A2 Economics Micro technique spot 2 – 1st best, 2nd best, 3rd best, 4th best

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May 26, 2014 by Paul Goldsmith

Pupils studying competition policy are often trying to get their head around what the regulatory authorities are trying to achieve. I have found it hard to explain this to them – and am grateful to Ray Powell – the former AQA economics chief examiner, who talked to us once about a way to explain it. This provides a useful way to assess the success of competition policy, whilst also giving you a very useful framework for explaining why it may not always work well.

The 1st best situation you could have in a market is for there to be a high number of firms in the market, all of whom are able to access full economies of scale. The importance of this is that should this be so, two things should be taking place: Firstly, they should all be able to lower their costs as low as possible (be as productively efficient as possible), but secondly, they should all be competing on price and quality – providing choice as there would be too many firms in the market to co-ordinate collusion successfully – and the resulting competition keeps prices down and encourages innovation to try and get ahead of the field. This would increase allocative efficiency and also possibly dynamic efficiency (although don’t ignore the possibility that the inability to make long-run super-normal profits in this market – which is probably quite contestable, may reduce the incentives to invest in dynamic efficiency.

The 1st best situation is rather unrealistic – in truth most firms with dominant firms in them have large barriers to entry – and so the regulators should aim for the 2nd best situation, which is where you have a well-regulated monopoly, or oligopoly – large enough to access all economies of scale. This means that there are the optimum number of firms in the industry – which can be worked out by dividing the total market demand by the minimum efficient scale (lowest output at which full economies of scale are realised) and rounding down. So if MES is 1m and total market demand is 6m the optimum number of firms for all of them achieve full economies of scale would be six. This means they CAN access the lowest possible costs and the good regulation means that they will be incentivised to charge low prices, improve quality and invest in dynamic efficiency. Skilled regulators will use all of the tools at their disposal to achieve this – including threatening further regulation (e.g. price capping, taxing monopoly profits) if the firms do not behave competitively.

If all this fails – you might get the 3rd best situation – which is where, usually as the result of a break-up of monopolies as they have failed to behave competitively despite all other regulatory efforts, a monopoly is broken into two companies or an oligopoly is split into more companies. After the break up of the monopolies no firm is able to achieve full economies of scale – because no firm produces enough output to achieve the minimum efficient scale. This means that it is impossible for any firm to produce at the lowest costs possible – and could mean that customers will have to pay higher prices because of this. It can be argued that those prices end up lower than the badly regulated monopoly that could access full economies of scale but was charging exploitative prices – which is why this isn’t the 4th best solution.

The 4th best solution is a natural monopoly – which means that economies of scale in the industry are so large that there isn’t room for any other firms in the market if firms are to be able to access full economies of scale. Water and the Rail franchises are examples of these (which begs the question of why they were privatized in the first place – a question for another blog!). The reason why this solution is 4th best is that the natural monopoly, if not regulated properly may simply not act in the customer’s interests, and could charge very high prices, reduce the quality of their products, and operate extremely inefficiently. This situation is like the 1st best situation in that it is very unlikely a natural monopoly would not be regulated. But it could happen, and economists would warn against it.

So there you go – the most ideal and realistic situation is the 2nd best situation – and many of the questions relate to how you arrive at that – although don’t forget it is worth having a go at achieving 1st best – why not?!

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