Access and quality of service

Each of the above techniques refers to ways by which the regulator can prevent

abuse of monopoly power in the form of excessive charges to the consumer and

excessive profits. But monopoly power can also be curbed by determining the conditions of access to the service or sector. For example, in the case of network operators in electricity, gas, telecoms or air transport, the monopolist has an obvious

incentive to provide access to its network on unfavourable terms. To counteract

this, the regulator must devise and open a fair and transparent licensing scheme

for new entrants. Considerable research has gone into establishing how access

charges for connection to networks should be determined. The efficient component

pricing rule has been developed to deal with such situations. It provides that

new entrants must pay an amount to cover the marginal cost of access to the

network plus some contribution towards fixed costs of setting it up which were

borne by the original state firm. This rule has many flaws, and there is no simple

rule of thumb for determining the relevant fixed and marginal costs. Another

factor here is that some providers may have universal service obligations, i.e. an

obligation to provide a minimum set of services of specified quality to all users at

an affordable price. The regulator must also have regard to the quality of service

offered by existing and new operators to the consumer and by the network owner

to competing operators. The existing operator must not be allowed to favour its

own downstream  arm over competitors. Finally, there is usually provision

for complaints procedures and for the development of customer charters.

    The above considerations demonstrate that regulation may be necessary, and

better than no regulation, but it is by no means costless. Regulators do not come

cheaply. They need large staffs of economists and lawyers. Regulators can be of

variable quality and regulatory capture is an ever-present danger. Their decisions

can always be subject to long and expensive appeal, just as in the case of competition law. Regulation cannot be considered a satisfactory substitute for

competition. The high cost of imposing regulation underlines the importance

of competition as an alternative, more efficient, policing device for curbing

excessive profits. In short, the best regulator will often be one that succeeds in

making itself redundant. Over time, emphasis must be placed on deregulation

and exposure to international competition as the most efficient way forward.

    When thinking of competition most businesses see their problem as one of excess

competition, not a lack of it. This is understandable from the perspective of an

individual firm already established in an industry. Competitive pressure has

increased in most economies. But the notion of competition being ‘excessive’ sits

uneasily with economic thinking on the role of free markets. Competition affords

opportunities for new firms to enter the industry. From these firms’ perspective,

the problem may appear one of too little, not too much competition.

Competitive pressure, however, gives firms an incentive to search more vigorously

for ways of protecting their domestic market, by developing market niches

and, if necessary, by circumventing competition legislation. As a result, new

entrants to an industry can be deterred by unfair trade practices, and financially

weaker firms can be discriminated against in the process, unless protected by law. The consumer, too, can suffer discrimination as larger firmsbuild up their war chests and tighten their hold on their market share. In short,competition policy is still needed.Competition policy should aim to be transparent, easy to implement and predictable. The need for case-by-case assessment, taking account of each market’s special features, can result in complex legal cases and much uncertainty.

    Competition policy is not a flawless set of precepts which can impose competition

in a costless way. It can be expensive and inefficient to enforce and can

be subverted and distorted. Yet, for all that, the secretary general of Unice,

the federation of European industry, reflected the weight of business opinion in

his assertion that the essential corollary of competitiveness [is] strong competition

policy.

    State-owned enterprises in formerly nontraded sectors of the economy – telecoms,transport, energy and public utilities – have become a focus for competition

policy in recent years. These enterprises were once regarded as ‘natural’

monopolies, but thinking has changed. Governments have become convinced

of the efficiency gains that can be obtained through a more market-oriented

framework. The European Commission has been particularly active in promoting

competition in these sectors through the use of competition law.

    Competition policy has been further bolstered by setting limits on the amount

of state aid provided by EU Member States to various industrial and regional initiatives.This type of action is welcomed by the weaker Member States because

they are unable to afford the cost of matching the subsidies offered by richer

Member States. The EU’s strategic policy to favour competition is also evident in

its support for SMEs.

