3 Competition law and economic efficiency

The
Economic Freedom
Network

Theoretical rationale for competition law

A central proposition in economic theory is that, under perfect competition, the allocation of resources is Pareto efficient. A Pareto efficient allocation of resources is one in which it is impossible to make one person better off without making another person worse off. For economists, Pareto efficiency is a desirable objective because it implies that all gains from trade among economic actors are exhausted. If so, it follows that no individual can be made better off without at least one person being made worse off. The fact that free markets (i.e., perfectly competitive markets), under certain conditions, can result in all gains from trade being exhausted, is testimony to the power of markets to allocate resources in an optimal manner.6

However, in order for the market to be Pareto efficient, it needs to be perfectly competitive. Perfect competition requires that all market participants be price takers. In other words, all market participants (consumers or firms) must have sufficiently little market power that they have no influence over market prices. All goods must be homogeneous and, if a single firm raises its price above the market price, its demand must fall to zero. Furthermore, there must be enough markets so that all goods, services, and contingencies are priced, and the costs of transactions in markets must be negligible--zero or extremely small. In the real world, few markets can be described as perfectly competitive since goods are non-homogeneous, both firms and consumers often posses market power (i.e., they are able to influence market prices), and there are missing markets for many goods, services, and contingencies. Further, there are real costs to transactions in the real world. Hence, most markets cannot be properly characterized as perfectly competitive.

Deviations from perfect competition have traditionally be used as a rationale for state intervention in economic affairs (e.g., Bator 1958). Because perfect competition is necessary for markets to be efficient, politicians and policy makers have often argued that deviations from perfect competition justify state intervention.

Competition law, or anti-trust law, is one means by which governments intervene in the operations of markets with the alleged goal of ensuring that real world markets operate in a manner roughly consonant with perfect competition. The main goal of competition law is to curb the ability of firms to influence price; in other words, it is aimed at reducing the market power of economic actors. Hence, the traditional focus of competition law has been to eliminate restraints to trade which, from the perspective of state authorities, are detrimental to competition and enhance the market power of firms. Thus, competition law authorities are concerned about such matters as cartelization of industries, price agreements among competing firms in an industry, vertical restraints on trade, and mergers, for these are all activities that--according to the conventional wisdom--are means by which economic actors are able to exercise and enhance their market power and, in so doing, reduce the efficiency of the market place.

Objectives of Canadian competition law

Over the past several decades, the stated objectives of Canadian competition law have evolved considerably (see Ross 1998). Most scholars agree that the primary objectives of Canadian competition policy have been to (1) maintain free competition; (2) prevent abuses of monopoly power; and (3) achieve economic efficiency. In addition, competition law has been used to advance a number of supplementary objectives, which include (1) codifying the Common Law doctrine of restraint of trade; (2) fighting inflation; (3) protecting the interests of small business; and (4) ensuring honesty and fairness in the market place (Gorecki and Stanbury 1984).

During the 1970s, many of these objectives came under increasing scrutiny. Partly as a result of advances in the field of industrial organization, many commentators came to the view that the primary objective of competition law should be to foster economic efficiency and that this objective should take precedence over the other goals (Skeoch and McDonald 1976). In the 1980s, concerns about efficiency were broadened to the international market place and, increasingly, efficiency was viewed as key to improving the performance of Canadian firms in world markets. Furthermore, the recognition that foreign competition (in particular, imports) can limit the market power of domestic firms was acknowledged (Leitzinger and Tamor 1983).

These developments eventually led to the overhaul of Canadian competition policy and the passing of the Competition Act in 1986. The purpose clause of the Competition Act reflects a primarily, but not exclusively, efficiency-oriented view of the objectives of competition policy. It states:

The purpose of this Act is to maintain and encourage competition in Canada in order to promote the efficiency and adaptability of the Canadian economy, in order to expand opportunities for Canadian participation in world markets, while at the same time recognizing the role of foreign competition in Canada, in order to ensure that small and medium-sized enterprises have an equitable opportunity to participate in the Canadian economy, and in order to provide consumers with competitive prices and product choices.

