Competition and welfare

Defining competition Why do we need a new definition of competition? Some readers may argue that market concentration (measured by, for instance, the Herfindahl index or the concentration ratio) is a good way to define competition. More competition then implies less market concentration. From a policy point of view, market concentration suffices as an appropriate measure of competition if the focus is on stimulating entry. If the government removes (regulatory or other) entry barriers, more firms will enter the market, and competition is enhanced. In this case, the rise in competition is reflected in a fall in market concentration. However, a number of policy variables influence competition without directly affecting entry. For instance, liberalizing shop opening hours clearly increases the intensity of competition between shops by removing (time) constraints on consumers’ search behavior. However, it is not aimed at increasing the number of firms in the sector. On the contrary, as argued below, liberalizing shopping hours is likely to raise market concentration. Similarly, abolishing the minimum price in the daily newspaper industry will increase price competition between publishers and hence may drive some less efficient firms out of the market, thereby increasing market concentration. In these two examples, policy does not affect competition by (directly) changing the number of players in the market but by changing the way players interact. Then, a policy change is said to enhance competition if it induces players to act more aggressively, lowering prices and/or increasing their output levels. If competition is seen from this perspective (as it is in this paper), market concentration is not a good measure of competition since market concentration is determined endogenously by the cost and demand structures in the industry and the way firms interact. In particular, a policy measure is said to increase the intensity of competition in an industry, if it meets the following conditions (C1)-(C4):1 (C1) reduces total industry profits, (C2) reduces the profit level of the least efficient active firm and increases that of the most efficient firm (the socalled leader) if it is far enough ahead of its opponents, (C3) increases total industry output and (C4) reduces the output level of firms that feature much higher costs than the leader. This definition of competition may look unfamiliar. The idea is that competition is defined in terms of its effects on output and profit patterns. For instance, if all firms in the industry are homogeneous, the definition implies that stronger competition raises total industry output and reduces total industry profits. The definition incorporates the realistic case in which firms are heterogeneous. In that case, the definition imAbstract This article proposes a new definition of competition, emphasizing that competition impacts the way firms interact in an industry. This definition is illustrated with four policy measures, recently proposed by the Dutch government, that affect competition. Finally, the article considers the welfare effects of more intense competition.