Government policies to promote competition and contestability aim to improve market outcomes by encouraging efficiency, innovation, and consumer welfare while reducing the dominance of established firms.
Promotion of Small Businesses
One of the central ways governments aim to promote competition is through active support of small and medium-sized enterprises (SMEs). These businesses typically face significant barriers to entry and may struggle to compete with large, well-established firms with considerable market power. Government intervention can help level the playing field and increase the contestability of markets.
Tax Incentives
Tax policy is a common tool used to assist small businesses. These may include:
Reduced corporation tax rates for small businesses.
R&D tax credits that allow firms to deduct a proportion of research and development spending from their tax liability.
Capital allowances that let firms deduct the cost of equipment and machinery from their profits before taxation.
These incentives lower the cost of doing business, enabling small firms to allocate more resources towards investment, expansion, and innovation. By reducing the financial burden, governments aim to encourage entrepreneurship and support the growth of firms that can challenge incumbents.
Subsidies and Grants
Governments may provide direct financial support to start-ups and SMEs, particularly in sectors deemed strategically important or underdeveloped. These include:
Startup grants to help cover initial costs.
Innovation vouchers that fund collaborative projects between businesses and research institutions.
Export subsidies to support entry into international markets.
Subsidies allow firms to overcome high initial fixed costs, making it easier to enter and survive in competitive markets. Grants may also target specific objectives, such as improving green technology adoption or promoting regional development.
Access to Finance
Many small businesses face difficulty securing credit due to their perceived riskiness by traditional lenders. Governments can improve access to finance through:
Loan guarantee schemes, where the state guarantees a portion of loans made by private banks.
Public investment banks that directly provide funding to SMEs.
Support for venture capital funds aimed at high-growth enterprises.
Improved access to finance allows small businesses to invest in capital, technology, and labour, increasing their ability to compete and grow in the long term.
Evaluation of Support for Small Businesses
Benefits:
Encourages dynamic efficiency by supporting innovation and entrepreneurial activity.
Increases market contestability, allowing more firms to enter and challenge incumbents.
May improve consumer welfare through more diverse products and lower prices.
Drawbacks:
Potential for government failure: funds may be allocated inefficiently or to firms with poor long-term prospects.
Risk of moral hazard, where firms rely on state support rather than becoming self-sufficient.
High opportunity cost: government funding could be used elsewhere, such as in healthcare or infrastructure.
Administrative complexity and inequitable access: not all firms may be aware of or able to access these schemes.
Deregulation
Deregulation involves the removal or simplification of legal, administrative, or institutional barriers that restrict entry or hinder competition in markets. It is particularly significant in previously state-dominated or heavily regulated sectors such as utilities, transport, or telecommunications.
Legal and Administrative Barriers
In many sectors, firms must comply with complex rules, licensing processes, or industry standards before they can operate. Deregulation can include:
Removing licensing requirements for non-essential activities.
Streamlining approval processes for new firms.
Reducing bureaucratic red tape and unnecessary compliance obligations.
Deregulation can lower sunk costs, increase ease of entry, and enhance contestability, especially when combined with technological change (e.g., the rise of ride-sharing platforms in the deregulated taxi market).
Sectoral Examples
In the UK, deregulation of the bus transport sector in the 1980s opened the market to new entrants. Although this initially increased competition, service quality and network coordination declined in some regions.
The deregulation of telecommunications allowed multiple firms to offer broadband and mobile services, leading to more choice and falling prices.
Evaluation of Deregulation
Benefits:
Enhances allocative and productive efficiency by allowing more firms to enter and operate freely.
Drives down prices and encourages innovation, benefiting consumers.
Reduces administrative costs for both businesses and regulators.
Drawbacks:
Inadequate regulation may result in market failures, such as poor safety standards or environmental degradation.
Can cause short-term instability or job losses if incumbent firms restructure to survive.
May lead to information asymmetry or consumer exploitation without basic protections.
Competitive Tendering
Competitive tendering introduces market mechanisms into the public sector by allowing private firms to bid for contracts to provide government services. It is commonly used in services such as waste collection, school catering, cleaning, and transport.
How It Works
Government agencies specify service requirements.
Private and public providers submit bids.
Contracts are awarded based on criteria such as cost, quality, and delivery times.
The aim is to simulate competitive pressures in sectors where natural monopolies or public provision previously dominated.
Applications in the UK
The NHS internal market allows private providers to compete for non-emergency services.
Local authorities use competitive tendering for waste management and infrastructure maintenance.