As Hazeldine (1998) notes, the pursuit of economic efficiency is not the sole objective of the 1986 Competition Act. Other objectives of the Competition Act are to ensure ``equitable opportunity'' for small and medium-sized enterprises and to ``expand opportunities for Canadian participation in world markets.'' These objectives are not always consonant with the pursuit of economic efficiency. However, at a first pass, it appears that efficiency is the primary goal of the Competition Act and that competition is not an end in and of itself (Ross 1998).

The Competition Bureau

The Competition Act is administered by the Competition Bureau and its Director of Investigations and Research (Priest and Stanbury 1998). Under the Competition Act, mergers and a number of other potentially anti-competitive business practices are dealt with through an administrative review process. The merger provisions of the Competition Act apply to all transactions that involve the acquisition or establishment of control over a significant interest in a business or a competitor, supplier, customer, or other person. Other potentially anti-competitive business practices that fall under the administrative review process include abuse of dominant position, refusal to deal, consignment, and tied-selling. Cases involving administratively reviewable matters of the Competition Act may be resolved by application to the Competition Tribunal, a specialized adjudicatory body established under the Act.

Conspiracies in restraint of trade, bid-rigging, predatory pricing, and price discrimination fall under the criminal provisions of the Competition Act. Matters relating to the criminal provisions of the Act may be prosecuted by the Attorney General of Canada, upon referral by the Director of Investigations and Research, in the Federal Court of Canada, or in a provincial court of relevant jurisdiction.

Since the Competition Act was passed in 1986, the Director has focused on ensuring effective enforcement of the Act. Effective enforcement involves not only applying the Act but also ensuring public awareness of the law and resolving competition disputes in a flexible and efficient manner. In this regard, the policy of the Competition Bureau has adopted a compliance-oriented approach to ensuring the effective enforcement of the provisions of the Act (Goldman 1989).

For instance, in order to assist firms in avoiding conflicts with the Competition Act, the Competition Bureau encourages firms to make use of the Director's program of Advisory Opinions. The bureau has found that requesting an Advisory Opinion frequently allows parties to obtain an explanation of the Director's concerns and affords opportunity to discuss possible ways of resolving them before a proposal (for instance, a bank merger) is implemented. Thus, under the Competition Act, it is possible for the Director of Investigations and Research to resolve competition problems before proceeding to the more expensive process of presenting a case before the Competition Tribunal or the Courts (see McFetridge 1998).

Policy guidelines of the Competition Bureau
as applied to bank mergers

As part of an ongoing review of financial service regulation, the Government of Canada set up the Task Force on the Future of the Financial Services Sector in 1996. Until the final report of the Task Force is delivered in the fall of 1998, the federal government is not expected to make a decision regarding the proposed bank mergers between the Royal Bank and the Bank of Montreal, and between the Canadian Imperial Bank of Commerce, and the Toronto Dominion Bank.7 Currently, a merger between major banks would be prohibited as government policy toward bank mergers is based on the principle ``big shall not buy big.'' The preliminary report of the Task Force has suggested that this prohibition be lifted and that the Competition Bureau review each of the proposed mergers and approve or disapprove of each merger on the specific merits and demerits of each case. In the meantime, the bureau is not expected to reach any conclusions until the Task Force has issued its final report.8

As part of its submission to the Task Force on the Future of the Canadian Financial Services Sector, in 1997 the Competition Bureau issued Merger Enforcement Guidelines as Applied to a Bank Merger. Based on the Bureau's 1991 Merger Enforcement Guidelines, the 1997 document provides the framework the bureau will use to assess the competitive effects of a bank merger among Schedule I banks. Much of this document is focused on defining the relevant geographic and product markets that are affected by a bank merger. In particular, the document discusses (1) whether the product markets should be defined as the individual services provided by retail banks, or the cluster of banking services generally available in retail banks; (2) whether individual neighborhoods, cities, or regions should be viewed as markets, or whether the relevant markets are national; and (3) whether substitute products are available. Market definitions are crucial for assessing the competitive effects of a merger because any market can be deemed a monopoly if the market definition is sufficiently narrow.9

Mathewson and Quigley (1998: 11-12) provide a succinct overview of the Bureau's approach to analyzing the competitive impacts of a bank merger.

