COLUMN-Competition policy withers in New Gilded Age: John Kemp

By Reuters Staff
June 30, 2010

– John Kemp is a Reuters market analyst. The views expressed are his own –

By John Kemp

LONDON, June 30 (Reuters) – “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices”, wrote Adam Smith in his famous “Inquiry into the Nature and Causes of the Wealth of Nations” in 1776.

Perhaps Smith should be resurrected as an adviser to the European Commission, which has just imposed fines totalling 518 million euros on 17 producers of prestressed steel used in the construction industry, who operated a price-fixing cartel for 18 years on the margins of trade conferences.

Steel is just the sort of industry in which cartels are most likely be found (with multiple producers making an undifferentiated commodity product, wielding little pricing power and with a strong incentive to collude in a bid to raise prices and make life more comfortable for everyone).

Like cement manufacturers and the makers of diverse materials from carbonless paper to calcium carbide and glass, steel producers are no strangers to the European Commission’s Competition Directorate. Some of these industries seem to have been under more or less permanent investigation for 30 years.

Announcing the penalties, Competition Commissioner Joaquin Almunia warned “The Commission will have no sympathy for cartelists; recidivists will be fined more and inability to pay claims will be accepted only when it is clear the fine would send a company into bankruptcy, which is rare even in the current difficult times.”

The Commission is still fighting valiantly on, and some member states such as the United Kingdom have toughened their anti-cartel rules, introducing criminal penalties and prison terms for executives found guilty of price-fixing. But in a larger sense competition policy (mergers, price controls and cartels) stands at a crossroads, and regulators and the public seem to be losing.

COMPETITION OR CREATIVE DESTRUCTION

Modern market economics is founded on the idea that competition between producers is the main engine of innovation, increased productivity, and rising living standards. The notion that competition rather than monopoly served the public interest was popularised by Smith and reached its culmination in the Sherman Antitrust Act of 1890.

The Sherman Act states simply “Every contract, combination in the form of a trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with foreign nations, is declared to be illegal”. Breaches are punishable by a fine $100 million for a corporation, $1 million for a person, and up to 10 years imprisonment (15 USC Section 1).

But while competitive markets may be an ideal for academic economists, they are not much fun for firms actually operating in them. All that hard work for only a very limited reward, a minimum return needed to keep capital employed in the industry.

Every entrepreneur and corporate captain secretly dreams of being a monopolist and reaping super-normal profits from captive customers. The polite term in business school is “market power”. Branding, consolidation and agreements with suppliers and sellers can all be used to give more control over pricing.

The fightback against Sherman began almost immediately, and even its early implementation got off to a halting start. It was not until 1911 the Supreme Court finally got around to breaking up Standard Oil, which had been one of the law’s targets.

But the monopolists really gained powerful intellectual cover with Austrian economist Joseph Schumpeter’s theory of “creative destruction” in his 1942 work “Capitalism, Socialism and Democracy”. Schumpeter argued innovation was largely driven by the prospect of attaining or retaining the rewards from (temporary) monopoly.

High profits attracted rivals and incentivised them to create their own breakthrough technologies. The threat of entry would keep monopolists and oligopolists disciplined and competitive. Markets rather than the law could ensure monopolies were temporary and held in check.

Discipline stemming from the threat of entry (“market contestability”) and new technologies, rather than fragmentation among rivals and presence of actual competitors, has become an increasingly popular theory among academic economists as well as consultants and lawyers acting on behalf of firms.

LEEGIN CREATIVE LEATHER PRODUCTS

New theories are also popular with judges. It has led to some surprising court decisions in recent years, endorsing efforts by manufacturers to enforce minimum selling prices and refuse to sell to discounters. In some cases, courts have sided with manufacturers in arguing that consumers benefit from paying higher prices, since they get all sorts of benefits like extra choice, brand identity etc.

The repudiation of a century of antitrust law reached its apogee with a remarkable U.S. Supreme Court decision in 2007 (“Leegin Creative Leather Products”) overturning a precedent dating from 1911. A closely divided court found agreements for enforcing minimum retail prices were not automatically (per se) illegal and against consumer interests, but should be judged on a case by case basis (via a rule of reason).

In a counterintuitive finding, the court wrote “Economics literature is replete with procompetitive justifications for a manufacturer’s use of resale price maintenance … [It] can stimulate interbrand competition … by reducing intrabrand competition among retailers selling the same brand”, according to the official summary of the judgement (syllabus, page 2).

“The Court … has evaluated other vertical restraints under the rule of reason even though prices can be increased in the course of promoting procompetitive effects. And resale price maintenance may reduce prices if manufacturers have resorted to costlier alternatives of controlling resale prices that are not per se unlawful”, Justice Anthony Kennedy explained.

An incredulous Justice Steven Breyer wrote in dissent “How often will the benefits [of resale price fixing] to which the Court points occur in practice?”

Expressing doubt about the clashing ‘expert’ views being offered, Breyer went on “The Court’s invitation to consider the existence of “market power” [in deciding whether resale controls should be allowed] invites lengthy, time-consuming argument among competing experts, as they seek to apply abstract, highly technical, criteria to often ill-defined markets”.

CONCENTRATION, COLLUSION, CONVERGENCE

Even in the area of merger control, regulators have been prepared to accept much higher levels of market concentration, as measured by the Herfindahl-Hirschmann Index (HHI), than would have been thinkable before the 1980s.

Formal cartels remain forbidden. Passing on pricing strategy to competitors is illegal. But what about the exchange of information and ideas at conferences that facilitate tacit collusion (illegal but hard to prove) or simply a convergence of ideas (“it would be more profitable if everyone restrained production and lifted prices”)?

There are plenty of areas where regulators and industries are asking questions about the structure of their industries.

In iron ore, Australia’s Competition and Consumer Commission is considering whether the proposed production joint venture between Rio Tinto and BHP Billiton would be procompetitive (bringing more ore to market sooner at lower cost) or anticompetitive (risking market dominance). The two firms insist a strict Chinese wall will prevent them forging a joint outlook on the iron ore market, but the steel industry is not so sure.

Even in the UK power market, regulator Ofgem has expressed concern that while generators are not colluding, they are all adopting the same strategy, building cheap gas-fired production, minimising investment risks for their shareholders, but leaving customers facing a lot of risk over fuel prices [ID:nLDE64925Z].

Many similar questions are being asked about whether the degree of concentration, and powerful barriers to entry, in the banking system, in the United States, the United Kingdom and elsewhere, is protecting unnaturally high profit levels.

No one is suggesting conferences should be banned (though steelmakers would be well advised to take their lawyers along in future). But current trends in competition policy and industrial structure do not necessarily favour consumers. Have new theories about competition really benefited them as much as was claimed?

It is time for regulators to start taking a more sceptical approach to some of these industry combinations and practices to protect both competition and the public.

((john.kemp@thomsonreuters.com; Reuters messaging: john.kemp.thomsonreuters.com@reuters.net; +44 207 542 9726))

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