Evaluation of Competitive Tendering
Benefits:
Encourages cost efficiency and better use of public resources.
Incentivises service innovation and responsiveness.
Improves transparency and accountability through clear performance benchmarks.
Drawbacks:
Risk of underbidding, where firms quote unrealistically low prices and later cut corners to stay profitable.
Employment insecurity for workers affected by contract changes.
Quality may deteriorate if lowest-cost bids are prioritised over service standards.
Privatisation
Privatisation is the process of transferring ownership of firms or assets from the public sector to private investors. It is based on the belief that market incentives lead to better outcomes than state control.
Objectives of Privatisation
Improve economic efficiency by exposing firms to profit motives and market discipline.
Increase consumer choice and responsiveness to demand.
Reduce the fiscal burden on the government by offloading costly operations.
Methods of Privatisation
Direct sale of assets to private firms or investment groups.
Initial public offerings (IPOs) that allow citizens to buy shares.
Franchising or outsourcing, where operations remain public but are managed by private contractors.
UK Examples
The privatisation of British Telecom (1984) was one of the earliest and most notable examples, leading to increased investment in telecommunications infrastructure.
British Rail was privatised in the 1990s, resulting in a franchised system of train operators, with infrastructure managed separately.
Evaluation of Privatisation
Benefits:
May increase productive efficiency due to profit-driven management.
Encourages capital investment without burdening public finances.
Potentially improves consumer service and responsiveness.
Drawbacks:
Can lead to private monopolies if markets are not competitive (e.g. water utilities).
Risk of regulatory failure, especially if watchdogs are under-resourced or politically influenced.
Public may lose access to essential services if profit conflicts with universal provision.
May result in job cuts or wage reductions to boost profit margins.
Comparative Evaluation
To evaluate the effectiveness of these policies, it is necessary to consider their impacts on different economic variables and long-term objectives.
Dynamic Efficiency
Policies that support SMEs—especially those involving subsidies and access to finance—are most closely linked to dynamic efficiency. These firms are often more innovative and responsive to new technologies or changing consumer preferences. Privatisation can also encourage dynamic efficiency if firms invest in long-term improvements.
Market Contestability
Deregulation and competitive tendering are particularly effective at increasing market contestability. By reducing barriers to entry or simulating market conditions, they allow more firms to participate, even in sectors where monopolistic tendencies exist.
Unintended Consequences
Each policy carries risks and trade-offs:
Promotion of small businesses may distort competition if support becomes permanent or misdirected.
Deregulation may result in market abuses if consumer protections are removed.
Competitive tendering can prioritise short-term savings over long-term service quality.
Privatisation without competition leads to private monopolies with little incentive to serve the public interest.
Policy Synergies and Frameworks
In practice, these policies often complement each other. For example, deregulation can be combined with SME promotion and tendering to create a genuinely open and contestable market. However, success depends heavily on regulatory frameworks, institutional capacity, and policy coordination.
Real-World Illustrations
In the UK energy market, privatisation and deregulation led to increased competition, but the need for intervention (such as the energy price cap) highlights the limits of market-based solutions.
The telecommunications sector saw improved service and falling prices, showcasing the benefits of combined privatisation and deregulation.
NHS tendering reforms brought cost-efficiency but also raised questions about fragmentation, continuity of care, and equity.
Through these tools, governments aim to foster a more competitive, efficient, and innovative economy, balancing the benefits of market forces with the need for oversight and equity.
FAQ
While promoting competition is often associated with lower prices, better quality, and increased innovation, it does not always guarantee improved consumer outcomes. In highly fragmented markets, excessive competition can result in reduced economies of scale, leading to higher unit costs and potentially higher prices in the long term. Firms may also reduce investment in quality or customer service to cut costs and remain competitive, especially if profit margins become unsustainably low. Moreover, consumers may face choice overload, particularly in deregulated sectors like energy or telecommunications, where complex pricing structures and tariffs can make it difficult to identify the best deal. In some instances, firms may even engage in misleading marketing practices to attract customers. Additionally, frequent market entry and exit can create instability, affecting service continuity. Therefore, while competition can be beneficial, it needs to be well-regulated and complemented by consumer protection measures to ensure positive outcomes for all stakeholders.