As a general matter, in defining markets, the Bureau looks to the extent to which the merging parties supply substitute products and identifies suppliers who are competitors to the merging parties. It considers both the ability of consumers to switch across alternative products and suppliers (the demand side) and the ability of other suppliers not currently in the market to switch capacity into the relevant market (the supply side). Markets can also have a geographical component.

    The bureau identifies current general bank products as deposits, loans, and other services, such as cash management. There may be further refinements in definition. It is useful to identify various classes of demanders, from individual consumers through small businesses to large national and international corporations.

    Under the bureau's hypothetical monopolist test, a set of products purchased by consumers constitutes a relevant product market if a sole supplier of these products (the merged entity) could profitably raise its price by a small but significant and nontransitory amount. (In most contexts, the bureau defines significant as 5 percent and nontransitory as a period of a year.)

    With respect to the definition of product markets, analysis conventionally requires an examination of the cross-price elasticities of demand or relevant proxies. In its guidelines, the bureau indicates that it will consider factors such as product attributes; the view, strategies, behavior, and identity of both buyers and the trade; consumer switching costs; and, prior to the merger, the correlation of prices and relative prices of potential substitutes. In analyzing supply substitutability, in general, the bureau looks at the ease with which potential suppliers can switch capacity into the market for the goods in question.

    As the bureau indicates, the geographical market obviously can vary from the local to regional to national to international. Again the general test is whether, over a hypothetical geographic market, a sole seller could impose a significant and nontransitory price increase. (Mathewson and Quigley 1998: 11-12)

Problems with the mainstream view
of competition and efficiency

Standard economic theory contends that market power--the ability of individual firms or consumers to influence market prices--is a source of market failure. If firms or consumers have market power, then one of the conditions required for markets to be perfectly competitive is violated. If markets are not perfectly competitive, then free market outcomes are not Pareto efficient and there exist unrealized gains from trade. The existence of market failure is a traditional justification for government intervention in the market place. Government intervention can take the form of regulation, competition law, or outright public ownership and control of industries.10

Measuring market power
in a meaningful way

One problem with this approach to public policy is that it requires that the analyst be able to define the relevant ``industry'' or ``market.'' The extent to which a firm has market power is a function of how the market or industry is defined (Armstrong 1990 and Hovenkamp 1990). Operationally, this is a difficult exercise for what exactly constitutes an industry or market is a conceptually slippery matter. For example, if an industry is defined as ``banking services offered by the Bank of Montreal,'' then a monopoly exists since there is only one producer of this service. (i.e., the Bank of Montreal). However, if we define the market more broadly as ``banking services offered by chartered banks,'' then clearly the Bank of Montreal has less market power than in the former situation because there are other chartered banks in Canada, such as the Hongkong Bank of Canada, the Toronto Dominion Bank, and the Bank of Nova Scotia. If we define the market even more broadly as banking services, then the industry becomes quite competitive, for now we must include many of the services offered by trust companies, credit unions, and mutual funds. Clearly, how much market power an individual firm possesses depends critically on how one defines the relevant market, and the broader the definition used, the less market power any particular firm will have. Because it is not clear where one ought to draw the line, the very definition of market power is suspect and this calls into question the ability of public policy to remedy the ``problems'' caused by this particular market failure.

Suppose, however, for the sake of argument, that it is possible to define the relevant market clearly and, by extension, that it is possible to measure the market power of individual firms in the ``banking industry.'' Does it therefore follow that the government should intervene in order to alleviate the inefficiencies arising from an imperfectly competitive market for banking services? The answer to this question is ``not necessarily,'' because (1) the number of firms in an industry may be a poor indicator of how competitive the industry actually is and (2) technological change works to reduce the market power of firms.

