CIMA BA1: BA1 Fundamentals of Business Economics

Module: 07

Regulation of Markets

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1. Economic systems

King Simon sat on his new throne - he had bought a large island named

Simonsland and being king came part of the package! On his island, he decided that he was going to let the market (consumers and suppliers) dictate the

price of things (what is known as a market economy). After all he believed in

free markets – he had made his fortune through trading and felt that he should

not interfere with trade in Simonsland.

This approach meant prices would fall at a level that reflected supply and

demand (the equilibrium point), and that would be fair. In Simonsland, the price

of steak settles at a higher price than chicken because there is lower supply (it's

hard to raise cattle on the island) and a higher demand (it's a favourite dish

amongst the islanders).

As time went on, King Simon began to wonder if leaving the market to dictate the

price of everything was a good idea after all. It seemed to work okay for food, but

providing healthcare was another matter!

In order to cover costs, the prices had to be high to encourage health providers to

provide their services on the island, but many people couldn’t afford it. Although

he could afford whatever he needed, King Simon wondered if this was really fair

for his people – shouldn't everyone have a right to healthcare? This failure of a

free market to be fair is called a market failure.

Reliance on market forces to set prices can be good for some products, like beef in

Simonsland, where it encourages production to a fair level given the island's

limited supply and high demand. However, it doesn't work so well for things like

healthcare. King Simon had a challenge ahead of him to decide when to leave

the market to itself and when to intervene – as of course do most governments in

the real world!

The three types of economic system

There are three different types of economic systems that can be used to run an

economy:

• Market economy – where the market is allowed to dictate prices – as

with King Simon in Simonsland. These are rare in the real world, due to

market failures (like healthcare in Simonsland).

• Command economy – where the government dictate quantities

supplied and prices paid (as used by the USSR during communist rule,

and more recently in North Korea).

• Mixed economy – which is a mixture of letting the market decide (e.g.

beef in Simonsland) and the government deciding (e.g. healthcare). Most

real-world economies use this approach, although some have a greater

focus on the market economy (e.g. the USA) and others lean more toward

the command economy (e.g. China).

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In a mixed economy the price, products supplied, and the distribution of

these products are determined as in a market economy, but the government

intervenes and regulates as needed. It is up to the government to dictate which

prices, goods to be produced, and distribution of resources, need intervention.

Market failures

A market failure is an instance where supply and demand do not result in an

outcome that satisfies both customers and suppliers.

In Simonsland, we saw the example of healthcare being too expensive for its

people to afford.

Other examples of market failure include:

• One supplier becomes the sole supplier of a good or service (a monopoly) and so can raise prices and lower quality without risking

decreasing sales, because consumers lack choice.

• People choose to buy goods that do not benefit society (e.g.

cigarettes, causing healthcare problems, or burning fuels, causing pollution).

• Costs are high to enter a market (e.g. there's very little competition

and so customers have little choice, which usually causes high prices).

In these instances, governments then seek to regulate the market in the hope of

creating an optimal outcome - i.e. command or mixed economies.

In addition to these market failures there are several other instances when the

government intervenes with regulation. We'll examine these in the next sections.

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2. Monopolies

You might have heard of the Monopoly board game, but have you ever thought

about how a Monopoly might impact you in real life? Our friend Barnaby has!

Barnaby is King Simon’s driver. King Simon doesn’t like the cold Simonsland

winters and rarely goes out, so there are several cold months during which

Barnaby has extra time at home. Barnaby was spending a lot on his heating bill

and was starting to get concerned at the price that he was being charged per

unit, so he decided to look for an alternative supplier.

But there wasn’t one! Barnaby wondered how on earth that was possible.

What Barnaby is experiencing here is one of the types of market failure brought

about by lack of competition in the industry. The utility company here is

actually a monopoly - the sole supplier of the product in the market.

In a mixed economy monopolies are well regulated, but not in Simonsland where

King Simon has created a market economy and there is no government

regulation! And the lack of choice is just the first concern Barnaby has!

Negative effects of monopolies

One downside to restricted competition is that large companies with significant

market control can use their position to set excessively high prices.

Barnaby’s heating prices are high because there is no one else he can buy it

from: he can have expensive heat, or no heat at all!