    A degree of tension between competition and industrial policy is to be

expected. Prior to the Second World War, cartelisation was seen as a way of building up more efficient and technically progressive industries in Germany and

Switzerland. Japan also had a tradition of looking with suspicion on ‘excessive’

competition because of its possible detrimental effects on an industry’s capacity

to exploit fully the economies of scale. According to one authority, the Japanese

authorities feared ‘excessive’ competition as much as monopoly as a potential

source of inefficiency._14 Their predilection for limiting competition and encouraging

mergers, vertical and horizontal firm groupings, and inter-firm operating

agreements, has been fundamentally at odds with anti-trust policy. In the case of

the automobile industry, for example, the Ministry for International Trade and

Industry sought to limit production to one firm and, failing that, a target

of ‘at most’ three firms was set. It proved impossible to restrict competition in this

way, however. The vigorous competition between domestic firms that prevailed

in postwar Japan proved to be an important source of vitality for the Japanese

economy. Yet, to this day, some countries maintain a more tolerant approach to

cartels than would be countenanced by most European countries. Keeping the

domestic market contestable often entails an element of compromise between

the objective of avoiding market dominance and allowing a technically efficient

size of firm.

Pricing

    Incentive regulation refers to the design of incentives to ensure that producers keep prices and costs as low as possible. The underlying assumption is that costs are not given but are influenced by the incentives set by the regulatory authorities. If

there was no regulation the privatised monopoly might well slip into the same

bad habits as the state company it replaced. Whether the new regulation achieves

a superior outcome to direct provision of the good or service by the state company depends on the effectiveness of the regulatory system.

    In the UK, following the privatisation of telecoms, gas, water, electricity and railways, regulatory bodies were set up for each industry.Their task was to prevent the abuse of monopoly power and to find ways of promoting competition. This sounds easy, but regulators frequently get into hot water in trying to achieve this objective.

    There are several ways of regulating a privatised industry with strong monopoly

elements:

1. Price # marginal cost. One simple way would be to oblige the monopoly firm to

charge a price equal to marginal cost, and provide a subsidy for any ensuing

loss. The drawback is the cost of the subsidy and the difficulty of determining

marginal cost.

2. Breakeven or average return on capital. Alternatively the regulator could insist on

a price that allows the firm to just break even. This eliminates ‘monopoly’

profits but leaves wide open the opportunity to reap the rewards of monopoly

in other guises .Some regulators use a formula related to rate of return on capital which the monopoly would not be permitted to exceed. This avoids the problem of direct price control, but has the disadvantage of reducing the incentive to firms to minimise costs, once the permitted profit rate has been attained. Rate of return controls have been applied extensively in the US. Not surprisingly there have been frequent disputes over the definition and measurement of rates of return in these cases.

3. RPI minus X. Another possibility is to set maximum prices. The UK authorities

have taken this approach. Various types of price-capping formulas have been

used, known as ‘RPI minus X’, whereby the regulator permits the firm’s price to

rise by no more than x percentage points below the retail  price

index .In a multi-product monopoly, such as telecoms, the regulator may

opt for a tariff-basket method, whereby the authorities decide which products

are placed in the basket and how the various prices are to be weighted. This

usually means permitting lower prices for price-elastic services and relatively higher prices on the price-inelastic part of their provision. While providing

flexibility, regulation can be highly controversial. The public will often

perceive such pricing structures as unfair, even if based on sound economic

principles. Where the output is more homogeneous, such as gas and electricity,

the regulator may use an average revenue target, whereby the predicted rise in

average revenue in the firm is not permitted to exceed RPI minus X.

 

     A key problem of incentive regulation is to determine the efficiency factor X. If X

is set too low, the firm will make excessively large profits and the regulator

will lose face. If it is set too high, the firm will become unviable. In deciding

on the right value of X, the regulator may have to be guided by the expert, but

hardly disinterested, knowledge of the regulated firm. Relations between the regulated and the regulator may become too close and cordial. Another problem is that the formula could act as a disincentive to efficiency if more efficient performance were to lead to subsequent upward revision of X. In practice, rate of return considerations are implicit in setting X. Even the most expert and experienced regulator can make mistakes. The UK electricity regulator, for example, had to undertake a full-scale review less than a year after establishing new price-caps because the regulated firms’ financial performance was much better than estimated. Opportunistic behaviour by the regulator can be highly destabilising.

