a profit maximizing monopolist, it would set a price where marginal cost equals to marginal benefit in both short and long run, and the price is always greater than marginal cost. The higher price leads to a loss of consumer surplus and a deadweight loss to the whole society. Therefore, monopolies are not allocative efficient. In addition, customers as price takers have little choices over product and pay higher prices than in a competitive industry. Many also criticise that although the state monopolies could provide low prices to consumers, there are always X-inefficiency where managers tend to spend more on prestigious products or maximize their salaries rather than on cost-saving or profit maximization. Therefore, highly competitive markets tend to yield more benefits to consumers than monopolies. However, monopolies such as state electricity and telecommunications industries benefit exclusively from economies of scale (lower average cost per unit as output increases) enabling them to provide cheaper products than in competitive markets. In addition, monopoly firms could use the hurdle model of discrimination pricing to charge different customers different prices, therefore minimizing the welfare loss. (Robert H. Frank).

Overall, the theoretical perspectives which favor high competition might overemphasize the benefits of competition and be ideological. So indeed having a deeper insight into the real life competition will be more useful.

Competition in real life

Martin Neil Baily (1993) supported the academic economics that more competition stimulates productivity and innovation. He researched four industries including telecommunications, retail banking, airlines and general merchandise retailing by comparing their productivity in Europe, Japan and United States respectively. In this research, Baily was a member of a research team sponsored by the McKinsey Global Institute. In airlines industry, there were great regulation and low competition in Europe. “Before the European Community (EC) embarked on its single-market program, some 200 bilateral agreements among twenty-two countries governed internal air service in Europe. Carriers were effectively prohibited from offering service between two other European countries. Of some 400 routes within the EC, only 44 allow such rights, and only about 20 had competition between more than one airline per country in 1987”. (Commissions of the European Communities, 1988, in Baily, 1993: 75). Baily’s research compared functional productivity over 171 carriers in USA and 89 carriers in Europe. They found that U.S. had higher functional productivity in all services than in EU. For example, the EU’s maintenance activity productivity was 57% of the USA, the productivity of the passenger handling activity was 89% of the U.S. level. The overall estimated productivity for EU was 72% of the U.S. level. Therefore, Baily argued that the European airline industries are inefficient and had excess labor in maintenance, ticketing and other activities due to regulation from trade union and government’s protection on employment, leading to substantial difference of productivity between the U.S. and the EU. Government should instead promote more competitive environment by privatisation or deregulation to encourage productivity and thus lower costs for survival and subsequently lower prices to consumers.

The EC commission argued in 1998 that “the substantial restrictions on competition in the EC countries were resulting in higher prices to consumers than those that could be obtained within a competitive market.” A Price-Waterhouse study for the EC estimated that the price of banking services would drop 33% in Germany and 18% in the UK if the European single market were completed. (Baily, 1993: 77). Baily’s study on retail banking industries in USA, UK and Germany by comparing functional productivity levels further demonstrated the potential productivity gains from higher competition. It is found that the USA’s retail banking has high “transaction intensity” of 57.8 billion transactions in 1989 compared with UK’s 7.2 billion transactions and 8.3 billion in Germany. In addition, USA had the highest credit outstanding, with 1.4 per person. In UK it was 0.9 and 0.7 in Germany. The overall productivity in Germany was 68% of the USA and in UK it was 64% of the USA. Therefore, Baily said that high competition in USA encouraged banks to have more innovations such as ATM which reduced the need for labor and increased the efficiency substantially. Consumers benefited from shorter waiting time and potentially lower transaction costs for customers. There are many other examples of how competition benefits consumers in terms of higher productivity. E.g. the USA railroads productivity doubled after deregulation in 1980. The British Airways enjoyed higher productivity and competitiveness since it was privatized.

However, there are also many criticisms. E.g. Robert J. Gorden (1993) criticized lack of control of variables in Baily’s research. Language could a main factor of lower functional productivity on services such as ticketing and sales in EU. E.g. a German passenger who wants to confirm her reservation may need officers who can speak German to help her, so EU required more employees than in USA. In addition, there are many examples (e.g. the housing insurance industries in both Switzerland and Germany) demonstrated that monopolies outperformed the competitive industries.