Similarly, if industries have only a few large companies in them, these companies can decide to work together in a cartel. A cartel is is where the companies work

together to agree to keep prices high and/or restrict supply and ensure

limited competition in the industry.

Cartels can be either official or unofficial but always result in consumers

facing inflated prices. Therefore, governments often develop a competition

policy to protect the consumer.

Barnaby does not want to deal with inflated prices and decides to go to King Simon

and ask him to intervene. Although King Simon agrees that it is unfair for Barnaby

to pay such high prices for his heating, he has to think very carefully about how to

intervene. King Simon knows there are some benefits to the monopoly which he

does not want to lose...

Positive aspects of monopolies

Some industries are naturally suited to being served by a monopoly as having multiple companies involved can result in inefficiencies, like in the utilities

industry. Barnaby might want some competition for his heating provider, but if the

new heating provider has to create a whole new infrastructure just for him it would

be a hugely inefficient use of the existing infrastructure on the island (e.g. cables,

pipes and the power station). It would be silly to double up this infrastructure.

Additionally, the existence of large companies can sometimes be beneficial, especially in industries where research and development costs are high. In

these industries, smaller companies wouldn’t be able to meet these costs,

thereby reducing the potential technological advances seen in the product and its

manufacture.

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3. Competition policy

Considering these positive aspects of monopolies, King Simon has some tough

work on his hands. How can he regulate to ensure competition thrives and

monopolies do not have all the power while also retaining the benefits?

King Simon needs a Competition Policy!

Competition policy covers the following situations:

Let’s look at these in turn:

Monopolies

In industries where monopolies are to some extent expected - e.g. utility

companies or rail travel providers - governments may decide to keep these as

nationalised industries, to be run and regulated by them to avoid customer

exploitation.

In some countries there has been a programme of privatising such state

monopolies in order to encourage competition and market forces into the

industry. However, in some cases privatising state monopolies has resulted in

effectively creating a regional monopoly - e.g. for utilities such as water or

railways.

To regulate situations where regional monopolies are nearly unavoidable

governments may set up industry regulators, such as The Water Industry

Commissioner in Scotland or OFWAT in England and Wales and the Office of Rail

and Road covering Britain’s railways. These regulating bodies keep a close watch

on the regional monopolies to ensure prices do not become inflated just because

there is a lack of competition.

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Abusing market power

In July 2016, the Competition and Markets Authority found evidence that Trod, a

seller of frames and posters on Amazon, had agreed with a competitor not to

undercut each others’ prices. As a result, both were fined a total of £163,371.

Here, the act of collusion between the two suppliers effectively reduces

competition and therefore undermines the market’s natural forces of demand

and supply to result in the optimum equilibrium price. Potentially, collusion leaves

the consumer facing inflated prices.

Other activities which would be an abuse of market power include:

• A company acting in collusion with others to restrict supply and hence inflate prices.

• A company in a monopoly position reducing its price below the average total cost for any potential new entrant, hence making it non-viable for any

company to set up as a competitor.

• Companies setting up exclusive distributor or retail agreements so that

other companies face difficulties finding outlets for their products.

• Companies setting up exclusive supplier agreements such that new entrants find it difficult to locate suppliers of key inputs.

• Imposing switching costs so that customers find it financially punitive to swap to other providers.

Organisations such as the Competition and Markets Authority in the UK, The

National Competition Council in Australia, Commission for the Protection of

Competition in Cyprus and The Federal Trade Commission in the US, are all

involved in the investigation and regulation of such abuses of power.

Mergers and acquisitions

Many different countries have competition policies that assess any merger activity

(when two companies combine) and acquisition activity (where one company

buys another) and will seek to intervene and regulate the situation if they feel it

won’t be in the interest of the consumer.

Why would mergers be against the public interest? Well, mergers result in

reduced competition, which if significant, could limit choice for the

consumer and may lead to higher prices.

An example of such intervention occurred in the UK in 2001, when the potential

merger of Lloyds TSB with Abbey National was blocked by the Competition

Commission (forerunner of the current Competition and Markets Authority in the

UK) on the grounds that it wouldn’t be in the public interest.

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Mergers don’t always need to be blocked. Sometimes agreement can be reached

between the regulating body and the organisations involved to ensure that,

despite the merger, competition will be maintained. This could involve selling off the

particular part of the business where market control could get too great should the

merger go ahead.

