Why intervene at all?

Everything here follows from 3.4. Left alone, firms with market power generate:

• Allocative inefficiency — P > MC, output restricted, a deadweight welfare loss.
• Productive inefficiency and X-inefficiency — no competitive pressure to control costs.
• Monopsony exploitation — suppliers and workers paid below the value of what they contribute.
• Restricted choice and lower quality — the customer has nowhere else to go.
• Collusion — cartels raising price towards the monopoly level.

The Competition and Markets Authority (CMA) is the UK's principal enforcer, alongside sector regulators — Ofgem (energy), Ofwat (water), Ofcom (telecoms), the ORR (rail).

But hold your nerve: monopoly is not automatically bad (economies of scale, dynamic efficiency, natural monopoly) and a contestable market may need no intervention at all. Every essay here must weigh the intervention's costs against the failure it corrects.

Competition policy & merger control

The CMA investigates a merger where it may lead to a "substantial lessening of competition" (SLC). In UK practice it can look at a deal where the merged firm would supply 25% or more of a market (or where the target's UK turnover exceeds the statutory threshold).

Possible outcomes:

• Clear the merger unconditionally.
• Clear with remedies — behavioural (price commitments) or structural (forced sale of stores/assets).
• Block it outright.

Competition policy also covers anti-cartel enforcement (fines up to 10% of global turnover, plus a leniency programme giving immunity to the first firm to confess — deliberately weaponising the prisoner's dilemma against the cartel) and the prohibition of abuse of a dominant position, such as predatory pricing.

Evaluation: merger control uses forecasts, not facts. The CMA must guess what would happen to price and choice — and it faces asymmetric information, since only the firms know their true costs and synergies. Blocking a merger may also prevent genuine economies of scale that would have lowered prices.

Will the CMA look at it?

What follows from 27%?

Price regulation: the RPI − X price cap

Where a natural monopoly cannot be broken up (you cannot build a second water network), the regulator instead caps the price.

The firm may raise prices by inflation minus X. This forces real prices to fall and mimics the cost discipline of competition. Crucially, if the firm cuts costs by more than X it keeps the difference as profit — so the cap creates a genuine incentive to become efficient, tackling X-inefficiency.

• A variant, RPI + K, is used in water, where K allows extra revenue for large capital investment (new reservoirs, sewage treatment).
• Danger: if X is set too tough, the firm cuts costs by slashing investment, maintenance and quality — which is why price caps must be paired with quality standards.
• Regulatory lag and asymmetric information mean the regulator can never know the firm's true scope for efficiency savings — only the firm does.

The permitted price rise

When X exceeds inflation

Profit regulation, quality standards & performance targets

• Profit (rate-of-return) regulation — the regulator caps the profit the firm may earn on its capital. Fatal flaw: it gives the firm no incentive to cut costs (since any saving is confiscated) and a perverse incentive to over-invest in capital — the Averch–Johnson effect — because a bigger capital base permits a bigger absolute profit. It may also encourage cost padding: high costs justify high prices.
• Quality standards — minimum service levels: water purity, punctuality, complaint-handling. These exist precisely to stop firms from meeting a price cap by degrading quality.
• Performance targets — measurable objectives (a % of trains on time, a maximum call-waiting time) enforced by fines. Risk: targets distort behaviour — firms optimise the measured variable and neglect the unmeasured one (cancelling a late train so it is not recorded as "delayed"). This is a classic form of government failure.

The regulator's dilemma in one sentence: price caps create efficiency incentives but threaten quality; profit caps protect consumers from gouging but destroy efficiency incentives. There is no perfect instrument — which is why regulators use several at once.

Which regulation, which flaw?

Making markets more contestable

Rather than police a monopolist forever, the government can attack the barriers to entry — the source of the power.

