COMPETITION RESEARCH FOR ECONOMIC DEVELOPMENT

    (CRED)

    BACKGROUND NOTE

    1. Purpose of this Note

    This Note accompanies the November 2007 Call for Proposals of the IDRC project

    ―Competition Research for Economic Development‖, a funding facility for research by

    Competition Authorities in developing countries and their collaborators. It expands the

    discussion in the Call for Proposals relating to the research topics that proposals submitted for funding are invited to address, setting out the current terms of debate on the issues, giving

    references to the academic literature (mostly in economics) and pointing to some areas in

    which new research seems to be needed.

    2. Introduction

    The project seeks to support research into two broad themes: the interaction between

    competition policy and regulation, and the potential benefits to consumer welfare and

    economic development from the enforcement of competition policy. These are two fairly

    new areas of research. Interest in them has arisen out of new approaches to competition

    policy inspired by the prosecution of international cartels in the 1990‘s and early-2000s, the

    inclusion of competition policy as a possible area of negotiation at the multilateral level and

    the incorporation of competition policy into free trade agreements and the domestic

    legislative agenda of many countries since 1990.

As competition policy has achieved renewed vigour in international policy making, civil

    society groups, academics and practitioners have become more aware of the impact that

    competition principles may have upon other domestic policies and different social groups.

    The link between competition policy and regulation occurs where rules applied to specific industries conflict with generic rules applying to the whole economy. Inconsistency between

    the mandates of sectoral regulators and competition authorities is perhaps the most obvious,

    but it is certainly not the only type of incoherence. Inconsistencies can arise for a number of

    reasons. They may result from poorly articulated competition legislation, misunderstanding

    of the role of the competition authority, or the lack of understanding of the need to give

    explicit consideration to integrating competition principles in all parts of the market. Or they

    may be due to the simple obsolescence of outmoded statutory provisions whose passage into

    law predated the development of the competition law. Though theoretical models of

    possible interaction exist, and empirical evidence is beginning to appear, the interaction of

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    competition policy and regulation in developing countries is not well understood. These

    issues deserve further exploration.

The link between competition policy enforcement and consumer welfare is well

    understood in theory. Opening up markets to more competition should cause prices to fall,

    which will benefit consumers. If the number of actors in the market is increased, competition

    enforcement may also have other developmental benefits, notably the expansion of

    employment. Additionally, the introduction of greater competition inevitably creates winners

    and losers which points to the importance of understanding the political economy of policy

    implementation in this field. The pattern of benefits may not have political traction, for

    example, if the losers are politically strong, or the winners see benefits only in the longer

    term. The full consumer benefits of enforcement and the political ramifications may not be

    fully understood, whether in terms of the equity dimension of consumer welfare, i.e. the

    impact on poor consumers, or the time incidence of benefits, or the impact on small firms or

    employment. The nature of vested interests that are active in particular markets may not

    always be apparent. Research into these topics could help strengthen the case for

    interventions in particular markets or help to prioritize areas of intervention.

This project focuses on areas of social welfare benefit other than efficiency. It is fully

    recognized, nevertheless, that in all areas of enforcement, competition authorities seek to

    promote efficiency gains in the productive sectors. This note will not elaborate on this key

    aspect of competition policy enforcement except to note that economists are continually

    reviewing and elaborating the dimensions of ―efficiency‖ relevant to competition

    enforcement. For reference, we present a Box overleaf containing up-to-date definitions of

    different types of efficiency.

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    Definitions of Efficiency

The definition of efficiency is not simple. The following discussion of different types of efficiency by Kolasky and Dick (2002) is pertinent to the implementation of competition law:

     "At the most general level, a market is said to achieve "allocative efficiency" when

     market processes lead society's resources to be allocated to their highest value use among all competing uses. In the context of market exchanges between consumers and

     producers, the allocative efficiency principle can be restated more specifically to say

     that the value of a product in the hands of consumers is equalized "at the margin" to

     the value of the resources that were used to produce that product."

     "This intuitive "equality at the margin" condition ensures that an economy maximizes the aggregate value of all of its resources by placing them in the highest value uses. Starting from an efficient market allocation, if a firm were to produce one additional unit of the product, the resource cost to society would exceed what consumers were willing to pay for that last unit. Total social welfare thus would fall as a result. By the same token, if the firm cut production by one unit, the loss that consumers would suffer would exceed the value of the saved resources in whatever alternative use they were deployed. Again, total welfare would fall as a result" (page 49).