In 2003 a bidding war broke out to purchase UK supermarket chain Safeway, with

Asda, Tesco, Sainsbury's and Morrisons all aiming to buy the company. The

Competition Commission rules that a takeover by Sainsbury's, Asda or Tesco

was "expected to operate against the public interest, and should be prohibited".

However, a takeover by Morrisons was held to be acceptable on the condition that

fifty three stores of the combined operation be sold, due to local competition

issues.

Having studied other countries’ competition policies King Simon decides to set up a

watchdog and monitor the behaviour of the biggest suppliers in Simonsland. He

asks Barnaby to lead the watchdog and Barnaby sets out to change the market for

heating!

However, even though Barnaby is now happy in his nice warm house, King Simon

notices plenty of other issues the market economy has caused in Simonsland.

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4. Inappropriate market price: too high or too low

There are instances where, left to their own devices, market forces effectively

create the wrong price! In Simonsland simonberries are staple food, as the local

environment and soil conditions favour its growth. Many farmers in the area

choose to grow it and the result is a large supply of simonberries that drives the

price down. When the market supply and market demand become balanced

to create an equilibrium, the price is lower than the cost to grow it!

An extremely low price for simonberries is dangerous, as, if left, many farmers

would go out of business, leading to a rise in unemployment in Simonsland. In

the long run, a reduction in supply in Simonsland (because so many simonberry

growers have gone out of business) would also lead to a rise in the price of this

staple food, which could then impact consumers to the extent they are

pushed into a position of poverty.

King Simon does not want his people to starve, and feels that there is a need here

to provide financial assistance to the farmers in the form of subsidies. Subsidies

for farmers effectively provide the difference between the current low price

and the preferred price which would provide a reasonable income.

We can see a real-life example of farmer subsidies through the Common

Agricultural Policy (CAP), which, as the agricultural policy of the European

Union, provides various programmes and subsidies to farmers. Why farmers?

Well, as an industry it operates in a very unique economic and political climate:

• Weather or disease – these can have significant impacts on whether farms

can produce enough output and is completely out of their control.

• Power of the large retailers – many of their products are bought by large

retailers, which as significant players in the market, can control the product

prices. These prices may not provide the profits needed for the farmers to continue to supply their products.

• New technologies or new entrants to the market throughout the world can

affect the level of supply and therefore the prices being paid.

• Many governments consider it key that their country have a secure food supply and therefore feel that it is important to support their farmers.

In recognition of the special circumstances surrounding the agricultural industry,

CAP initially provided guaranteed prices; however, these encouraged oversupply.

This oversupply resulted in surpluses of certain products creating “butter

mountains” and “wine lakes”!

In the 1980s and 90s measures were taken to avoid these surpluses. One method

used to avoid surpluses were the set-aside schemes, where payments were

made to farmers for specified percentages of land being purposely left unused for

growing crops, and quotas being set on milk production which limited the amount

that could be produced.

Later in the 90s, a movement was made away from quotas and set-aside

agreements to subsidies. However, by the 2000s assistance was given as a

single farm payment which was not linked to production. By separating the

assistance from output levels the creation of surpluses was stopped.

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What are the benefits of schemes like CAP?

• Producers are provided with a stable income. This ensures continued

supply of the product as producers feel confident to remain within the

industry.

• By providing a given level of income, investment in research and

development can be maintained. This helps to ensure future industry

progress via more efficient production techniques and new technologies.

• Customers get a stable supply at a stable, affordable price.

• Other issues can be addressed. For example, CAP has been used to

support various green issues, such as with subsidies for protecting certain

environments like ponds and hedgerows.

What are the disadvantages?:

• Surplus product - any kind of guarantee of income, via either price or

subsidy, can attract producers into the field, or encourage current producers to increase their output.

• Misallocation of resources – putting effort, labour and other resources

into producing unnecessary output.

King Simon decides to go ahead with giving subsidies to growers of Simonberries

to encourage supply. As we have seen though, he does need to carefully manage

this to ensure that the level of simonsberries remains at fair levels.

