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p. 68 of 77 BACK | NEXT Foreword, Acknowledgments, Acronyms and Abbreviations, Definitions I. Developing Asia and the world II. Economic trends and prospects in developing Asia III. Promoting competition for long-term development Introduction Benefits of competition Competition policy regimes Consistency with other development objectives Competition policy in the context of regional and global integration Issues for implementation Effects on government finances Toward a competitive future Summary and conclusions Endnotes and references Statistical appendix

Asian Development Outlook 2005 : III. Promoting competition for long-term development

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Benefits of competition

Economic theory suggests that prices and quantities in a competitive market will equilibrate to levels that generate efficient outcomes at a given point of time, i.e., attaining static efficiency, if there are no government interventions, asymmetries of information, impediments to the entry and exit of firms, or anticompetitive practices by firms. In this situation, the price that consumers pay for a good will equal the incremental (or marginal) costs of the firm that produced the last unit of the good.³ Competition is then beneficial because it gives to consumers wider choice and provides sellers with stronger incentives to minimize costs, so eliminating waste. Competition increases the likelihood that cost savings resulting from efficiency gains will be passed on to a firm's customers, who may be either final consumers or other firms (in which case costs of those firms are also lowered). Ample empirical evidence supports these arguments.

Thus, the importance of competition for achieving a higher rate of innovation and adoption of new technologies over time is critical for sustaining Asia's rapid growth. Yet competition is not automatic, and is not the same as laissez faire.⁴

In fact, there are reasons for believing that less mature markets tend to be more, rather than less, vulnerable to anticompetitive practices than the markets of developed countries. The reasons include: (a) high "natural" entry barriers due to inadequate business infrastructure, including distribution channels, and (sometimes) intrusive regulatory regimes; (b) asymmetries of information in both product and credit markets; and (c) a greater proportion of local (non-tradable) markets" (Anderson and Jenny 2005).

While perfect competition is a fundamental assumption in any market economy, there is little mention in most economic texts about how perfect competition can be achieved. Early economists such as Adam Smith and Alfred Marshall emphasized the benefits of free entry to, and exit from, industries. This refers to the dynamic form of competition. For the greatest efficiency gains to accrue to the economy, new and efficient firms must be able to enter the market with relative ease, while forcing old and less-efficient firms to upgrade or exit. Competition for profits forces existing firms to seek greater efficiency in resource allocation to boost productivity and lower costs. Inefficient firms are forced out, and their resources reallocated to new or more efficient firms. Firms need to constantly innovate and adapt quickly to the changing environment, thus creating dynamic efficiency (UNCTAD 2004).

Freedom of entry and exit is therefore a crucial condition for maximizing the efficiency benefits of competitive markets. It should be noted that the lower production costs boost the competitiveness of the country's exporters in foreign markets. However, the industrial structure most efficient for static resource allocation is not necessarily the most efficient for dynamic efficiency. Some temporary market power after a new invention or innovation is introduced may be necessary to provide firms with the incentive to undertake such inventions or innovations. This will require consistency and coherence among industrial, trade, investment, competition, and intellectual property regimes.

Economic efficiency is an important, but by no means the only, goal of most countries. Fortunately, competition also serves to diffuse socioeconomic power, broadening participation in economic, social, and political advances while ensuring opportunities for new entrepreneurs. Moreover, it can facilitate realization of the benefits for the domestic economy of integrating into international trade and investment patterns.

In a context of market distortions and restraints to competition

Competitive forces work best in the presence of markets that are free from distortions. However, a perfectly competitive environment rarely exists in all sectors of an economy, so the full benefits of competition do not often materialize. Competition is usually not intense and not equal for reasons of special interests, big government, and citizens' weak economic understanding (Lewis 2004). When markets are not competitive, whether due to policy-induced distortions, technological characteristics, or anticompetitive behavior on the part of market participants, an economy may miss many potential benefits for its citizens. Furthermore, government deregulation efforts that are intended to benefit consumers do not always work as planned.

