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OPINION

Competitive pressures

Competitive pressures
February 7, 2019
Competitive pressures

Arguably, the wider ramifications are even more important. In particular, there is the question of whether hard-pressed UK consumers will benefit from the merger between the grocery market’s second and third biggest players or whether they will be legged over in the long run.

That puts the spotlight on the UK’s competition regulator, the Competition and Markets Authority (CMA), a regulator with a limited track record – it only began operations in April 2014 – and not a terribly auspicious one. And, given the especially high profile of the deal – everyone but everyone has an opinion about food prices – the CMA’s decision may help to revive the status of competition regulators in both Europe and the US, or may hasten the decline.

Putting the issue into stark – albeit simplistic – terms: will the CMA demonstrate the trust-busting credentials that are needed to put overmighty companies in their place, or will it cave in against the legal, political and economic fire-power that today’s blue-chip companies have at their disposal?

The CMA’s chairman since last June, Andrew Tyrie, the former chairman of the Treasury Select Committee, says that the CMA will be “round to see” companies that rip off consumers and exploit the vulnerable. Fine sentiments. Still, the smart money would back caving in.

That bet would be based on both the CMA’s own record and that of its predecessor, the Competition Commission, when dealing with monopolies issues in the food retail industry. In December 2017, the CMA approved without reservation the merger between Tesco and Booker, the UK’s biggest groceries wholesaler, on the assessment that the combination would not reduce competition in any market where the two operate, despite their enhanced buying power.

Quite possibly that judgement emboldened Sainsbury and Asda to pursue their much more ambitious venture. Yet besides that, both of the CMA’s predecessor regulators, the Competition Commission and the Office of Fair Trading (OFT), investigated food retailing several times – both over specific transactions and in industry-wide probes – and never did more than tinker with deals; such as when in 2009 the OFT told the Co-Operative Group to sell 133 stores as a condition of buying the Somerfield chain of supermarkets.

Yet that is consistent with a growing concern throughout Europe and the US that big companies are becoming too powerful for regulators to cope with. They have better resources, they fund smooth lobby machines, they can hire smarter lawyers and they can offer regulators a lucrative career path, via their advisers, both legal and financial. In short, the regulators have been captured.

This even reveals itself in a certain contempt for regulators on the part of companies, nicely illustrated by the $19bn takeover of WhatsApp by Facebook (US:FB) in 2014. During the European Union’s (EU) investigation into the proposed takeover, Facebook promised the EU’s competition directorate that it would not match the identities of Facebook users to those of WhatsApp; indeed, it even said that it was not technically possible. By 2017, however, the EU commission discovered not only that Facebook and WhatsApp accounts had been linked, but that this had been planned all along.

For misleading the EU in such a brazen way Facebook was fined about £100m. That sounds a lot, but it was just 0.7 per cent of what Facebook paid for WhatsApp and quite possibly less than it paid its advisers on the transaction. In other words, the fine was just a minor cost of doing business.

That the EU’s competition directorate should be singled out for its weakness may be unfair because it appears to be more effective than the competition regulators in the US, where responsibility is shared between the Federal Trade Commission, which reports to Congress, and the Department of Justice, which is answerable to the president.

Certainly, two industrial-organisation economists from New York University, Germán Gutiérrez and Thomas Philippon, are not in doubt. In a paper they produced in June 2018 they say that the EU’s competition regulators “are more independent than their American counterparts and they enforce pro-competition policies more strongly than any individual country ever did”.

At first glance, that might seem odd. It’s not just that the US invented competition regulation via its anti-trust laws of the early 20th century, its leaning towards the free-market model for an economy also encourages politicians to prevent market dominance turning into market abuse.

Yet that has changed in the 21st century, more because of what has happened in Europe, say Messrs Gutiérrez and Philippon. The EU’s competition office has become more effective than its US equivalent because it is more independent of political lobbying. Paradoxically, that is because, according to the academics, within EU countries “politicians are more worried about the regulator being captured by the other country than they are attracted by the opportunity to capture the regulator themselves. French and German politicians might not like a strong and independent anti-trust regulator, but they like even less the idea of the other nation exerting political influence over the institution”.

However, what remains unclear is whether the limited effectiveness of competition regulation is a cause of the rising power of companies throughout the developed world or simply an effect of that greater power.

Whichever, it is less in doubt that the market power of companies is rising, especially in the US but also in Europe. That is why in the past 30 years US companies have been able to mark up their prices by rising amounts, according to research by Jan De Loecker of the University of Leuven and Jan Eeckhout of University College London.