Maximum pricing

Simonsland has become a very popular tourist destination and as a result

property prices in Simonsland are rising very quickly. King Simon is worried that

property prices are now becoming too high for local people and some are being

forced to leave the island as they are being priced out of the market. King Simon

is wondering whether he should cap them i.e. impose a maximum price on

property sold.

So we’ve seen situations where prices got too low and the government have to

intervene – but what about when prices get too high? Governments may feel

that they have to set a maximum price when:

• Customers are being exploited by a monopoly situation - e.g. through unnecessarily high prices or limited product range.

• An unexpected shortage in a product threatens an increase in price -

e.g. where the production of a staple food stuff is subject to extreme weather damage.

• To ensure that the product is affordable for all sectors of society -

e.g. housing or utilities, as in Simonsland.

• To reduce inflationary pressures - e.g. as inflation is a measure of the

increase in prices, by putting a cap on the price of key items inflation can be controlled.

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Setting the price level

For a maximum price to be effective, it must be set below the equilibrium

price. However this can cause problems.

Let’s consider this graphically:

At P₁ (£2), the maximum price set by the government, there’s not enough

product being made: supply is at A, but demand for the product is at B. There

will be more demand for the product than supply, so not everyone who wants

to purchase the product will be satisfied.

There are systems which can manage the shortage caused by a maximum price,

such as the rationing of food goods during WW2 in the UK, which guaranteed

food to every member of the British public at the price set by the government.

Other systems to manage a shortage might use a simple system of queuing and

delivering the product on a first come first served basis, or create another kind of

preference system. However, systems to deal with shortages are prone to abuse,

and are often very unpopular.

If the shortage continues a number of things can occur:

• Creation of a black market – Due to the excess demand, suppliers may

create unofficial, illegal markets which sell the product at higher prices in order to fulfil demand.

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• Suppliers reduce their supply – In the long run, due to the low profit

margin, suppliers may opt to change the product they produce to

something which offers a higher level of profit. This will exacerbate the

situation.

• Suppliers may reduce the quality of their product in order to maintain

profit - If suppliers cannot increase their price, they may decide that the

only way to obtain the profit levels that they require is to reduce their costs.

They may therefore turn to lower quality inputs to produce their product.

In 2016, Berlin introduced rent-control legislation on rental of properties to halt the

fast-rising rents in the city. Landlords in the capital were barred from increasing

rents by more than 10% above the local average for all new rental contracts. The

aim was to maintain rents at manageable levels. As we've seen though this

situation does need careful management to ensure there remains enough

available rental units and properties do not start to be rented out illegally at

higher rents.

Berlin's situation is not unlike Simonsland. However, if King Simon does decide to

impose maximum price increases on property he too will need to be careful to

ensure that the excess demand does not create a limited supply of houses

coming to the market or illegal sales going through.

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5. Externalities

Within any transaction there are two parties who are involved with the deal: the seller and the consumer - the first and second parties. Anyone outside the

seller and consumer who is affected by a transaction is considered a third

party. The way they are affected is an externality.

Externalities are sometimes also called spill over effects. When externalities are

negative they can be called external costs.

Negative externalities (external costs)

Some externalities have negative impacts on people outside the transaction.

Examples of negative externalities include:

Source Negative externality

Production processes Waste and emissions affecting local communities

Noise pollution For example, from deliveries to a production or

retail outlet or from a local night club affecting

those nearby e.g. stopping them sleeping.

Smoking Passive smoking by others.

Additional taxation costs or insurance payments for

healthcare for non-smokers.

Excessive drinking of

alcohol

Damaged caused by people whilst drunk.

Increased healthcare costs for all as everyone

pays for healthcare issues from drinking through

tax or increased health insurance.

Road congestion For example, pollution, accidents, delays, reduced

output due to impact on working hours

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Managing negative externalities

What can be done about negative externalities? How can they be taken into

account in any decision making process?

Negative externalities

Tax Taxing the item will increase its price making it less

attractive to purchase e.g. tax on cigarettes.

Evaluate the

social cost

If a figure can be put on the social cost, this could be

included within the decision making process to

encourage governments to act.

Regulation A level of acceptable usage (e.g. pollution) is agreed by

the government and imposed on users.

Information for

consumers Educating consumers to stop using the product e.g.

smoking education.