The most obvious form of noncompetitive behavior is the case of a monopoly, where the price and quantity of production that maximize profit for the monopoly are higher and lower, respectively, than those that would yield the most welfare for society. Similarly, cartelization and collusion by firms, which also raise prices above marginal costs and may limit choices available to consumers or end-user industries, result in market outcomes where the sum of producer and consumer welfare falls below the level attained with static efficiency. Consequently, measures to enforce policies that encourage firms to compete (or discourage or prevent firms from resisting rivalry) can improve the allocation of resources by making market outcomes move toward the statically efficient outcome.⁵ Thus, the benefits from competition are not limited to keeping prices at marginal cost for the benefit of consumers, as in static efficiency, but also create a conducive environment for new businesses to enter and grow while at the same time compelling existing firms to continuously improve and perform better.⁶ It is important to note that cartels can be local, national, or international.

Given the importance of competition in contributing to economic efficiency in both its static and dynamic aspects, policies to promote competition remain of considerable interest to developing countries in both the domestic and international contexts. The existence of atypical production cost or consumer preference structures in certain economic sectors can also cause tension between promotion of competition and the realization of dynamic efficiency goals. Arguments to limit competition often stress the expected value of letting some firms achieve a large scale of operations. In principle, firm size is said to be important for corporate "competitiveness" under conditions of:

• economies of scale (where larger production runs are associated with lower average costs of production);
• when firms need to attain a certain minimum scale to successfully innovate or imitate, or to raise funds in capital markets; or
• when "learning-by-doing" is faster in larger firms.

When firms have pronounced economies of scale, it is possible that enforcing competition law so as to maximize rivalry between firms is not necessarily a good idea, because there then exists a trade-off between competition policy and efficiency. An example of this is a natural monopoly--i.e., a situation where, due to overwhelming economies of scale, a market is most efficiently served by a single supplier. This applies often in the case of utilities, usually leading to a regulatory framework to prevent abuse of dominance.

Related to cartelization and monopolization is abuse of dominant position, which consists of both structural dominance of a relevant market as well as harmful conduct (e.g., predatory pricing) within that context. Concepts of what constitutes a dominant position (in terms of both market share and insulation from competitive market forces), a relevant market (on the basis of geography or similarity of products), or harmful conduct are often subject to debate, leading to a "rule of reason" approach in trying to determine wrongdoing.

Excess capacity may also draw attention as it can trigger price wars. Mergers and acquisitions can result in vertical market restraints--contractual arrangements linking firms at different levels of the market, such as exclusive dealing, exclusive territories, tied selling, or resale price maintenance (Box 3.1). Governments could, therefore, be justified in taking an active role in managing investment decisions by firms in high-growth or targeted industries (Singh 2002, p. 19). This argument calls into question whether a maximum degree of competition is optimal and suggests that increasing economic growth requires a mix of cooperation and competition by firms.

Another example that has received much attention in recent literature and policy debates relates to industries where network externalities are pervasive.⁷ In the presence of such externalities, the maximum amount that consumers are willing to pay for a good or service depends, in part, on the number of other consumers who also purchase the item in question. Much of the discussion of network externalities takes place within the context of markets where firms have advanced technologies (Box 3.2), such as in the market for computer software. However, many communication and infrastructure services that are important for economic development exhibit network externalities. Such services include telephones, railways, and water-supply systems (Laffont and Tirole 2000).

Although the analysis of market outcomes in the presence of these externalities can be complex, one theme that does emerge from much of the literature is that there are instances where consumers will prefer that a smaller number of goods (and possibly a single good) be available in the marketplace. If a small number of firms supply a product to a large number of consumers, the positive externalities generated for consumers (resulting from the fact that each product they consume is also consumed by many others) may outweigh the effect of higher prices that might follow from a high degree of market concentration. Put simply, there may be times when consumers prefer concentrated markets with a small number of firms because of the network externalities that larger output levels can create.

Moreover, firms in such industries may adopt pricing strategies that deliberately take into account the impact of the current number of customers on the future demand for their products. Many potential customers may only be willing to buy a product once the number of existing customers exceeds some critical level that generates sufficient externalities. In that case, firms will have an incentive to keep prices lower at present than they would in the absence of network externalities, in order to raise their customer base to that critical level. Network externalities therefore benefit current consumers both directly and through the effects of stronger than usual disincentives for firms to raise prices. Both theoretical and empirical analyses have shown that firms in industries with network externalities often adopt complex pricing strategies that typically involve substantial price discrimination across customers.

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