High office buildings facing sky representing Institutions and Services Trade

Can Public Enforcement of Competition Policy Increase Distortions in the Economy?

Authors: Vasiliki Bageri, University of Athens, Yannis Katsoulacos, Univeristy of Athens,  and Giancarlo Spagnolo, SITE.

Competition law has recently been introduced in a large number of developed and emerging economies. Most of these countries adopted the common practice of basing antitrust fines on affected commerce rather than on collusive profits, and in some countries caps on fines have been introduced based on total firm sales rather than on affected commerce. Based on recent research, this policy brief explains how a number of large distortions are connected to these policies, which may facilitate competition authorities in their everyday job but at the high risk of harming the consumer and distorting industrial development. We conclude by discussing the possibility to depart from these distortive rules-of-thumb opened by recent advancements in data availability and econometric techniques, as well as by the considerable experience matured in estimating collusive profits when calculating damages in private antitrust litigation.

Competition policy has become a prominent policy in many developing economies, from Brazil to India. Indeed, the available evidence suggests that in countries where law enforcement institutions are sufficiently effective, a well designed and enforced competition policy can significantly improve total and labor productivity growth.

It is already well known that the private enforcement of competition policy can give rise to large distortions: since competition law is enforced by Judges and not by economist, it is easy for firms to strategically use the possibility to sue under the provision of competition law to protect their market position rather than the law being used to protect competition.

It is somewhat less known that a poor public enforcement of Competition Law by publicly funded competition authorities can also end up worsening market distortions rather than curing them. In the reminder of this policy brief we explain why, according to recent research, a mild and suboptimal enforcement of antitrust provisions – in the sense of fines that are too low to deter unlawful conduct (horizontal agreements and cartels in particular) and fines which are based on firm revenue rather than on the extra profits generated by the unlawful conduct, could significantly harm social welfare, even if we abstract from the direct cost the public enforcement of competition law imply for society.

Current Practice in Setting Fines

A very important tool for the effective enforcement of Competition Law is the penalties imposed on violators by regulators and courts. In this policy brief, we uncover a number of distortions that current penalty policies generate, we explain how their size is affected by market characteristics such as the elasticity of demand, and quantify them based on market data.

In contrast to what economic theory predicts, in most jurisdictions, Competition Authorities (CAs), but also courts where in charge, use rules-of-thumbs to set penalties that – although well established in legal tradition and in sentencing guidelines and possibly easy to apply – are hard to justify and interpret in logical economic terms. Thus, antitrust penalties are based on affected commerce rather than on collusive profits, and caps on penalties are often introduced based on total firm sales rather than on affected commerce.

A First Well Known Distortion Due to Legal Practice

A first and obvious distortive effect of penalty caps linked to total (worldwide) firm revenue is that specialized firms which are active mostly in their core market expect lower penalties than more diversified firms that are also active in several other markets than the relevant one. This distortion – why for God’s sake should diversified firms active on many markets face higher penalties than more narrowly focused firms? – could in principle induce firms that are at risk of antitrust legal action to inefficiently under-diversify or split their business to reduce their legal liability.

In a recent paper published in the Economic Journal, we examine two other, less obvious, distortions that occur when the volume of affected commerce is used as a base to calculate antitrust penalties.

A Second Distortion: Poorly Enforced Competition Law May Increase Welfare Losses from Monopoly Power

If expected penalties are not sufficient to deter the cartel, which seems to be the norm given the number of cartels that CAs continue to discover, penalties based on revenue rather than on collusive profits induce firms to increase cartel prices above the monopoly level that they would have set if penalties were based on collusive profits. Intuitively, this would be done in order to reduce revenues and thus the penalty. However, this exacerbates the harm caused by the cartel relative to a monopolized situation with similar penalties related to profits, or even relative to a situation with no penalties due to the distortive effects of the higher price and, in comparison to a situation with no penalties, the presence of antitrust enforcement costs.

A Third Distortion: Firms at the Bottom of the Value Chain May Pay a Multiple of the Fine Paid by Firms at the Top for an Identical Infringement

Firms with a high revenue/profit ratio, e.g. firms at the end of a vertical production chain, expect larger penalties relative to the same collusive profits that firms with a lower revenue/profit ratio would get. Our empirically based simulations suggest that the welfare losses produced by these distortions can be very large, and that they may generate penalties differing by over a factor of 20 for firms that instead should have faced the same penalty.

Note that this third distortion takes place also when at least for some industries fines are sufficiently high to deter cartels. This distortion means that competition is only enforced in industries that happen to be in the lower end of the production chain, and not in industries where the lack of competition is producing larger social costs. Note also that our estimation is based only on observed fines, i.e. on fines paid by cartels that are not deterred. Since cartels tend to be deterred by higher fines, this suggest that if we could take into account the fines that would have been paid by those cartels that were deterred (if any), the size of the estimated distortion would likely increase!

Concluding remarks

We argue that if one wants to implement a policy, one must be ready to do it well otherwise it may be better to not do it at all. This is particularly relevant for countries with weaker institutional environments where it is likely that political and institutional constraints will not allow for a sufficiently independent and forceful enforcement of the Competition Law.

It is worth noting that – in particular in the US but also increasingly so in the EU – the rules-of-thumb discussed above do not produce any saving in enforcement costs because the prescribed cap on fines requires courts to calculate firms’ collusive profits anyway. Furthermore, the distortions we identified are not substitutes where either one or the other is present. Instead, they are all simultaneously present and add to one another in terms of poor enforcement.

Where there are sufficient resources to allow for a proper implementation and where enforcement of Competition Law is available, developments in economics and econometrics make it possible to estimate illegal profits from antitrust infringements with reasonable precision, as regularly done to assess damages. It is time to change these distortive rules-of-thumb that make revenue so central for calculating penalties, if the only thing the distortions give us is savings in the costs of data collection and illegal profit estimation.