Compensation

schemes

These may compensate financially those affected by the

externality. e.g. payments to people who live near an

airport to compensate for the noise caused or those

producing light pollution may have to buy black out

curtains for their residential neighbours.

Governments often intervene in the market process via taxation in order to

increase prices and provide public revenues to cover additional costs. What will

this look like in terms of supply and demand?

Let's consider a new tax on sugary drinks designed to reduce demand for these

products for health reasons.

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In the graph above we can see how the effect of the taxation on sugary drinks

increases price from £3 to £4 (P0 to P1). This increased price leads to a fall in

quantity (supplied and demanded) from 3m to 2m units. The difference

between P0 and P1 will also represent the tax revenue raised for each unit sold

which can be used to counter the negative externality -

e.g. increased healthcare costs to combat the negative effects of an excessive

consumption of sugar.

An example of such intervention to counter a negative externality would be the

change in the law in the UK to make large retailers charge 5p for carrier bags,

brought in in October 2015 to encourage consumers to recycle old carrier bags.

Prior to this change, carrier bags were free. This caused the following negative

externalities:

• Time to degrade creating a waste issue.

• Danger to wildlife if inappropriately disposed of.

• Visible as litter reducing enjoyment of public areas.

• Volume of material being used for bags due to people viewing them as a

one-use only commodity. If not used for bags, this material could be used to

make a product producing a more long term benefit.

In this case the 5p charge was not a tax although the businesses covered were

expected to use the funds raised to support charities or other good causes.

According to the UK Government, the expected benefits of this scheme over the

10 years following its implementation are:

• Overall benefit of £780m to the UK economy.

• Up to £730m raised for good causes.

• £60m saved in litter clean up costs.

• £13m savings in carbon clean up costs.

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Positive externalities

Externalities are not always bad. Examples of positive externalities include:

Source Positive externality

Treatment/vaccines

for diseases

Public at large benefit from reduced risk of

infection/illness.

Education

Increasing knowledge and skills within the

population benefits business, the economy and the

world in many ways.

Infrastructure e.g.

new road

Better transport facilities for all regardless of who

the original target consumer was. e.g. build a road

for haulage to a dock which everyone can use.

Research and

development

New technologies, production techniques or new

knowledge may benefit more than the original

recipient.

Example

Mrs Smith buys a plot of land, previously neglected and full of discarded rubbish,

and grows trees on it. Which of the following are positive externalities resulting

from her actions?

1. Improved view for residents

2. Cleaner atmosphere due to absorption of pollutants by the trees

3. Reduction of CO2 through absorption of this gas by the trees

4. The jam she sells from the fruit on the trees

Answer

1,2 and 3 are all spillover benefits from her actions enjoyed by third parties.

4 – Whilst this may be delicious, this isn’t an externality as it only benefits the

people specifically involved in the transaction of purchasing the jam.

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Encouraging positive externalities

There are various ways to encourage positive externalities:

Positive externalities

Increase supply Via government grants and subsidies to producers

which reduce costs and therefore encourage increased

supply.

Increase demand

Governments price subsidies to consumers. Reduced

price will result in increased demand and therefore an

increase in the positive externality e.g. subsidy

schemes to encourage householders to put insulation in

their homes and therefore save energy.

Creating laws to make consumption compulsory e.g.

being in a form of education is compulsory in the UK up

to the age of 18.

Providing information to overcome a lack of take up of

the product or service caused by ignorance of the

benefits e.g. public information broadcasts or leaflets

about the benefits of vaccination.

Evaluate the

social benefit

If a figure can be put on the social benefit, this could be

included within the decision making process to

encourage governments to put policies in place which

encourage usage.

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6. Merit and demerit goods

Merit Goods are goods which are considered suitably important and

necessary so as to warrant being provided through public finances. e.g.

education.

They demonstrate the following characteristics and often have positive

externalities resulting from them:

The lack of appreciation of the benefits of merit goods by consumers means

that they are often under consumed if not provided by the state.

e.g. if education was not state funded some parents might choose not to send their

children to school at all, or to send them to work at an earlier age.

If they were left to be provided under the normal market forces of demand and

supply, the situation could be further exacerbated by the equilibrium price being

too high i.e. the market would not be taking into account the social benefits. e.g.

some parents might not be able to afford schooling.