    Kolasky and Dick then go on to discuss the concept of productive efficiency:

     "Production is said to be efficient when all goods are produced at minimum possible total cost. An equivalent way of phrasing the productive efficiency criterion is to say that there is no possible rearrangement or alternative organization of resources (such as

     labor, raw materials, and machinery) that would increase the output of one product

     without necessarily forcing a reduction in output for at least one other product. This

     restatement highlights the principle that firms' choices involve explicit trade-offs

     between competing demands for scarce resources" (pages 51-52).

     Dynamic efficiency is also relevant:

    "Whereas allocative and productive efficiency can be viewed as static criteria—

    holding society's technological know-how constant—a more dynamic view of

    efficiency examines the conditions under which technological know-how and the set of

    feasible products optimally can be expanded over time through means such as

    learning-by-doing, research and development, and entrepreneurial creativity" (page

    56).

     Transactional efficiency is the fourth type of efficiency discussed by Kolasky and Dick who note that: "…market participants design business practices, contracts, and organizational forms to minimize transaction costs and, in particular, to mitigate information costs and reduce their exposure to opportunistic behavior or [so-called] "hold ups"' (page 58). Business practices may differ in the magnitude of the costs that parties must incur in order to transact with one another and, therefore, some practices may be more "efficient" than others in this regard.

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     Source: WTO, 2003

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    3. Competition Policy and Regulation

    One reason why some markets may not work well is that the level of competition is adversely affected by regulations which impede competition. Regulations may be set and administered by different agencies and departments of government concurrently, thereby leading to a sub-optimal outcome. Additionally, legislators may enact laws that have an anticompetitive effect. Weak legislation can overburden the competition authority in the ex post resolution of competition issues rather than preventing them ex ante.

    Work on this topic comprises two distinct approaches. The first approach relates to how the competition authority promotes competition in relation to sectoral regulators. The second approach relates to areas of statutory legislation emanating from other parts of government.

    With respect to sectoral regulation, governments may manage market entry and exit or reinforce privatization policies through sector regulators. With respect to regulating market entry and exit and promoting consumer welfare, regulators have similar powers at the sectoral level to those exercised nationally by the competition authority but they go further by also carrying out price setting functions. Sector regulators have become the preferred mechanism for policing firms that operate in imperfectly competitive environments such as public utilities where competition between many firms may not be feasible. ‗[S]imply moving a monopoly from the public to the private sphere will not result in competitive behaviour‘ Ambrose, et al (1990). An empirical study of privatization in Africa and Latin

    America indicated that after privatization of a state-owned monopoly establishment of an independent regulator is necessary (Wallsten, 1999). Using telecommunications as an example of a sector that had been controlled by government monopolies and delivered poor service, Wallsten examined the increase in service delivery as measured by market penetration across Africa and Latin America. His results showed that privatization was generally associated with better service delivery and that the success of the privatization was positively affected by the existence of a sector regulator (see also Wellenius, et al 1992; Megginson, et al 1994; Petrazzini and Clark, 1996).

The relationship between a country‘s competition authority – in its capacity as national

    guardian of the competition principle – and the sectoral regulators is likely to be contentious

    and problematic for a number of reasons.

    First, it has been noted in the literature that sectoral agencies may be subject to regulatory capture, the process by which small groups exert a distorting influence upon policy by capturing decision makers. Small groups of well-coordinated elites that have a stake in a particular policy outcome can undermine the impartiality of an agency that is supposed to be working in the public interest. Anderson and Jenny (2002) recognize this facet of regulation: ―In fact, experience in both developed and developing countries shows that, in many cases, rather than having regulation imposed on them for the public benefit, incumbent firms have often sought regulation for their own benefit, for the purpose of limiting entry into the industry and helping them to enjoy higher prices for their products.‖ It might be possible to demonstrate that, in a given economy; the success of privatization differed across sectors

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    depending on the extent of regulatory capture and associated lack of competition, perhaps

    using new indicators of regulatory capture (e.g. presence of former civil servants on the

    boards of regulated companies).