Mark-ups for US firms were stable in the 25 years to 1980, the two showed in a paper published in November. Since then they have risen from an average of 21 per cent above marginal cost to 61 per cent now. Mark-ups rose steeply in the 1980s and 1990s, then stabilised in the 2000s and rose sharply again after the 2008 financial crisis. In a similar piece of research published earlier last year, the academics showed that average mark-ups had risen more in the UK than in the US or Europe.

True, in all countries part of the widening of mark-ups is a function of the shift towards an economy where companies’ fixed costs are higher. This is epitomised by the cost structure of technology companies where the up-front cost of developing intellectual property is high but the marginal costs of reproducing the technology, once developed, are very low. However, the academics reckon that higher fixed costs account for only a quarter of the rise in average mark-ups.

In the absence of other explanations, the remainder can be attributed to stronger market power. Such an inference is consistent with the academics’ finding that the greatest increase in mark-ups was achieved by those companies that already had the widest profit margins. In other words, better profitability has become more skewed towards those companies that were most profitable in the first place.

Research by the Resolution Foundation, a think tank whose aim is to raise living standards for the poor, generates similar conclusions for the UK. It showed that Britain’s 100 biggest companies accounted for 23 per cent of total revenues across British business in 2015-16 compared with 18 per cent in 2003-04. Perhaps more telling, on average, the five biggest companies within each industry that the foundation analysed accounted for 43 per cent of the revenues in their sector compared with 39 per cent in 2003-04.

Meanwhile, in some sectors concentrations are especially high – the research highlights general retailing and betting. The top five’s share in retailing rose from 62 per cent to 74 per cent in the years under review and in betting the figures were 68 per cent up to 85 per cent.

The foundation is in no doubt that competition regulators should take note of these trends. It says: “Takeovers and mergers involving market leaders should be very closely scrutinised, not just for their impact on prices for today but also for their potential impact on concentration in years to come.”

Yet the significance of the foundation’s findings is open to question. Its analysis puts much focus on so-called ‘concentration ratios’ (see box 'Let's concentrate') and points out that, on average across the UK, concentration ratios for the top five players – CR5 in the jargon – has risen from about 39 per cent to 43 per cent in the 12 years to 2015-16 and such ratios have risen similarly for the top 10 and the top 20.

Yet arguably a concentration ratio for the top 10 or top 20 companies in any sector is meaningless. If there are 20 substantial players, that suggests effective competition anyway. In 2015-16, according to the foundation, the average sectoral CR20 market share was 58 per cent. That implies an equally weighted market share of about 3 per cent for each player among the top 20 and over 40 per cent of the market being taken by however many smaller players. The most obvious interpretation of such data is that competition is thriving rather than withering.

And even if there is concentration in market shares, that still prompts the question: does it matter? One response would be to say that it matters enough for the world’s central bankers to discuss the issue at their annual jamboree at Jackson Hole, Wyoming last summer. For their discussion, New York University’s Thomas Philippon prepared a briefing paper in which he outlined three hypotheses of market concentration – the good, the bad and the indifferent (for consumers, that is).

●  Good. That rising concentration reflects the improved efficiency of industry leaders. It is linked to higher profits only in so far as it stems from better productivity and it reflects consumers’ rising expectations of good pricing and quality. This, if you like, is the ‘Amazon effect’ in which a new format revolutionises an established industry and benefits consumers but only a few winning companies.

●  Bad. Market concentration is due to higher barriers to entry within industries, thus allowing dominant players to extract rents by overcharging consumers and eventually offering a poorer service as they stint on capital spending and reject innovation. This would be the US airline and telecoms industries, where rates of profit have risen in line with rising concentration and slowing growth.

●  Indifferent. Higher concentration is a response to declining demand and/or more foreign competition. Mergers are necessary to eke out profits. Consumers neither gain nor lose. This could be any number of declining industries in the developed world.

So which is it? In truth, no one knows – possibly least of all the competition regulators. That’s partly because they are being asked to do a job they are not equipped to do and therefore cannot do, says Carl Shapiro, a business school professor at the University of California, Berkeley and a former attorney at the US Department of Justice. More of that in a moment. Meanwhile, Professor Shapiro highlights six areas where competition regulation can – and probably should – be toughened.

 

Going after cartels

The propensity to rig prices may be hardwired into human nature; not for nothing did Adam Smith note in The Wealth of Nations that “people of the same trade seldom meet together but the conversation ends in some contrivance to raise prices”. Two hundred and fifty years on and it’s much the same and this despite the fact that in both Europe and the US regulators have effectively pursued cartels for the past 25 years or so. Last year the EU toughened its act by introducing a whistle-blower system to encourage cartel insiders to fess up. The application of these so-called ‘ECN+’ rules might even survive Brexit in the UK. However, there is always more to do; as Professor Shapiro says: “To the extent that markets have become more concentrated, cartel enforcement becomes all the more vital.”