Regulatory reform and natural monopolies

    Regulatory reform is designed to promote competition, regardless of whether

the industry is in state or private ownership. In principle it is a separate issue from

privatisation. Yet, in practice, reform of government regulation of industries,

particularly state-owned utilities such as electricity, gas and telecoms, has been

associated with the issue of privatisation. For that reason we introduce the subject

at this stage of the discussion.

    Suppose a state-owned company exists in a context where competition is not

apparently possible. Economies of scale are so preponderant that it is not profitable

for more than one firm to operate in the industry. This is the case of a

natural monopoly. The state may still wish to privatise in the hope of securing a

change in the ‘managerial culture’ of the organisation, or to add to government

revenues, even though the privatised firm will continue to retain monopoly

power. How do costs and benefits stack up in this instance? Clearly there are benefits from privatisation, but these will be achieved only if there is also some state

regulation of the privatised entity. How should the privatised monopoly be regulated?

The economics of regulation now enter the picture.

    Natural monopolies were until recently regarded as dominant in the energy,

transport and telecoms industries. In addition, private sector competitors were

often excluded by law from trying to compete with the state monopoly in these

sectors. But banning competitors would be redundant if economies of scale were

really that powerful, so the existence of legal restrictions suggests that the

monopoly was not so ‘natural’ after all. When such is the case, one solution is to

remove the restrictions on entry, subject to the new entrants satisfying some

basic minimum operating criteria such as prudential reserve ratios, safety provisions,

and so on. Privatisation can then proceed, though whether deregulation

comes before or succeeds privatisation can have an important bearing on how

much revenue is obtained from the sale.

    Deregulation has been applied to many industries in addition to those controlled

by state monopolies. Major changes have been made in the rules governing

banks, stockbroking, insurance, and radio and television broadcasting. These

initiatives were inspired by belief in the merits of the free market. No less important

was technological change. In some industries, it has made restrictions on

new entrants unenforceable; in others it has made small production units more

efficient. For example, technical advance has now made even very small electricity

generating plants more efficient than previously. The combined effects of

deregulation and technology have opened up many hitherto restricted markets.

The resultant increase in contestability has brought about huge improvements in

efficiency.

    However, there remain some important sectors where the monopoly proves to

be genuinely ‘natural’ and where consequently the degree of competition is

limited. There are two major steps in dealing with the situation. The first step is

to break down or ‘unbundle’ the services provided by the monopoly into component

parts so as to isolate the core natural monopoly element in the industry. In

electricity, for example, the real monopoly element is not power generation or

power distribution but the transport of electricity through a network. By

unbundling the industry into its different potentially competitive and natural

monopoly components, efficiencies can be secured through the market system.

The potentially competitive parts can be sold to the private sector, or put into

competitive play by out-contracting or competitive tendering.

    The second step is how to deal with the natural monopoly element. This

involves three interrelated strands: pricing, access and quality of service. We

briefly review each of these, recognising that the relevance of each aspect will

differ according to sector and the period of time since the liberalisation process

was begun.

Effects of privatization

    Privatisation programmes come in diverse forms and it is not always easy to determine their success or failure. Studies of the UK experience suggest mixed results. Some privatised companies achieved a highly successful turnaround, notably British Telecom and British Airways, but the verdict on the privatisation of British Rail, the water industry and the health service is far less flattering._12 The Economistdescribed the privatisation of British Rail as a disaster. Experience also differs between countries. In a highly generalised way, one might say that privatization has been successful in the UK while unsuccessful in Russia.

    The effects of privatisation can be evaluated under several headings: effects on

efficiency, effects on government revenue and effects on income distribution.

