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Why competition policy matters for growth?

Economic literature suggests that competition can have broad economic effects in three areas: the total amount of economic wealth available in the market at a given point of time, companies’ productive process, and their incentives to innovate or improve the quality of their products.

By: Date: February 18, 2014 Topic: Digital economy and innovation

See also event ‘Competition policy enforcement as a driver for growth

Economic literature suggests that competition can have broad economic effects in three areas: the total amount of economic wealth available in the market at a given point of time, companies’ productive process, and their incentives to innovate or improve the quality of their products.

In the first area, any transaction creates some value. An increase in prices resulting from a reduction of competition in the market, however, does not automatically translate into a one-to-one shift of value from the buyer to the seller. Unless consumer demand is perfectly inelastic (that is: purchasing habits do not vary with price), some of the value that was enjoyed previously by the buyers disappears and does not translate into higher profits. This happens because a number of transactions no longer take place, because some buyers drop out of the market. This deadweight loss is inversely correlated with the degree of competition in the market. By triggering a misallocation of resources, lack of competition may therefore imply a smaller cake to be divided between sellers and buyers (Tirole, 1988). In other words, from a static perspective, lower levels of competitions are associated with lower levels of aggregate wealth, everything else being equal.

Competition also affects companies’ productivity. Two main effects are identified in the literature. First, competition raises managers’ incentives to out-perform competitors and, therefore, is often associated with higher levels of total factor productivity (Van Reenen, 2011). Second, competition operates a Darwinian selection: only the most efficient firms survive high competitive pressure. Therefore, when competition is healthy, production is rationalised naturally because of the churn of inefficient firms leaving the market and efficient firms entering and prospering in it (see, for instance, Disney et al, 2003). Competition has ambiguous effects on companies’ incentives to innovate. While actual competition increases R&D because innovation offers an opportunity to escape competition and achieve higher post-innovation profits, the prospect of future competition might indicate smaller post-innovation rents and, therefore, reduce incentives to innovate in the first place (Shumpeter, 1939). This dichotomy has been identified in the data and described as the “inverse-U” relationship between competition and innovation (Aghion et al, 2002). This explains why competition policy cannot be used as an instrument to fight market power per se: a degree of market power can sometimes be the necessary price to pay to achieve higher overall welfare levels.

Correct implementation of competition policy would take those short-term and long-term effects into account, ensuring that customers would access products or services at competitive prices without dumping incentives to innovate. Most scholars agree that this is best achieved by antitrust authorities preserving market competition and not defending competitors (Motta, 2004).

Likewise, many economists tend to be skeptical about the effectiveness of policies designed to create or nourish national champions, while developing economies, such as China, are often blamed for their pro-domestic industry subsidisation policy. National-champions policies are based on the assumption that governments are better equipped than markets to select the most efficient companies. Industrial policy is however often captured by vested interests, and rent-seeking politicians are unlikely to out-perform markets in the process of selecting companies that maximise social welfare (Persson and Tabellini, 2000). On the other hand, economic patriotism, the other main potential explanation for national-champions policies, has little backing in the empirical literature. There is no case for favouring companies on the basis of their nationality, on the assumption that domestic companies would be more beneficial to the domestic economy. Studies on several sectors in different countries generally show a positive impact on productivity and no significant impact on employment following foreign takeovers (see OECD, 2009, for an overview, or Bernand and Jensen, 2007, for the US).  Moreover, foreign direct investment is frequently associated with significant positive spillover effects on domestic firms’ productivity (for example, see Wei and Liu, 2006, for a study on the benefits of FDI for China’s manufacturing sector).

References

Aghion, P., Blundell, R., Griffith, R., Howitt, P., Prantl, S. (2009). The effects of entry on incumbent innovation and productivity. The Review of Economics and Statistics, 91(1), 20-32.

Bernard, A. B., Jensen, J. B. (2007). Firm structure, multinationals, and manufacturing plant deaths. The Review of Economics and Statistics, 89(2), 193-204.

Disney, R., Haskel, J., Heden, Y. (2003). Restructuring and productivity growth in UK manufacturing. The Economic Journal, 113(489), 666-694.

Motta, M. (2004). Competition policy: theory and practice. Cambridge University Press.

OECD (2009). Employment and industrial relations – 2008 Annual Report on the OECD Guidelines for Multinational Enterprises.

Persson, T., Tabellini, G. (2004). Constitutional rules and fiscal policy outcomes. American Economic Review, 25-45.

Schumpeter, J. A. (1939). Business cycles (Vol. 1, pp. 161-74). New York: McGraw-Hill.

Tirole, J. (1988). The Theory of Industrial Organization. MIT Press Books, Ed. 1, Vol. 1.

Van Reenen, J. (2011). Big ideas: How competition improves management and productivity. CentrePiece – The Magazine for Economic Performance 340, Centre for Economic Performance, LSE.

Wei, Y., Liu, X. (2006). Productivity spillovers from R&D, exports and FDI in China’s manufacturing sector. Journal of international business studies, 37(4), 544-557.


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