The formal integration of competition principles into the mandates of regulatory agencies is a

    necessary first step to prevent regulatory capture. The operating principles of sectoral

    regulators sometimes include and sometimes expressly exclude reference to competition

    principles alongside sector-specific technical provisions (OECD, 1999, OECD, 2000). There

    is evidence of some developing country experiences in the literature. It has been argued that

    in Zambia the practices of both the Securities Exchange Commission and the Energy

    Regulation Board have some important anticompetitive effects. In Tanzania the authority‘s

    recommendation for an increased number of mobile phone operators prevailed against the

    views of telecommunications regulator itself. It is particularly interesting for the current

    project that, for example, in Kenya the ―infrastructure‖ sector appears to have an exemption

    from competition scrutiny (CUTS, n.d.). Studies documenting the existence - or lack thereof

    - of competition principles in different sectoral regulators‘ mandates in developing countries, and evidence of their impact would be valuable. Another possible subject for a study would

    be if an authority seeks to build the case for overturning some new competition-reducing

    provision of a regulator, or chooses to revisit the merits of the case for introducing more

    competition in sectors where the technology is changing or where experiences of other

    countries suggest new market structure possibilities.

In some countries, the sector regulators are procedurally bound to take competition principles

    into consideration. In Pakistan and Sri Lanka, for example, the various utilities regulators

    may seek advice from the competition authority but are not legally obliged to do so. The

    situation in South Africa is particularly interesting in this connection. The South African

    government recognized the fact that the overlapping jurisdictions between competition

    authorities and regulatory bodies created problems because firms took their cases to the

    forum they believed to be most favourable. Therefore, it was stipulated that the Competition

    Act did not apply to ‗acts subject to or authorized by public regulation‘. But firms used this

    provision to argue in the High Court that the Competition Act did not apply, not just to areas

    1under the control of the sectoral regulators, but also to the agricultural and banking sectors, In the light of this as there are a series of other acts regulating the practices of these sectors.interpretation, the stipulation was seen to be untenably broad and it was removed from the

    Act. Instead, the South African Competition Act now provides for consultations to avoid

    situations of conflict between competition authority and regulatory agencies. A Regulator‘s

    Forum is being established to implement this provision. The Commission is negotiating

    agreements with each regulatory authority to coordinate and harmonize the exercise of

    1 Interestingly, in the case of a proposed merger between two of the four national retail banks, the courts, ruled the jurisdiction lay with the Minister of Finance. The Competition Commission prepared a report for the

    Minister of Finance opposing the merger on grounds of likely reduction in competition. The Minister followed

    the Commission‘s advice and disallowed the merger.

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    jurisdiction over competition matters within the relevant industry or sector. Information from other developing countries on the stated rationales given by regulators for not consulting, or not taking the advice of, the competition authority could be very valuable, especially if accompanied by estimates of the costs this neglect imposes on consumers, small businesses or other social groups.

    As regards types of restrictive legislation emanating from other parts of government than the sectoral regulators, there is plenty of anecdotal evidence that legal provisions normally remote from the scrutiny of the competition authority may significantly impair competition. The topic warrants systematic enquiry. The most common type of provision with anti-competitive effect occurs when the government regulates entry and exit to specific sectors. In banking, publishing and broadcasting, many countries choose to regulate ownership or restrict entry, especially to foreign companies. Energy, air, land and sea transport (ranging from air routes to liner shipping to taxis) and even petroleum and professional services such as legal advice are other examples.

    Broadman (2000) noted a broad range of regulatory obstacles to competition in Russia‘s economic transformation. Although the experiences of a relatively high-income transition country may be idiosyncratic, they do contain several lessons for developing countries. He identifies registration and licensing requirements, exclusive warehousing and distribution networks, capital barriers to entry, limited dispute resolution procedures and inequitable land and real estate access and taxes a long with proactive policies in favour of incumbents as types of government-erected barriers to entry.

    Governments may also unwittingly encourage rent extraction from expenditure of public resources by failing to ensure that competitive bidding procedures are in place for public tenders.

    Consumers may be disproportionately effected by local authority regulations (for example, in transport). Situations of this kind present the competition authority with an operational challenge of how far to pursue its mandate outside its normal business of national markets or firm-level investigations. Nevertheless, action to override the anticompetitive effects on local markets of regulations set by lower level government authorities such as municipalities or regional governments may yield substantial consumer benefits (see the discussion Stewart et al 2007 on actions of this kind taken by the competition authority in Peru).