    A key consideration is the effect of privatisation on efficiency, i.e. on measured

labour productivity or, better still, total factor productivity. The resultant fall in

unit costs can be passed on to the consumer in terms of lower prices and better

quality. In the UK, telephone charges fell by 35 per cent in real terms between

1984 and 1994, whilst electricity prices for business fell by 30 per cent during the

period 1990_–_99. According to the US Department of Justice Antitrust Division

Annual Report 1994, increased competition in the US telecoms industry hastened

the introduction of fibre optic technology and spurred an increase in technological

innovation. Electricity charges also declined in real terms. As a general rule,

experience shows that the more competition in the privatised companies the

greater the likelihood of a positive outcome. This is just as economic theory

would predict. A policy environment that encourages long-run investment in the

privatised companies is also important.

    The effect on government revenue is more complex than might appear. In the

case of an outright sale, the gain to the state cannot be equated with the sale

price. The state has just replaced one asset with another. To calculate the net financial gain to the state, we must compare the present value of the stream of net revenue expected from the firm had it remained in state ownership with the proceeds from the sale. The price paid for the company is thus a crucial variable. If under-priced, the privatisation programme could end up worsening instead of improving government finances in the long term. Also there must be some assessment of how this extra cash accruing to the government is being used. It is being spent on building up military power or on consumer handouts or on long-term investments for the future?

    Last, one must consider the income distribution effects. There are at least four

parties to consider: the state, employees of the privatised firms, the consumer, and

the new owners. The mode of privatisation has an important bearing on the

outcome. Share flotation is one mode, often associated with a certain predetermined

allocation to existing employees.Direct sale. Management buy-outs are another possibility. In each case, careful analysis is needed in order to assess the resultant income distribution effect. It is obviously easy for the state that is strapped for cash to be induced into selling too cheaply.Also shares can be sold too cheaply to the public in order to curry popular favour or to ensure that the flotation will be a ‘success’, as happened in several Western European countries.

    There is little doubt that in most instances privatisation has brought benefits to

the consumer, not just in terms of lower price but also in terms of improved

quality of service and efficiency. There are many areas of the economy to which

the ethos of a state company is particularly unsuited and where privatisation has

yielded unambiguous benefits. Examples are state-owned hotels and restaurants

or manufacturing industries, where quickness of response and an entrepreneurial

approach is especially important. State farms, created on the grounds of

economies of scale, have never become successful enterprises. To some extent,

governments have voted with their feet. The number and scope of privatisation

programmes around the world shows that finance ministries are convinced that

the potential benefits exceed any potential losses. Experience to date would

support this verdict. But it will take time before the dynamic efficiency effects of

privatisation can be fully evaluated.

Competition and globalization

    Domestic markets are becoming more and more exposed to foreign competition.

This increased globalisation of national economies is having several different

effects. First, it means that high concentration and rationalisation at a domestic

level need not necessarily be a cause of concern. A more open market is by definition a more competitive market. Openness may encourage concentration of production in the domestic market but it simultaneously prevents concentration

translating into market power. Second, national industries are becoming more

sensitive of the need for a ‘level playing field’. If country A has strict competition

rules and country B has lax rules, this could mean that B’s producers are able to

set up arrangements to reserve B’s markets for themselves, while enjoying free

access to A’s market. This will not seem fair to A’s producers. For this reason pressure is growing for similar competition rules to be introduced in countries participating in world trade. Third, as the global reach of firms in many industries

extends, the danger of abuse of monopoly power by giant multinationals

becomes more potent. Mega-mergers between companies in different parts of the

world create corporations of global dimensions. Even without an actual production

presence in countries, firms can form strategic alliances that enable them to

penetrate foreign markets with international partners. This is particularly true of

the information technology, entertainment, air transport and pharmaceutical

industries, but high levels of global concentration are also found in less glamorous

products such as tea and bananas. In these circumstances, coordinated

action by competition authorities on an international scale is necessary if the

enhanced opportunities which free trade provides are not to be undermined. The

formulation of global competition laws is high on the agenda for many countries,

including those of the EU.

