First Approach: Competition

It is tautological to say that increasing competitive pressure can diminish problems of market power. However, competition also addresses the information asymmetry problem in two ways. The first way is that the operator, in its pursuit of profits, has an incentive to provide service quality levels and price levels that are best for customers, subject to the operator’s need to cover its costs. Competition can provide this result because fully informed customers will buy only from those operators that provide the most beneficial combinations of quality and price. In other words, each customer seeks to maximize his net consumer surplus.

Even if the operator in a competitive market is state owned, competition presses the operator to act as a privately owned operator because the state-owned operator must be responsive to customers in order to finance its operations. Of course a state-owned service provider might be able to use its relationship with the government to gain an advantage over rivals, which would at least in part thwart the discipline of the competitive market. For example, if a state-owned operator were allowed access to taxpayer-provided monies when cash flows are unable to support investments, the state-owned operator could have an incentive to make uneconomic investments that further the operator’s political goals or reduce competitive pressures.

The second way that competitive pressure addresses the information asymmetry problem is that competitive market outcomes reveal actual customer demand, the operator’s innate ability to be efficient, and how much effort the operator is willing to exert to be efficient. Even if competition is weak, competing firms can benefit from using all of the information at their disposal to succeed in the competitive marketplace.

Competition has additional benefits. It limits a government’s ability to use regulation to favor certain stakeholders or to sacrifice long term efficiency for short term political goals. It also limits operators’ abilities to raise prices and creates opportunities for different firms to try innovative ways to attract customers.²

Policy makers or regulators subject operators to competitive pressures by liberalizing markets and facilitating competition. There are three basic approaches. The first approach is to have multiple operators compete in the market for customers. This is called competition in the market and examples include having multiple mobile telecommunications service providers and multiple operators of electricity generation plants. The second method, called competition for the market, is to have operators compete for the market by having the operators bid for the right to be a service provider.³ Franchise bidding to operate a city water system is an example of this second approach. The third technique is to have operators in different markets compete by comparing the efficiency and effectiveness of their operations and rewarding those operators that provide superior performance. Competition in the market is reviewed next, followed by competition for the market. The third approach, called competition between markets, but also called benchmarking or yardstick regulation is covered in the section on Incentive Regulation.

Footnotes

1. Market Structure and Competition covers competitive issues, except for competition between markets, which is covered in Price Level Regulation.
2. This is not to imply that competition is without problems. There may be situations where operators compete aggressively in lowering prices and so do not have adequate cash flows to make needed investments. Competition has generally been most successful in telecommunications.
3. Operators may also bid for the right to be a service provider in situations of competition in the market. This might be the case in mobile telephony, for example, where radio spectrum limits the number of possible operators.