3.6.1 - Government intervention

Competition Policy and Mergers

Competition policy matters because market power can build before a pure monopoly exists. A cartel may restrict rivalry, a dominant firm may abuse its position, and a merger may remove an important competitor. In the UK, the Competition and Markets Authority (CMA) is the main body enforcing competition law, investigating mergers, and acting against anti-competitive conduct.

The CMA can investigate mergers, require remedies, block deals, and fine firms that break competition law. Businesses involved in illegal anti-competitive behaviour can be fined up to 10% of worldwide turnover, and individuals involved in cartel activity can face up to 5 years in prison. That matters because intervention is not just guidance. It changes incentives directly.

When the CMA looks at a merger, the key test is whether it is likely to create a substantial lessening of competition (SLC) compared with the situation without the merger. Since January 2025, a merger usually qualifies for investigation if the business being acquired has UK turnover of more than GBP100 million (the threshold was GBP70 million before then), or if the merging firms together would supply at least 25% of a particular good or service in the UK and the merger adds to that share. The decision is not based on size alone. The CMA weighs possible gains such as economies of scale or improved competitiveness against possible losses such as higher prices, reduced choice, lower quality, or weaker innovation.

A useful contrast comes from UK groceries. Tesco's purchase of Booker was cleared in 2017 after an in-depth review because the CMA judged that the firms did not compete closely enough head-to-head for the merger to reduce competition substantially. By contrast, the CMA blocked the proposed Sainsbury's-Asda merger in 2019 because it concluded that shoppers and motorists were likely to face higher prices, less choice, and a poorer overall shopping experience.

Merger control is still imperfect. Regulators do not have full information, firms can lobby hard, and regulatory capture is a constant risk if regulators become too close to the industries they supervise. Resource limits matter too, so only a fraction of possible cases receive detailed investigation.

Regulating Monopoly Behaviour

Holding a dominant position is not illegal by itself. The problem is how a monopoly uses that position. If it can charge high prices, restrict output, cut quality, or allow costs to drift upward, government may regulate it to protect consumers and improve efficiency.

The logic of RPI - X is more important than the formula itself. This is price regulation: the regulator limits the price, not the profit. If inflation is 4% and X = 2, the firm can raise price by only 2%. That means profit is not guaranteed. The firm has to cut costs or improve productivity if it wants to protect margins. If it beats the target, it can keep some of the gain until the next price review (usually every five years), so the scheme is meant to mimic competitive pressure. This is why price-cap regulation is usually seen as stronger on incentives than simple profit control. UK regulators such as Ofwat and Ofgem now link their caps to CPIH inflation rather than RPI, but the logic is the same.

That contrasts with rate-of-return regulation, a form of profit regulation, where the firm is allowed to cover costs and earn a "fair" return on capital. This can stop obviously excessive profits and may support investment, but it also creates weaker cost-cutting incentives and can encourage gold-plating. Firms may over-invest in capital because a larger asset base justifies a larger allowed return.

Regulators can aim even lower on price in theory by setting P = MC, which would achieve allocative efficiency. The difficulty is that this often creates losses in a natural monopoly because average cost may still be above marginal cost. So real-world regulation is usually a compromise between lower prices and financial viability.

Price caps are not the only tool. Governments may impose quality standards such as water purity rules, daily postal delivery obligations, or minimum electricity capacity. They may set performance targets such as train punctuality or utility response times. They may also use yardstick competition, where separate regional firms are compared and the best performers help set the benchmark. That is one reason comparison across regional water companies matters in UK regulation.

Other approaches still appear in evaluation. Governments can use windfall taxes on excessive profits (in 1997 a one-off windfall tax on the privatised utilities raised about GBP5.2 billion), break up a monopoly where scale economies are no longer decisive (in 2009 the Competition Commission ordered BAA to sell Gatwick, Stansted and one of its two big Scottish airports), subsidise output if they want lower prices, or rely on self-regulation. The weaknesses are familiar: regulators face asymmetric information, firms may game the target system, subsidies need public money and good cost information, and self-regulation is cheap but usually weak.

Promoting Competition and Contestability

Instead of regulating a dominant firm after market power has appeared, government can try to make markets more competitive in the first place. The aim is either to increase the number of rivals or to make entry easier, so incumbent firms behave more competitively because the threat of rivalry is stronger.

Supporting small businesses is one route. Governments can use tax relief, start-up grants or subsidies, business advice, training, lighter administrative burdens, and investment schemes such as EIS or SEIS. The hoped-for effect is more entry, more innovation, and more pressure on established firms to keep prices keen and costs under control.

Deregulation works by removing unnecessary legal barriers to entry. Standard UK examples include telecoms, postal services, bus markets, and parts of financial services. The benefit is that easier entry can increase competition, improve efficiency, and widen choice. The evaluation point is that not all regulation is pointless. Some rules protect safety, consumers, or financial stability, and badly designed deregulation can encourage harmful behaviour, as debates after the 2008 financial crisis showed.

Competitive tendering introduces competition into publicly funded services without necessarily selling the asset itself. The government specifies the service, firms bid, and the contract goes to the lowest-cost or best-value provider that meets the required standard. This has been used for services such as waste collection, prison services, cleaning, catering, and some historically PFI-linked projects in schools and hospitals. The attraction is lower cost and access to private-sector expertise; the drawbacks are costly bidding, inflexible contracts, and the risk that firms cut quality to win.

Privatisation is a bigger change because it alters ownership rather than just who wins a contract. The UK's privatisations of BT, British Gas, water, electricity, and rail are standard examples. Supporters argue that private ownership can reduce X-inefficiency, expose firms to profit incentives, improve public finances through asset sales, reduce day-to-day political interference, and make managers more accountable through shareholder pressure. Some also argue that worker or manager share ownership can align incentives more closely with performance.