Privatisation

     Privatisation has become an integral part of most countries’ pro-competition programme and is a familiar feature of new-consensus economic policy. It is defined as the transfer of state-owned assets to private control. This can be achieved through direct sale of the assets to the private sector. Another possibility is to transfer the administration of these assets to the private sector but for the state to retain ownership. This section focuses on privatisation in the former sense. The move to privatisation began in the UK and New Zealand in the 1980s; it spread to continental Europe in the 1990s and is now taking a front seat in developing and transition economies. The US was a significant absentee from this trend, largely because it had so few nationalised industries to privatise. European government receipts from privatisation amounted to $675 billion between 1990 and 2002 Cumulative privatisation revenues had exceeded $1000 billion by 2000. However, following the stock market crash there has been a marked slowdown in the rate of privatisation worldwide.There is something paradoxical about privatisation of state-owned companies in Western countries. After all, these companies were originally set up to resolve an economic problem, not to cause one! Many were established in response to situations of private monopolies or of ‘excessive’ competition among private firms.Nationalisation was designed to encourage exploitation of scale economies and to ensure that monopoly profits, to the extent that they existed, would accrue to the state, which would distribute them in a socially optimal way. In retrospect these expected advantages failed to materialise. Too often nationalised firms abused their monopoly power. They gave bad service at high prices. They suffered extensive X-inefficiencies. Although they tended to ‘featherbed’ their employees, they were prone to surprisingly bad industrial relations. They also suffered from political interference, mixed managerial signals and sometimes outright corruption.

Mergers and state aids

    Another instrument for maintaining competition is control of mergers regulation.

A merger comes within the scope of this regulation if it exceeds a certain size – the

aggregate world turnover of the merged units must exceed e5000 million and the

Community-wide turnover of at least two of the undertakings must exceed e250

million. Proposed mergers have to be notified to the Commission. Sometimes

they are rejected, sometimes approved, and on other occasions approved with

qualifications. Merger policy in the EU, as in many other countries, is predicated

on the assumption that, provided no significant increase in market power ensues,

mergers are efficiency-enhancing. Entrepreneurs are considered better equipped

to judge the future economies to be gained from a merger than outsiders – though

they are far from being infallible in this regard, as we have seen.

    State aids have been an intrinsic component of the industrial and regional policies

of many states. Government aid which distorts competition and which

affects cross-border trade is regarded as incompatible with the common market.

The main thrust of policy has been to ensure that state aids are transparent, monitored and subjected to upper limits. Any new state aid likely to affect trade

between Member States has to be approved by the Commission. The thrust of

policy has been to curtail the amount of subsidies and other indirect supports

provided by Member States. Of course, political and economic considerations can

conflict on these issues, and the Commission has been criticised for being overly

influenced by political pressures, particularly where powerful state companies are

involved.

    The European Commission sometimes acts on its own initiative and at other

times responds to complaints from the public or competitors concerning the

abuse of monopoly power. Sometimes action is triggered by tip-offs from insiders.

Its investigative powers are considerable. These include ‘dawn’ raids whereby its

officials arrive without prior notice at the premises of companies in order to

search for evidence. Executives can have their offices searched, an alarming experience, and can be subjected to oral questioning even before any charges are

brought against the company. Telephone print-outs, possession of competitors’

business cards and even invitations to business lunches can be used as indirect

evidence of ‘concertation’. The scale of the dawn raids can be considerable. A

dawn raid was carried out in April 1995 on the offices of 40 newsprint producers in seven European countries suspected of price collusion. After all this, the

Commission can order firms to refrain from certain practices which it deems anticompetitive.It can also impose fines of up to 10 per cent of a company’s worldwide turnover, as some major EU firms have discovered to their cost. Fines of

e248 million ,for example, were imposed on 33 European cement producers in November 1994, on the grounds that they used secret agreements to reduce price differences between them in order to protect their national markets. Prestigious companies such as Blue Circle,Italcementi and Lafarge were among the accused .  

           

    The monopoly power of public utilities has been the subject of special attention.

Often what is required is the application of competition law combined with

specific legislation. The Rail Directive of December 1991 is one of many examples

of action to enhance competition in Europe’s state-owned infrastructure companies.

The Directive sought to introduce greater financial discipline and more

operational competition within Member States and across borders. National

railways were pressed to separate track infrastructure from train operations and

to produce transparent accounts revealing the respective costs and revenues

attributable to infrastructure and to services. This approach was based on the belief that the provision of rail services on that infrastructure, for freight and passengers,

can, and should, be opened to competitive tender._11 Similar initiatives were

taken in the case of energy, telecoms and postal services.