    Information management plays an important role in conspiracies. Research undertaken for IDRC in the pilot phase of this project showed that in the pharmaceuticals industry in Jamaica, companies used product information selectively to influence consumers' perceptions of the quality of generic drugs compared to branded ones in order to maintain abnormally high prices. Information plays a key role in binding together the conspirators in international cartels are well known for their reliance upon information to maintain successful conspiracy among many cartels. Cartel information requirements extend to documentation, agreements to divide markets, the level at which to set prices and a multitude of other concerns that requires the agreement of all the cartel members. Competition authorities can generally

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    assume, therefore, that conspirators in price fixing schemes or cartels will have compiled enough evidence to ensure their own prosecution if the relevant documentation can be brought to light. Unfortunately, the cross-border nature of these conspiracies tends to ensure that documents required in one jurisdiction are usually located in another. One of the problems faced by a competition authority may relate to the challenge of identifying the appropriate information and then finding the appropriate legal instruments to extract this information. In some jurisdictions, the legal instruments for extracting this information simply may not exist. In the case of cross-border cartels, forging cooperative relationships with legal authorities in neighbouring jurisdictions and the impact this cooperation may have on the ability of the competition authority to prosecute cartels may be an area that deserves further explanation in the context of developing countries.

Competition authorities might also wish to supplement efforts under national ―Private Sector

    Development‖ (PSD) programmes aimed at improving the business environment. In many countries, large numbers of regulations across all government departments whose original justification is either outmoded or forgotten are being reviewed and rationalised to optimise their impact on business and investment. Research that systematically and specifically examines the competition implications of regulatory provisions of this kind, to supplement the PSD perspective, could be valuable. For example, a study done in Egypt notes that a wholesaler or retailer cannot import directly from abroad except through an Egyptian importer. This provision undermines government efforts to increase competition by liberalizing investment in the retail distribution sector (Dihel and El Shinnawy 2006).

4. Competition and Consumer Welfare

    Consumers suffer when firms don‘t compete. Research by economists and political scientists indicates that society as a whole also suffers from imperfect competition, not just the direct victims of high prices. Whether anti-competitive practices take the form of collusion, monopolistic behaviour or abuse of a dominant position all anticompetitive practices share the same feature, which is that they attempt to raise prices within their target market and to extract abnormally high profit from consumers.

    Cartels are now thought to represent the most pernicious form of anticompetitive behaviour. Cartels are illicit organizations designed to extract higher than competitive prices from consumers. Cartels can be national or international in character and consist of firms colluding together to set prices for directly substitutable goods or services. The last fifteen years have taught us much about the nature of cartels in the developed world, but case studies of examples of cartels in the developing world would add enormously to understanding of the scale and extent of damage caused by this problem.

    A wave of prosecutions of cartels since the early-1990s revealed that cartels are long-lived and stretch across national boundaries. Early research into the cartels initially prosecuted by the United States department of Justice (USDOJ) showed that cartels tend to form across all

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    sectors and industries and that they raised prices by a conservative estimate of 10 – 25%

    (Suslow and Levenstein 2002). Furthermore, the unraveling of these cartels showed that Chicago School theorists had been wrong to assume that cartels would fall apart under their perverse incentive structure. What economists and strategy theorists had previously believed – that the incentive for cartel members to cheat on their fellow conspirators would always undermine the capacity for individual firms to collude – was shown to be wrong. Many of the

    cartels uncovered during the 1990s and were long-lived, with lifespan of four years or more and some had survived for upwards of ten years. It seemed that the incentive of firms to defect from a cartel was low if the time horizon for the cartel was perceived to be long.

    The USDOJ prosecutions and further academic research (Clarke and Evenett 2003) also revealed that cartels that formed between conspirators present in one country tended to form between the same conspirators in other countries. The Vitamins cartel was a good example of an international conspiracy uncovered in one country that was found to be present in most other markets serviced by the conspirators. IDRC welcomes submissions from researchers that support or question these findings. These cartels tended to exist across borders and segment markets geographically, in addition to price fixing. Revealingly, the cartels relied upon extensive documentation to maintain fidelity among conspirators (see Competition and Regulation, above).