How do we get around this? Well, governments usually step in to provide the

service, as most countries do with education.

Additional benefits of taking these into the state sector can also be the

economies of scale that can be achieved e.g. the increased buying power that

comes about through providing healthcare through the state e.g. being able to buy

school text books at a lower cost by purchasing them in bulk for all schools.

Demerit goods

These are products that potentially harm the consumer in some way e.g.

smoking, alcohol, gambling, junk food or recreational drugs. They may also

produce negative externalities – see earlier.

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If left to the market, the concern is that consumption would be too high

because the negative social costs aren’t being taken into account. Governments

therefore often intervene in the following ways:

• Taxation e.g. on cigarettes.

• Laws banning consumption or supply e.g. recreational drugs.

• Regulations over advertising or packaging e.g. restriction of cigarette advertising and packaging.

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6. Public goods

King Simon notices that several ships have been wrecked when delivering goods

to Simonsland at night, but finds there are no lighthouses on the coast to guide

them. He wonders why none have been built when they could clearly save lives

and reduce the amount of goods being lost at sea.

Then King Simon beings to wonder who should pay for the lighthouse. Should the

cost of the lighthouse be paid for only by the local boat owners who may benefit?

What if someone sails into the bay who isn’t local, should they pay too?

King Simon wasn’t sure. Usually these sort of goods or services are provided by

the government, because there is no obvious market solution and without

regulation they have not been supplied.

Goods which are not produced through the market but which are

necessary, like lighthouses, tend to be provided through government

intervention, and are called Public Goods.

Public goods have the following properties:

Non-excludability

Back to the lighthouse. Barnaby’s wife Josie owns a fishing boat and due to some

dangerous rocks at the entrance to the bay where she moors, she thinks about

paying for a lighthouse to be built. But then she realises she can’t she stop anyone else who sails into the area from benefiting from it! This is called the

free-rider problem e.g. you can’t stop others from benefiting regardless of

whether or not they are contributing in any way.

Non-rivalrous

If Josie’s lighthouse would offer the same amount of light and safety benefit to any

of the other locals with boats, regardless of how much she or they used it.

Regardless of how many times Josie sails in and out of the harbour in one night,

any other boats in the area would get the same level of benefit as she does. One

person’s usage doesn’t affect anyone else’s.

Because of the above, no-one in Simonsland had been willing to provide

lighthouses, or any other public goods and services. Why should Josie pay to build

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a lighthouse if everyone else is going to get the benefit of it for free? Due to the

benefits for all, but the lack of a market for the provision of the good to operate in

(no willing suppliers), King Simon realises public goods need to be provided

through public provision, with the cost being borne through taxation.

Pros of state provision of public goods

• Goods and services that would never be produced, despite the public benefits, are made available.

• State provision on a large scale means that economies of scale are benefited from, thus reducing the overall cost.

• The cost to each individual is kept low as it is spread over the entire

population through taxation.

Cons of state provision of public goods

• Collection of costs through taxation means that no one can opt out if they

would prefer to.

• There is no allocative efficiency. Allocative efficiency is where the level

of production is consistent with consumer demand. Under state

provision everybody receives the product whether they want it or not, and this may mean over supply!

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7. Environmental concerns

The last reason why the government may intervene in the market to either provide

goods and services or to influence price, is due to environmental concerns.

For example, the operations of the free market may not take the affect on the

environment into consideration e.g. in terms of externalities like pollution.

King Simon is concerned about the amount of pollution in the seas around

Simonsland, but what can he do? Taxing companies who are polluting the sea so

that there are funds available to clean it could be one solution. It would also

discourage pollution too. Regulating the amount of pollution allowed may be

another good solution

In the UK, businesses are now required to undertake integrated financial

reporting which includes detailing their impact on the economy, society and

the environment. This information is then available to all their stakeholders and

so provides a stimulus for businesses to take these environmental concerns into

consideration in their decision-making process because they know they will be held

accountable.

King Simon's problem

As we can see below, there's a lot to consider when running a government and the

free market does not always reach the conclusion that is best for society. What

started for King Simon as a concern has proved to be quite a challenge. He's going

to have to do lot of thinking to decide exactly where he will step in and where he

will let the market decide. It's a difficult problem that politicians and economics

have argued about for centuries. Best of luck to him!