    In addition to the 1992 programme, the EU is committed to further trade liberalization.Liberalisation of foreign trade can be a potent antidote to monopoly power. The expectation is that exposure to global competition –increasing the degree of contestability of the domestic market – will make industries more efficient. More concentration and rationalisation at a domestic level may be a fall-out of this policy and need not necessarily be a cause of concern. A more open market is, by definition, a more competitive market and the competition authorities’ job is done for them by the market. This saves on the high compliance costs attached to enforcement of competition by legal means.

    Competition law is being applied with increasing rigour across a growing

number of countries. The 1998 Competition Act, regarded as the biggest shake-up

in British competition law in 25 years, brought UK competition law into line with

that of the European Union for the first time. It gave sweeping new powers of

investigation to the Office of Fair Trading and opened the way for massive

fines if companies break the rules. Directors and employees can be sent to prison

for obstructing investigations. The OFT has been given powers to demand information and carry out dawn raids if it suspects anti-competitive behaviour.

Interestingly, earlier that year the loss to the UK economy from monopolistic

behaviour was estimated at 1 per cent of GDP or about £7.6 billion at 1996

prices.

    In 1999 the mighty Microsoft ran foul of the US anti-trust authorities. Judge

Thomas Jackson began his 207-page ruling with a four-word sentence: ‘Microsoft

enjoys monopoly power. He went on to rule that the company used its power to

eliminate competition from a range of rivals across the industry, particularly

from Netscape. Emerging relatively unscathed from the American anti-trust proceedings,Microsoft faced a new assault from competitors on the European front.

An umbrella organisation representing Sun Microsystems, Oracle and Nokia,

among others, filed a complaint against the latest version of the Windows

operating system. The European Commission expressed concern that Microsoft

was leveraging its Windows monopoly into the servers and audiovisual software

markets.

hich � � u a ��S 8S ition and allow business a

reasonable degree of certainty, but have enough flexibility to deal with cases

where market power may be necessary on technical grounds.

EU competition law – the Woodpulp case

    According to the Commission, whenever a producer has charged the same price as another producer for a given product in a given region and during a given quarter, it must, in principle,be regarded as having ‘concerted’, i.e. colluded with the other producer. But parallel conduct cannot be regarded as furnishing proof of collusion unless collusion constitutes the only plausible explanation for such conduct. Also, although Article 85 of the Treaty prohibits any form of collusion which distorts competition, it does not deprive economic operators of the right to adapt themselves intelligently to the existing and anticipated conduct of their competitors.

    This case gives the flavour of the problems that can arise in trying to resolve difficult economic issues in a legal framework. In March 1993, the European Court of Justice finally closed one of the longest-running cases in competition law, the Woodpulp case, nine years after the original decision by the Commission! This was a case where the Commission had found that a group of Scandinavian, Canadian and US woodpulp producers had operated a price cartel over a sustained period. The parties challenged the Commission’s decision.

    First, they challenged it on grounds of jurisdiction. However, because the arrangements challenged in the decision had effects within the Community, the Court found that the Commission had been perfectly entitled to make a ruling on it, regardless of the place of origin of the parties or of where the agreements were actually drawn up and signed.

    Second, the parties claimed that ‘parallel price behaviour’ did not amount to collusion. They claimed that it could be explained by the operation of legitimate market behaviour. This turned into the key issue.

    Eventually, the Court commissioned two reports by economic consultants to help

them come to a ruling on the case. The first report dealt with parallelism of prices and, in particular, whether the evidence justified the findings of parallelism of announced prices and transactions prices. The second report analysed the woodpulp market during the period in question.

    According to these reports, the system of price announcements agreed between the parties to the arrangement was introduced in response to the producers’ customers.The quarterly cycle was the result of a compromise between the consumer’s desire for a degree of predictability as regards the price of pulp and the producer’s desire not to miss any opportunities to make a profit in the event of a strengthening of the market. The simultaneity or near-simultaneity of the price announcements could be explained as reflecting a high degree of market transparency.