5. Other developmental benefits of competition enforcement

    Consumer welfare, strictly defined, is only one type of development benefit. The relationship between competition enforcement and other components of economic development raises interesting questions for research. The impact of competition policy implementation on small firms and the creation of employment on equitable terms are two particular areas of great interest and importance. Empirical studies that pushed forward understanding of these issues would add significantly to knowledge and assist competition authorities to have a better understanding of the potential value of interventions. In developing countries, the economy tends to be characterised by small and medium enterprises, ranging in size from roadside stalls to tiny, family owned retailers and minor industries. These enterprises may exist outside the formal sector, which limits the ability of formal institutions to affect their behaviour. Economic reforms imposed on developing

    countries by international financial institutions or through bilateral treaties with wealthier countries have been criticised by legislators, academics and civil society groups for not taking into account the particular circumstances of developing countries, such as their reliance upon small firms and large informal sector.

    The potential for competition measures to promote both employment and small firms is in fact recognized in some countries‘ legislation. The Competition Act of 1998 in South Africa cites as one of its goals to promote employment and advance the social as well as economic welfare of South Africans; This multiplicity of goals reflects the fact that:

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    "A fundamental principle of competition policy and law in South Africa is the need to

    balance economic efficiency with socio-economic equity and development"

    (Introduction, web page of the South African Competition Commission,

    http://www.compcom.co.za/aboutus/aboutus_intro.asp?level=1&desc=7, emphasis

    added).

The aspects of competition enforcement related to development may become complicated

    during a country‘s transition from a centrally planned economy to a market-based one. In

    China and Vietnam, for example, the legacy of economic central planning is reflected in the

    provision of social services through state-owned enterprises. This presents great challenges to

    policymakers in those countries when they seek to balance efficiency and equity in the design

    and implementation of competition law.

Study of the impact on small firms and on employment generation of particular competition

    measures is a new area for research. Some of the factors that might be taken into

    consideration are the following.

First, it is important to recall that ―consumer benefits‖ may be enjoyed by producers as

    consumers of production inputs. In some product markets, small firms may be the primary

    victims of the product price consequences of non-competitive market structures and

    anticompetitive conduct. If business associations are lacking, small firms are unlikely to raise

    complaints with the competition authority, and investigation of possible cases may require a

    different approach to data collection and analysis – closer to research – than the authority is

    accustomed to handle. The indirect gains for personal consumers from competition

    enforcement in intermediate markets for goods and services could be significant on condition

    that the markets in which small firms are active are themselves competitive. Prima facie this

    is likely to be the case, but a research study may reveal anticompetitive practices amongst

    small firms suggesting the need for the authority to intervene in that market as well.

Second, the content of some national competition laws presents an opportunity to investigate

    such issues and contribute to understanding the broader benefits of competition enforcement.

    It is reported that in Namibia competition policy has been used to promote small and medium

    enterprises (SMEs) to ensure that they have an equitable opportunity to share in the benefits

    of Namibia‘s economy, and to distribute ownership of national wealth more equitably among

    the population (NEPRU, 2005). In South Africa, regulators and the competition authority

    must respect the social needs outlined in the Black Economic Empowerment act (BEE).

    Little is known of the challenges that these authorities and those in other jurisdictions with

    similar ―social welfare‖ goals in the competition law have had to face in addressing these

    considerations and the real impact of their interventions in this respect.

Third, the effects of regulatory provisions affecting firm start-ups can have a cumulative and

    complex effect on market entry. For example, corruption rises with the number of procedures

    required to start a new business. (see figure 2.1 below).

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    Figure 2.1.

    The impact may be biased against small firms and specifically affect their decision to enter, or remain outside, the formal economy. Research by competition authorities could bring a new analytical perspective to this high profile issue. Informality has significant negative developmental effects. Informal firms are less likely to grow and contribute to job creation and informality is strongly associated with poor job quality and lack of employment rights and social protection for workers. In some countries, analysis of market conditions might be able to identify types of competition-related policy changes needed in different situations. In some cases, reduction of regulatory barriers inducing the transformation of previously informal into formal enterprises may be sufficient to attract new entrants to the market, but in others although reductions in entry barriers for small firms are needed, so also would be enforcement actions against firms already in the market displaying anticompetitive conduct.

    Labour market regulations might also fruitfully be investigated from a competition perspective. India provides a case in point. Up to 1998, labour regulations in India deterred market entry because of strict conditions on hiring and employment and long dispute settlement procedures. These regulatory barriers served as a protection mechanism safeguarding disproportionately high levels of employment-related benefits for a small number of employed labourers at the expense of those outside the formal sector. Knowledge

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