In 1996, Thomas von Ungern-Sternberg carried out cross section comparison of housing insurance market in Switzerland. In Switzerland there are competitive housing insurance industries in 7 cantons and state monopolies in 16 cantons. It was found that the premium rate of state monopolies are 70% cheaper than that of the competitive insurance companies overall. Why was it the case? He explained that the state monopolies had substantial investment on fire prevention and less spending on damage rate (possibly higher spending on fire prevention reduces the damage rate). When using the premium rate to deduct the above 2 components. The remaining amount was 17.7 ct/1000 frs for government monopolies and 46.9 ct/1000 frs for the private ones. Then these amounts were used to cover administration costs and profits. The private insurance company spend approxmiately16.9 ct/1000 frs for commissions and 14.9 ct1/000 frs for administrative costs (e.g. substantial advertising costs to compete for limited customers). In contrast, the state monopolies had very low administration costs of 6 ct/ 1000 frs because advertising to attract customers were not needed. Therefore, the state monopolies would have lower mark-up on damage payments than private insurance companies and benefit consumers with much lower prices and positive externalities associated with higher spending on preventions. In addition, state monopolies tend to benefit from economies of scale where average costs per unit fall when firms expand their output. So, it demonstrates that low competition could also generate low prices for consumers. In addition, in 1996, Karl Epple & Reinhard Schafer also conducted time series comparison of Germany’s housing insurance companies in Barden Wurttemberg when former monopolies are opened to competition on July 1, 1994. Again, their research shows that the increasing competition leads to increase in administration and commission costs substantially over time, and so the premium rates for house owners have increased by 84% to 117% since 1992. According to the academic economists the monopolists would charge higher prices for profit maximization and in competitive market. In reality, however, Germany’s insurance market proved that the state monopolies charged lower premium rate which just cover sufficiently the administration costs and damages expenses to provide social welfare for residents. Private insurance companies instead have higher prices, which is not allocative efficient. Therefore, we may conclude that increase competition lead to higher prices in housing insurance industries in Germany.

Apart from the lower price local state monopolies offer to consumers, K.Epple & R.Shafer (1996) found that they also provide more comprehensive insurance cover. In state monopolists, all customers must buy insurance and enjoy insurance coverage including standard insurance (e.g. storm and hail) and high risky one such as flooding, snow pressure and earthquake. Every citizens are obliged to buy insurance at the same premium price effectively prevent the adverse selection risks and the large number of insurance portfolio guarantee the diversification and spreads of risks over different insurances. In contrast, highly competitive private insurance companies normally do not have enough capital to cover highly risky insurance such as earthquake. Moreover, they tend to face adverse selection where the most risky consumers buy the insurances which further drive the private companies to increase mark ups on damages costs. So private companies facing higher competition always charge higher premium price than state monopolies. E.g. In Germany, the cartons of Rhine and Zollern have the highest risk of earthquake and flooding. But residents could not find any insurance companies to cover them. Therefore, we are suspicious of the statement of the EC Commissioner Leon Brittan claiming that in the European Single Market for insurance” Policy-holders will have the greatest possible choice of products at competitive prices”. (Brittan, 1992, in K. Epple & R. Schafer, 1996)

Conclusion

In conclusion, competition is not always good for consumers. Although higher competition leads to more choices, cheaper products for consumers, it could come at the sacrifice of the quality of goods and services to reduce costs. In addition, with too much competition and imperfect information between producers and buyers, firms tend to spend substantial amount on advertising, marketing to increase their brand awareness, resulting in higher prices for customers. Especially for highly standardized products such as insurance companies where monopoly might outperform privatised firms in competitive environment. On the other hand, monopolies or oligopolies facing low competition tend to have lower productivity, higher price and lower output for consumers. But low competition allow monopolies to benefit from economies of scale and have enough capital to innovate which are good for customers.. E.g. Commins and Wise (1993, in S. Felder, 1996) indicated that mild diseconomies of scale for large firms, but potentially significant scale economies for small and medium size property-liability insurance companies. So it really depends on the structure of the market. Some natural monopolies are more efficient-standardized product. than smaller firms, on the other hand,….. Therefore, I would suggest that oligopolies with certain level of competition might benefit consumers more. ( Baily, 1996; F.M. Scherer 1980)