    On the parallelism of announced prices, the experts concluded that this could be

plausibly explained by market conditions rather than collusion. The market in question was oligopolistic on the producers’ side and also on the customers’ side. This led to a situation where prices were slow to react in the short term.

    On the basis of the expert reports, the Court upheld the appeal by the companies

and quashed the fines imposed by the Commission.

    This case illustrates the complexity of competition cases. The judicial process on

competition cases can be protracted and uncertain. Note also that the remit of

the economic consultants advising the Court was to discover whether a restrictive

arrangement existed. Had they been asked to quantify the effects of such a possible

arrangement, the exercise would have been even more prolonged.

Exclusive dealing in the European motor trade

    EU law bans any agreement between firms intended to prevent or distort competition.But ‘selective and exclusive dealerships’ the arrangements which govern all new car sales, are exempt under what is known as Rule 123_85. A typical European new car dealer offers models of only one make, or a few select makes. The customer cannot cross the street and buy the same car more cheaply because, by agreement, the next dealer will probably be located several miles away. The rule also applies to spare parts. Manufacturers can refuse to sell to wholesalers or can ‘advise’ their equipment producers against reaching agreements with them unless certain terms are agreed.

    SEDs are examples of what economists call vertical restraints. Vertical restraints

involve agreements between producers of complementary goods. They are distinguished from horizontal restraints which relate to agreements between producers of the same good or close substitutes. Thus if a car manufacturer places a limit on what retailers sell and how they sell the product, that is a vertical restraint. Agreements between car manufacturers themselves as regards price or market share is a horizontal restraint. Generally, vertical restraints are considered innocuous for competition. By contrast, there is a presumption that horizontal restraints are

harmful to competition.

    An SED typically specifies what retailers sell and how they sell it. Under ‘selective

dealership’, a producer uses only those retailers who agree to support its brand in specified ways – perhaps by giving information to potential customers or providing aftersales service to those who buy. ‘Exclusive dealerships’, as the name suggests, commit retailers to selling one brand. They often go hand-in-hand with ‘full-line forcing’, under which retailers stock a manufacturer’s whole range, not just one or two products.

    Other vertical restraints include ‘exclusive territories’, which limit a retailer’s sales to a particular area  and ‘franchise fees’, which are sometimes paid to manufacturers for the right to sell their wares or to put their logos above the shop door .Producers may also try to fix retail prices, either by controlling discounts or by demanding that retailers sell minimum quantities of their products.

    At first sight, these devices look like a conspiracy against consumers. But sometimes they can benefit the consumer, because contracts with vertical restraints are often the most efficient way for producers to get their products to the customer and to ensure good after-sales service.

    A manufacturing firm can sell through an independent retailer or by setting up its

own retail network. Independent retailers have stronger incentives than employees to

maximise retail profits and they may know more about local markets.

    However, retailers may set prices higher than producers would like.Suppose producers sold their goods to retailers at a uniform wholesale price. If retailers

have some monopoly power in their local markets, they can set retail prices above

wholesale prices .But manufacturers would like prices to be lower: that would expand retail sales, reduce unit costs, and boost the manufacturer’s sales and profits. One of several ways around this is to set up a SED, i.e. insist that retailers pay a franchise fee for the right to sell the product and, in return, cut wholesale prices.

Payment of a franchise fee does not affect the dealer’s profit-maximising level of sales. But a lower wholesale price does, and gives an incentive to the dealer to cut the retail price and raise sales volume.

    Complaints against vertical restraints might still be valid in that consumers’ range of choice is being restricted. However, if there are many competing producers, retailers, even with exclusive territories, do not have much market power. While they face no competition from others selling the same brand, other local retailers are selling competing brands, curbing their ability to exploit consumers.

    Hence the rationale for exempting SEDs under the competition regime. This exemption has been extended to 2004. Current economic thinking stresses the importance of market structure. The more competition between brands, the more likely that pro-competitive and efficiency effects of vertical restraints will outweigh any anticompetitive effects.