Government intervention: controlling monopolies and mergers

The case for intervention

Firms with market power may charge prices above MC (allocative inefficiency), let costs rise (X-inefficiency), cut quality, reduce choice, exploit suppliers and workers (monopsony), and collude. Competition authorities aim to protect consumers and promote efficient, competitive markets.

Controlling monopoly power

• Price regulation: a price cap such as RPI - X: prices may rise by inflation (RPI) minus X%, where X reflects expected efficiency gains. If a firm cuts costs faster than X, it keeps the extra profit, so the cap gives an incentive to be efficient. (RPI + K allows extra rises to fund investment, as in water.)
• Profit regulation (rate of return): profits capped as a percentage of capital employed. Weak efficiency incentive, and firms may over-invest or let costs rise.
• Quality standards and performance targets (punctuality, call answering, leakage), with fines for failure.
• Regulatory referral: investigations by the competition authority into markets or firms suspected of abusing a dominant position.

Merger control

Mergers above certain size thresholds can be investigated and blocked, or allowed with conditions (such as selling some stores).

Real example: on 25 April 2019 the UK's Competition and Markets Authority (CMA) blocked the proposed merger of Sainsbury's and Asda. It found the deal would lead to higher prices, reduced quality and range, and a worse shopping experience, and that motorists would pay more at over 125 places where the two firms' petrol stations were close together. It judged that discounters and online rivals would not be enough to offset the loss of competition (GOV.UK press release, 2019).

Limits to government intervention

• Regulatory capture: regulators come to act in the interests of the firms they regulate (close contacts, staff moving between them).
• Asymmetric information: firms know their costs better than regulators, so caps or X may be set wrongly.
• Inadequate resources and expertise to investigate.
• Lack of regulatory power: weak penalties, or global firms beyond national reach.
• Government failure: regulation imposes compliance costs and may reduce investment incentives.

Worked example

A regulated water company charges $120 a year. RPI inflation is 3.5% and X = 1.5. Find the maximum price for next year.

1. Allowed change = RPI - X = 3.5 - 1.5 = 2%.
2. New maximum = 120 x (1 + 2/100) = $122.40.

Answer: $122.40

Check yourself

1. RPI inflation is 4% and the regulator sets X = 2.5. By what percentage may prices rise?
   Show answer

   1.5 %. RPI - X = 4 - 2.5 = 1.5%.

2. A rail fare is $40. RPI is 3% and X = 1. Find the maximum new fare.
   Show answer

   $40.80. 40 x 1.02 = $40.80.

3. A telecoms price is $60. RPI is 2% and X = 5. Find the maximum new price.
   Show answer

   $58.20. RPI - X = -3%, so 60 x 0.97 = $58.20: a real and cash cut.

4. Why does an RPI - X price cap give an incentive to cut costs?
   • The firm keeps any extra profit from cutting costs faster than X
   • It guarantees a fixed rate of profit
   • It allows prices to rise faster than inflation
   • It bans the firm from making profit
   Show answer

   The firm keeps any extra profit from cutting costs faster than X. The price is fixed by the formula, so lower costs mean higher profit.

5. Regulatory capture occurs when
   • the government nationalises a firm
   • a firm takes over a rival
   • the regulator acts in the interests of the firms it regulates
   • the regulator sets prices too low
   Show answer

   the regulator acts in the interests of the firms it regulates. The regulator is 'captured' by the industry.

6. According to the CMA's 2019 decision, why was the Sainsbury's/Asda merger blocked?
   • It was expected to raise prices and reduce quality and choice
   • The firms were not profitable enough
   • It would have created too many jobs
   • The firms were in different industries
   Show answer

   It was expected to raise prices and reduce quality and choice. The CMA found a substantial lessening of competition.

7. Asymmetric information limits price regulation because
   • consumers know more than firms
   • regulators have perfect information
   • firms know their own costs better than the regulator
   • prices are always set by the market
   Show answer

   firms know their own costs better than the regulator. The firm can overstate costs to win a looser cap.

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (XEC11/YEC11), Unit 3 Business behaviour and Appendices 6 and 7
• GOV.UK press release, 25 April 2019: CMA blocks merger between Sainsbury's and Asda
• Pearson Edexcel IAL Economics WEC13/01 mark scheme, January 2021

Last updated 8 November 2026. Spotted a mistake? Tell us.