Market power in a contestable market

The first reason why intervention by the state may be undesirable is that the number of firms in an industry may be a poor measure of the extent of competition in that industry. According to Demsetz (1968), and Baumol (1982), and Baumol, Panzar, and Willig (1981), a monopolistic firm can be induced to behave ``as if'' it is competitive if there is a threat that other firms will enter the market. The key to understanding this kind of market structure--called a ``contestable market''--is to note that what determines whether or not a firm enters an industry is the presence of positive profits, and that when profits are positive, other firms have an incentive to enter the industry. When other firms enter, prices fall, output increases, and profits are eroded. The very threat of entry may deter the incumbent firm from setting its prices above the competitive level.

The fact that only one firm (or only a few firms) supply a product (or in the case of chartered banks, a cluster of products) is not a reason in itself to believe that the firm (or the few firms in the industry) is producing the monopoly level of output and earning super-competitive profits. Indeed, H. Demsetz writes that ``no good theoretical link has been forged between the structure of [an] industry and the degree to which competitive pricing prevails, because no good explanation has been provided for how present and potential rivals are kept from competing without some governmentally provided restrictions on competitive activities'' (1974: 166-67).

Consider the contestable market argument in the context of the banking sector. Suppose mergers between the Bank of Montreal and the Royal Bank and between the Canadian Imperial Bank of Commerce and the Toronto Dominion Bank, are supported by the Competition Tribunal and the OSFI, and ultimately permitted by the Minister of Finance. If we believe that the banking market is a contestable market, then the fact that only three firms (the two mega-banks plus Scotiabank) as opposed to five are servicing the market need not result in less competition and higher prices for consumers.11 If entry into the banking sector is open to both foreign and domestic firms, then the threat of such entry deters the banks already operating in that banking market from raising their prices by restricting output. An effort on the part of these banks to raise prices by restricting output could be met by, say, a large-scale entry of a foreign bank, or the expansion in the operations of other financial or non-financial institutions such as credit unions. Hence, the impact of mergers on the competitiveness of the banking industry may be benign if free entry into the industry is permitted.

Technological progress and market power

Another reason why government intervention may be unnecessary is that the market place is dynamic in nature as entrepreneurs and firms are constantly searching for new methods of production and new products. If technology is always changing, then what constitutes a monopoly at one period in time need not be a monopoly in the future. In other words, the market power that firms possess today can be eroded by technological change and the appearance of new products (Brenner 1990).

The growth in telecommunications and the Internet permits other banking institutions with no physical presence in Canada to offer products to Canadians. Consider, for instance, Wells Fargo Bank and the service it offers to small businesses in Canada. Wells Fargo provided a pool of $50 million for unsecured lines of credit for small businesses (mainly in southwestern Ontario) through direct mail and a 1-800 number located in the United States. Competition law and regulations that were set up to reduce the market power of firms under a given set of conditions can therefore become quickly outdated in an age of rapid technological advance. The argument for government intervention to reduce the market power of large firms is greatly weakened when we acknowledge the dynamic nature of the market place and the power of innovation and technological progress to undermine the market power of firms already operating in a market.

Conclusion

There are several reasons to question the need for significant government intervention to mitigate the effects of market power. Contestable market theory suggests that the relation between the number of firms in an industry and the ability of firms to exercise market power is weak at best. If entry is possible, then even a monopolistic firm may be induced to behave as if it were a competitive one. Some empirical studies (Nathan and Neave 1989; Shaffer 1993) suggest that the Canadian banking industry may be adequately characterized as contestable. Hence, it is unclear whether mergers among the Big 5 chartered banks will reduce competition in the banking sector, particularly if current barriers to foreign competition in the banking sector are reduced or eliminated.

The dynamic nature of the market place tends to reduce the market power of firms already operating in a market. In the long run, this process of creative destruction will curb the market power created by the formation of megabanks. Hence, the need for policy intervention is called into question.

info@fraserinstitute.ca

You can contact us at the above email address for any comments or information requests. Please report any dead links or technical problems.

Last Modified: Wednesday, October 20, 1999.