Government intervention supports innovation primarily by reducing entry barriers and incentivising entrepreneurial activity. Policies that promote contestability—such as subsidies, tax credits for R&D, and easier access to finance—allow new and smaller firms to experiment with novel products, processes, and technologies without the overwhelming threat of financial ruin. Deregulation can further enhance innovation by removing restrictive compliance burdens that stifle creative approaches. For example, in the fintech sector, regulatory sandboxes allow innovative firms to trial new financial products in a controlled environment. Moreover, competitive tendering forces firms to differentiate themselves not just on cost, but also on service innovation, particularly in public procurement. Privatisation, if accompanied by open market access, may also encourage former monopolies to innovate to stay ahead of new entrants. In short, innovation thrives when contestability is combined with targeted support and effective risk management, allowing both incumbents and new entrants to pursue value-creating activities.
Regulatory bodies play a critical role in overseeing and enforcing policies that aim to increase competition and contestability. Their main responsibilities include monitoring markets, investigating anti-competitive behaviour, enforcing compliance, and evaluating the effectiveness of policies such as privatisation, deregulation, and competitive tendering. For example, in the UK, the Competition and Markets Authority (CMA) investigates mergers and market practices that could harm competition. Without active regulation, policies like deregulation or privatisation may simply replace public monopolies with private ones, diminishing rather than enhancing competitive dynamics. Regulators are also tasked with ensuring transparent and fair access to essential infrastructure, such as electricity grids or rail networks, which is crucial in maintaining contestability. Furthermore, they must guard against regulatory capture, where firms manipulate regulatory outcomes to their advantage. Overall, regulatory bodies ensure that the theoretical benefits of pro-competition policies translate into practical and sustained improvements for markets and consumers.
Policies to promote contestability are generally most effective in markets with high fixed costs but relatively low sunk costs, where potential entrants are not discouraged by the irreversibility of initial investments. Sectors such as telecommunications, transport, education services, and waste management often fit this profile. These industries typically have scope for multiple firms to operate, provided that access to infrastructure or contracts is fairly regulated. Markets with natural monopolies—like water supply or rail infrastructure—may see limited effectiveness unless regulation ensures that different parts of the service (e.g. operations versus infrastructure) are separated to allow competitive access. Policies are also more impactful in dynamic or innovation-driven sectors, such as technology and software, where the ability to enter, disrupt, and scale rapidly can be decisive. Contestability is harder to achieve in markets with high brand loyalty, significant sunk costs, or regulatory complexity, unless accompanied by strong institutional support and initial de-risking measures.
Over the long term, contestability-promoting policies can significantly reshape market structures by increasing the number of active firms and reducing concentration ratios. As barriers to entry fall, new entrants challenge incumbents, forcing even dominant firms to become more efficient, responsive, and consumer-focused. This can result in a more competitive market structure—shifting from oligopoly towards monopolistic competition, depending on the industry. However, outcomes are not uniform. In some cases, contestability leads to market fragmentation, with too many small firms competing inefficiently, which may necessitate consolidation or selective withdrawal. Moreover, if government support is withdrawn prematurely or regulations are inconsistently applied, firms may exit, leading to re-concentration. In highly innovative markets, contestability fosters dynamic churn, where firms regularly enter and exit, keeping the market vibrant but potentially unstable. Ultimately, the long-term impact depends on policy coherence, enforcement, and complementary interventions such as access to finance, infrastructure support, and continuous regulatory oversight.
Practice Questions
Evaluate the effectiveness of government policies aimed at increasing market contestability.
Government policies such as deregulation, subsidies for SMEs, and competitive tendering can enhance market contestability by reducing barriers to entry and simulating competitive pressures. Deregulation lowers compliance costs, encouraging new firms, while SME support promotes innovation. Competitive tendering ensures efficiency in public services. However, effectiveness depends on regulatory oversight—deregulation may reduce standards, and privatisation without real competition risks private monopolies. Moreover, subsidies can misallocate resources if poorly targeted. Overall, while these policies can foster contestability and efficiency, outcomes vary with market structure and enforcement quality, and long-term sustainability requires well-designed regulatory frameworks.
Explain how privatisation can improve economic efficiency.
Privatisation can enhance economic efficiency by exposing firms to market discipline and profit incentives. Private ownership encourages cost-cutting, innovation, and responsiveness to consumer demand, improving productive and allocative efficiency. Firms may also invest more capital, free from public sector constraints. For example, the privatisation of British Telecom led to better service provision and infrastructure upgrades. However, improvements depend on market competition—without it, firms may exploit monopoly power, reducing efficiency. Effective regulation is therefore essential to ensure benefits. Thus, privatisation can improve efficiency, but outcomes depend on market conditions and the strength of regulatory institutions.
