MEASURING MARKET COMPETITION IN THE EU ... - Bank of Valletta

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Measuring Market Competition in the EU: The Mark-up Approach market competition can be measured and will outline the methodology for measuring market competition. Section 4 will present the results while Section 5 will explore possible factors underpinning market competition. Section 6 outlines some methodological issues and limitations. Theoretical Background Conventional wisdom in economics posits that there is a negative relationship between the degree of market competition and profits level of firms. Consequently, according to classical models, it is in the best interest of profitmaximising firms to reduce the degree of market competition, especially if it can be done through some legal means, such as product differentiation and horizontal merger. Irrespective of the assumptions made, increase in the contestability of markets and the reduction of the incumbent’s market power motivate firms to set prices closer to marginal costs. As a consequence, super normal profits tend to decrease while the allocation of both resources and goods becomes more efficient. Recent empirical studies have pointed to a positive effect of product market competition on productivity growth, particularly at low levels of competition (Aghion et al., 2005). An increase in competition may also impact on the dynamic efficiency of firms where firms will have an incentive to innovate and hence to speed up the move to the modern technology frontier. Such improvements can have a significant impact on productivity (Ahn, 2002; Griffith and Harrison, 2004). The general idea behind this argument is that when regulatory reforms lead to a more competitive output markets, the wedge between prices and marginal costs is minimised, resulting in lower degree of market distortion. Furthermore, a more competitive climate will lead to pressure for the less efficient firms to exit the market. Through this channel, market shares will shift from lower productivity to higher productivity firms. A highly influential contribution in this area was provided by Nickell (1996) who used firm level data to investigate where changes in competition affect productivity levels and growth rates. Until recently, the relationship between the level of market competition and price dynamics did not receive particular attention, with research being 21
Mario Borg more focused on the relationship between competition and price level. The connection between market competition and inflation was systematically dealt with only recently, with an important contributions made by Martins et al., (1996) and Neiss (2001). Neiss (2001) focused on the empirical evidence relating the overall degree of competition among firms, as measured by the mark-up of price over marginal cost, and inflation. The author found that mark-up is in fact an important determinant in cross-country average inflation rates. Przybyla and Roma (2005) tested the hypothesis that higher mark-ups lead to higher inflation and found that competition in product market plays an important role in explaining average inflation rates across countries and sectors. Measuring Market Competition Several approaches can be utilised to measure market competition, ranging from the use of indicators to econometric based methods. A method based on a set of indicators is built on the belief that market competition is a multidimensional concept which cannot be captured by a single index. The analysis can be further complicated if it is restricted to specific sectors as this requires a definition of ‘relevant’ markets. Generally, an indicator-based approach aims to capture information about the market structure, performance of firms in the market, and conduct (such as infringements). A drawback of such an approach is that conclusions drawn from indicators depend heavily on the benchmark chosen. However, they have the advantage that many of these indicators are readily available for comparative purposes. A second approach is to use national accounts data to infer conclusions about the difference between the selling price and the marginal cost. For obvious reasons, this cannot be done at firm level; however, sufficient data is available to permit attempts at a more aggregated level. This approach generally attempts to estimate mark-up ratios. An advantage of such methods is that they are more grounded in theory than indicator-based approaches. On the other hand, care should be taken when interpreting the results as several factors, including data measurements, might influence the final estimates. The Mark-up Approach The approach adopted in this paper is to estimate econometrically the level of market competition by following the methodology adopted by Roeger 22
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MEASURING MARKET COMPETITION IN THE EU ... - Bank of Valletta

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