Weakening competition policy in Europe risks creating monopolies rather than industrial champions.

An interventionist style of industrial policy, one that revolves around picking winners, has recently been getting traction in the EU, with even free-market oriented governments like Germany’s seemingly supporting such a change.

Recently, the French and German governments have released a joint manifesto for a new European industrial policy.((“A Franco-German Manifesto for a European industrial policy fit for the 21st Century.”)) Among other things, the document calls for a revamp of competition policy, which includes the possibility for the European Council—the body which consists of the heads of state of the EU member states—to override decisions by the European Commission’s competition authority, an independent body whose verdicts on merger review cases are based on clearly defined technical rules.

The Franco-German proposal comes hard on the heels of the European Commission’s decision to block the merger between Alstom and Siemens—a merger that would have created a near-monopoly in several European rail markets. According to the approach that underlies the proposed changes, Europe needs bigger firms with more market power—European champions—that would be able to compete with American and Chinese giants. If Europe needs to coddle these national champions with state aid, the thinking goes, then that’s a price worth paying. For German and French policymakers, rules that curtail firms with strong market power would be considered competition fundamentalism, and critics of activist industrial policies are just being naïve.

This view, however, is distant from the facts. Market competition across many sectors in Europe is on the decline, and persistent regulatory barriers have deterred competition. Weakening competition policy in Europe, therefore, risks creating monopolies rather than industrial champions.

Market concentration has been rising in most of the EU member states. All EU countries, with the exception of Poland, have shown a rise in market concentration (measured through the Herfindahl-Hirschman Index) between the beginning of the 2008 financial crisis and 2012. The greatest increases, in percentage terms, were registered in Estonia, the Czech Republic, Austria, Finland, and Spain. Market concentration was substantial not only in low-competition industries like postal, air transport, and telecommunications, but also in service and manufacturing industries where a healthy dose of competition was expected. For example, the ten largest IT-services companies in Germany delivering information services such as data processing and data hosting control 75 percent of the market. In the Czech Republic, the ten largest retailers supply half of the consumer goods market. Across Europe, the biggest telecommunications companies hold almost 90 percent of the market.((The descriptive analysis of market concentration and market power includes the following EU countries: Austria, Belgium, the Czech Republic, Estonia, Finland, France, Germany, Italy, Latvia, Poland, Portugal, Romania, Slovenia, and Spain, which together represent 69 percent of EU GDP.))

Markups—the difference between the cost of producing a good or service and the selling price—have declined on average during the same period.

The average increase in market concentration and the decline in markups were both expected, given the fall in demand during the financial crisis. However, in a recent study, we also found that market concentration and markups had risen in 25 percent of European industries. Moreover, the markups of the companies charging the highest margins grew faster than the margins of the companies with average markups. Across sectors, services such as management consultancies, legal services, and accounting enjoyed some of the highest commercial margins across many EU countries.

Unfortunately, our analysis of market concentration and market power only includes data up to 2012. It might well be that during the subsequent economic recovery, competition has resumed. Yet business churn—the speed with which new firms enter markets and old companies fade away—has also followed a downward trend between 2009 and 2016,((Eurostat. Business demography. Data can be accessed here.)) which indicates a fall in economic dynamism.

A possible explanation behind this fall in market competition is regulation.((Other reasons behind the increase in market concentration and market power such as the need to recover the investments in tangible and intangible capital, network externalities, and zero marginal costs are discussed in detail in Guinea and Erixon (2019).)) Regulatory barriers represent a fixed cost, which deters new entrants. Even though every company in the market bears the cost of higher regulation, incumbents are better suited to adapt and influence current and future regulatory costs (Stigler 1971). Moreover, incumbents may lobby the government in favor of additional regulation, if that prevents competition. As a policy measure, regulation has a clear advantage over other forms of industrial support like subsidies. While subsidies encourage new entrants, regulatory barriers directly limit competition.

In order to fully appreciate the likely consequences of weakening competition policy in the pursuit of industrial champions, it is important to take account of the impact that regulatory protection can have on market competition. In markets protected by a regulatory moat, any increase in market concentration will be difficult to reverse. Therefore, an industrial policy which favors size over everything else must take into account both the regulatory framework and the contestability of the market. Otherwise, government-led actions to encourage market concentration will run the risk of producing private monopolies rather than industrial champions.

The OECD measures a country’s regulatory stance over time using its economy-wide indicator of product market regulation (PMR). The PMR index shows that for the EU, more than half of all product market liberalizations undertaken from 1998 until 2013 were achieved during the first five years. The deceleration in the pace of reforms suggests that liberalization has become harder and that countries have moved away from market-friendly legislation. This lack of progress is evident in some of the components of the overall PMR indicator, in particular those that cover barriers to entry and exit.

We used a fixed-effect econometric model to investigate the impact of regulation on market competition in Europe.((Gutierrez and Philippon (2017) also investigate the role of regulation in the growing levels of market concentration in the US economy. The authors show that US industries with growing regulation have been experiencing substantial increases in concentration. De Loecker and Eeckhout (2018) find evidence of a strong relationship between market valuation relative to sales, which they use as a measure of the stock of profits, and markups. Finally, the IMF (2018) finds that profits and market concentration measures are positively related.)) The objective of this analysis was not to prove a particular channel of causality but to understand the relationship between regulation, market concentration, market power, and profitability.((To perform this analysis, we merge data from OECD Product Market Regulation (PMR) and the Competitiveness Research Network (CompNet) to build an unbalanced panel dataset with indicators on product market regulation, market power, market concentration, and profitability for 18 EU countries that together make up 72 percent of EU GDP.))

The key findings of this analysis are as follows:

  • Regulatory barriers are associated with higher levels of market power and market concentration. A change in market regulation, however, may take some time to impact the economy. The same regressions were run with a one-year lag in the PMR index, obtaining similar results.
  • It is also possible that firms, having gained market power, use the additional profits from setting prices above the marginal costs to persuade governments to raise regulatory barriers. The results show that higher levels of market power, market concentration, and profits are associated with higher regulatory barriers in the economy. This two-way relationship between regulation and market competition indicates that regulation could be used by incumbents to protect themselves from competition.
  • Market concentration, market power, and profitability are positively related to each other. There is evidence that market concentration is associated with higher markups and, at the same time, that markups have a positive effect on incumbents’ profits.

These findings are relevant for the European debate on competition and industrial policy. Market competition is determined not just by the number of players and their market share but also by the contestability of the market. A more permissive competition policy in Europe will lead to a degree of market consolidation that, because of the regulatory barriers protecting incumbents, will be difficult to reverse.

Oscar Guinea is a Senior Economist at the  European Centre for International Political Economy (ECIPE). You can follow him on Twitter at @osguinea. Fredrik Erixon is the Director of the ECIPE. You can follow him on Twitter at @FredrikErixon. ECIPE is an independent and non-profit policy research think tank dedicated to trade policy and other international economic policy issues of importance to Europe. 

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