• Deregulation — removing the legal barriers that protect incumbents (opening the coach industry, energy supply, or postal services to entrants). Raises contestability and forces incumbents to cut prices and X-inefficiency. But where there are natural-monopoly elements, deregulation can produce dangerous cost-cutting and cream-skimming of the profitable routes only.
• Competitive tendering — the state remains the funder but forces private firms to bid for the contract (refuse collection, rail franchises, NHS catering). Introduces competition for the market where competition in the market is impossible. But firms may win by bidding unrealistically low and then cutting quality — and the tendering process itself is costly.
• Promoting small business — lower corporation tax for small firms, start-up loans, simplified regulation, tax relief for investors. Raises the number of potential entrants.
• Privatisation — transferring a state asset to the private sector.

The Baumol point again: if a market is genuinely contestable, the threat of entry alone disciplines the incumbent, and no further intervention is needed. So the cheapest competition policy is often simply to lower sunk costs and barriers.

Privatisation vs nationalisation

Privatisation — the sale of a state-owned asset to private owners. Nationalisation — bringing an industry into state ownership.

The sophisticated answer: ownership matters far less than competition. Privatising a monopoly without opening the market simply swaps a public monopoly for a private one — with a profit motive attached. The structure of the market, not who owns it, determines the outcome for consumers.

Privatisation without competition

Restricting monopsony power

Market power on the buying side needs its own remedies.

• Protecting suppliers: the Groceries Supply Code of Practice, enforced by the Groceries Code Adjudicator, stops supermarkets from imposing retrospective charges or unilaterally changing supply terms. It exists precisely because a handful of buyers face thousands of small farmers.
• Protecting employees: the National Minimum / Living Wage is the classic restriction on monopsony power in the labour market — and, as you saw in 3.5, in a monopsony it can raise both wages and employment. Add health-and-safety law, maximum working hours, and the legal right to union recognition (a countervailing power).
• Nationalisation is itself listed by the spec as a tool here: bringing a monopsonistic employer into public ownership removes the profit motive for exploiting its workers and suppliers.

Evaluate: squeezing supermarket buying power may raise farm-gate prices — but supermarkets may pass those higher input costs on to consumers as higher food prices, which hits the poorest hardest (food is a regressive item of spending). Protecting one group very often costs another.

What is this policy trying to do?

Tap a policy, then tap its main aim.

The impact on prices, profit, efficiency, quality and choice

• Prices — usually lower: price caps, greater contestability and blocked mergers all restrain pricing. But if regulation blocks a merger that would have delivered economies of scale, prices could end up higher.
• Profit — lower supernormal profit. That is often the point — but note the consequence for dynamic efficiency: less retained profit means less R&D. A regulator that squeezes an energy firm's profit too hard may starve the grid of investment.
• Efficiency — competitive pressure raises productive efficiency and cuts X-inefficiency; lower prices move price towards MC, improving allocative efficiency. But dynamic efficiency may fall (see above). This trade-off is the single best evaluation line in the topic.
• Quality — competition normally raises quality (non-price competition), but a tight price cap can degrade it, which is why quality standards must accompany it.
• Choice — more firms means more choice; blocking mergers preserves rival brands.

Government failure

The spec names two limits explicitly — know them cold.

• Regulatory capture — the regulator, working closely with the industry it oversees and dependent on it for information and expertise, comes to identify with the firms' interests rather than consumers'. Staff move between the regulator and the firms ("the revolving door"). The result: a price cap that is too generous, or targets that are too easy.
• Asymmetric information — the firm knows its true costs; the regulator does not. A firm has every incentive to overstate its costs and understate the efficiency savings it could make, so that X is set low and its profits stay high. The regulator is trying to set a cap using data supplied by the very firm it is capping.

Add the general causes of government failure: administrative and enforcement costs (a CMA investigation costs millions and takes years — the market may have moved on); unintended consequences (target distortion, cream-skimming); and political self-interest, where decisions follow the electoral cycle rather than the evidence.

Name the failure

Match the policy to its description

Tap a description on the left, then the policy on the right.

The dynamic efficiency trade-off

The big ideas to know

You've covered the whole of Edexcel 3.6 — and with it, Theme 3. Press Finish to see your score.