 

Stricter merger rules

Competition regulators spend much time investigating mergers, fine tune just a few and block hardly any. This may not be the way to proceed because academic studies have found that mergers are associated with increases in mark-ups and there is little evidence that they improve efficiency through streamlining companies’ operations.

Meanwhile, industries have become more concentrated in the past 30 years and that may be linked to the rising returns to capital that are clearly in evidence. In which case, says Professor Shapiro, regulators should (a) challenge more mergers and (b) insist on stronger remedies.

They should also pay more attention to how a merger might lessen competition in the future. The $85bn takeover of TV content provider Time Warner by AT&T (US:T), America’s biggest telecoms company, looks a good case in point. No overlap in activities between those two, but the potential to reduce competition in future if and when, for instance, AT&T’s telecoms companies exclusively push Time Warner’s content through their networks. True, the US Department of Justice wanted to block that deal, but the courts gave the go-ahead.

Focusing on the future might also curtail a way of life for technology giants, who routinely buy smallish, newish companies operating in adjacent markets that one day might become rivals. Easier said than done, of course, but the very fact of technology titans paying huge multiples of revenue for lossmaking juniors ought to get the regulators wondering.

 

Abusing market power

Last year, the EU competition office fined Google – now part of Alphabet (US:GOOGL) – €2.42bn for breaching its anti-trust rules by favouring its own shopping comparison service on its search engine. Let’s have more of the same, was the widespread response among consumer groups. Hold on, says Professor Shapiro, it may be tempting to go to war against the likes of Google and Amazon simply because they are big and slightly scary but, as regards their business practices, “the key question is whether the conduct disrupts the competitive process and either harms consumers or is likely to harm them. Let’s avoid the ‘big is bad’ mentality and let’s truly have the interests of consumers in mind. Proper anti-trust enforcement is about protecting consumers and protecting the competitive process, not about protecting competitors”.

True enough, but measures can be taken and in this particular niche of competition regulation Europe leads the US, especially in Germany where its regulator, the Bundeskartellamt, now formally acknowledges that markets can exist and can be abused even where money does not change hands – data mining IT companies, please note.

 

Cutting barriers to entry

High company profits and slowing productivity growth suggest that barriers to entry should be cut even when they are not that high. In the US that would mean attacking the ‘licence raj’ that has crept up in the past 20 years. This restricts even small businesses where entry barriers should barely exist, such as hairdressing and interior decorating. In Europe and the UK that could extend to turning attention towards the government itself. Indeed, when the UK’s Competition and Markets Authority began operating in 2014, the Institute of Economic Affairs, a free-market think tank, suggested that its first task might be an investigation into government impediments to competition in providing services where promoting competition is an explicit part of government policy. Local authority planning restrictions would probably wander straight into that firing line. The CMA should even be given the powers to investigate all government services, suggested the think tank. Don’t hold your breath.

 

Breaking up titans

It’s a popular call, but Professor Shapiro is doubtful. “It makes me nervous,” he says. If technology titans are broken up for economic reasons alone then there would need to be sound logic that somehow consumers would benefit – and demonstrating that would be tough.

Meanwhile, the very fact of their size implies that the biggest are the most efficient. Besides, part of their success is based on the economies of scale and the networking effects that accrue to the most efficient. So if the authorities broke them up, their markets “might drift back to winner-takes-most anyhow”.

 

Regulating dominant companies

And if you can’t break them up, regulate them. Granted, today’s obvious corporate targets are not natural monopolies. Meanwhile, price controls have proved “notoriously messy” in utilities industries and industry regulators are susceptible to so-called ‘regulatory capture’. Even so, the response to growing demands to patrol and to police companies’ use of data and infringements of customers’ privacy may end up as regulation by another name.

Which is partly why the hostility to dominant companies necessarily carries a political agenda, too. “Today’s populist sentiments are fuelling a ‘big is bad’ mentality,” warns Professor Shapiro. And, sure enough, going through the US Congress have been bills for the Accountable Capitalism Act and the Merger Retrospective Act. These would give companies federal licences that could be revoked for bad conduct and empower government to review past mergers for their impact on prices, quality of service, average salaries, plant closures and such like.

Neither will become law, but they are a sign of the way popular opinion has shifted – a direction that will only pile extra pressure on competition regulators. However they respond, they won’t keep everyone happy – a fact of life that will be amply demonstrated when the UK’s competition authority adjudicates on the merger between Sainsbury and Asda.