This chapter evaluates the major concern and, ultimately, failure of communism: to catch up with the economic advance of the West. Section 1 discusses the motivation underpinning the major policy objective, common to all socialist economies at all times, namely their excessive emphasis on growth.

Despite the intertemporal injustice that heavily penalised the first generations under socialism through very high forced savings, later generations did not reap the benefits of their forebears' sacrifices. Socialist economies seemed doomed both to fail in their bid for sustained growth and to be quite unable to let their citizens enjoy the fruits of sacrifice.

Section 2 deals with the preliminary issue of measurements, as Soviet accounting standards are not easily reconcilable with Western practices. Section 3 starts from a growth-accounting framework and shows the contributions of the accumulation of factors of production (labour, capital, land) and of productivity growth. If the Soviet economy had been able to put its immense accumulation of productive factors (extensive growth) to efficient use, it would have been at the top of the world's growth league. Unfortunately it was not. Section 4 provides an overview of the successes and failures of Soviet communism and section 5 concludes.

Growth: the overriding plan objective

In all poor countries, catching up with advanced nations is a top policy priority. Socialist revolutionaries came to power on a promise to achieve exactly that (and to redistribute income in favour of the working classes).

Evaluating Russia is not straightforward – and has never been. In 1925, Keynes summed up his impression of the new economic system as follows:

Keynes's statement remains valid today. Judgements on the effectiveness of the reforms in Russia from international institutions, academics and the press have ranged across the entire spectrum from very optimistic to extremely pessimistic. The best example of Russo-mania remains probably Layard and Parker's (1996) title The Coming Russian Boom. This boom had a rather short life, but predictions of descent into hyperinflationary chaos and disintegration after the crisis of 1998 proved equally wide of the mark. It is thus not easy to provide an overall judgement of the reforms in Russia as already anticipated by Keynes seventy-five years earlier. Hence, this chapter does not pretend to provide a comprehensive overview of developments in Russia over the last decade. Instead it concentrates on the most salient features of the reform process in Russia, often comparing them to what happened in Central Europe (especially Russia's largest Slav brother, Poland) in order to find some general features that can help in understanding how the Russian economy works in general, and where it might be going in the future.

The collapse of socialism in Eastern Europe transformed the economic and politic parameters of the European continent. Creating market economies was not the only hope that arose after the liberating events of 1989–90. Indeed, the basis for any analysis of the future of the transition countries must be that most of the countries west of the FSU made their choice early on: they wanted to join the European Union (EU). Since it was not possible for them to join the EU immediately, a transitional arrangement for trade was created in the early 1990s. Section 1 describes the transitional arrangements and section 2 provides a theoretical framework for judging their utility as a bridge to EU membership.

The EU is much more than a free trade area. If it were only that, the case for joining the EU rather than opting for worldwide free trade would be greatly weakened. The EU offers an integrated single market underpinned by a single currency – with free movement of capital and labour – supported by institutions that make the single market work and provide an indispensable common regulatory framework plus a solid monetary policy. How does this affect the choice of the applicant countries? The strength of this institutional framework makes membership particularly attractive for countries that have had only a decade to build market institutions, or, in some cases, simply did not exist before 1990.

Before 1990 nobody would have ventured to suggest that the Soviet Union might disappear. When it did in 1991 most observers saw it as a historical accident. We argued in Gros and Steinherr (1991a), written before the split, that the explosion was unavoidable and, in economic terms at least, desirable.

It is, in fact, interesting to observe that socialist states with a federal structure – the Soviet Union, Yugoslavia and Czechoslovakia – split up during transition. There are strong reasons for this dramatic failure. First, all three federations were composed of different ethnic groups with a history of painful conflicts. Adversity was reinforced in the Soviet Union and Yugoslavia by religious differences. Second, the Soviet Union and Yugoslavia were artificial, imperial creations. As argued in chapter 1, the Soviet Union just pursued Russian imperialism by adding the Baltic states, transferred entire ethnicities and subjugated dissonant people or countries, such as the Ukraine. Togetherness was maintained only by brute force in all three federations. Third, none of the three federations provided a harmonious balance of rights and responsibilities between the centre and the states of the federation. The federal structure was a paper construction, a Potemkin façade. All the power was with a Communist Party that had a monolithic structure. States of the federations had little real autonomy. Fourth, in market-based federations, such as Germany or the United States, income redistribution is achieved through budgetary transfers. Rich states keep most of their revenue, but support less prosperous states.

Chapter 4 concluded that transition as a sui generis problem is over in Central Europe. This does not mean, however, that all transition economies are already in a state of bliss. In some, particularly the successor states of the FSU and in South-East Europe, a lot of work still needs to be done to make them prosperous.

In this chapter we do not discuss problems specific to one or a few countries. We focus on one issue that, to varying degrees, applies to all: the task of institution building. Although economists were certainly aware of the need to create markets, laws and regulations and to reform public administration, they underestimated the difficulty of implementing the advice offered. If virtually all firms are bankrupt, a bankruptcy law is unhelpful; if property rights are not clearly defined or are not enforceable, banks will not lend. It is, therefore, not surprising that unfinished business mainly concerns those activities where institutional requirements are particularly demanding. The most visible shortcomings of institution building are in the political domain, conditioning shortcomings in the economic domain. Democracy and state institutions have not progressed significantly in many countries. As two insiders of Russian reforms observe (Braguinsky and Yavlinsky 2000): ‘… the economy was not freed from old Soviet-type monopolies; rather these monopolies were freed to pursue their own goals at the expense of the large society, almost without any restraint! Thus, the controls of the planned economy are diminished, but the accountability, legal framework and supremacy of a democratic society have not been established.’

INTRODUCTION

Collusive agreements can take different forms: firms might agree on sales prices, allocate quotas among themselves, divide markets so that some firms decide not to be present in certain markets in exchange for being the sole seller in others, or coordinate their behaviour along some other dimensions. Institutional arrangements to sustain collusion might range from a very well organised cartel-like structure where a central office (secret, if anti-trust laws exist) takes the main decisions, to situations where firms merely find some form of communication to sustain the agreement. Further, a collusive outcome might be sustained even in a situation where firms never meet to discuss prices or never exchange sensitive information (but I shall argue that in such a case, labelled “tacit collusion”, the law should not intervene.)

Collusive practices allow firms to exert market power they would not otherwise have, and artificially restrict competition and increase prices, thereby reducing welfare. Accordingly, they are prohibited by any anti-trust law, and a large part of the anti-trust authorities' efforts is devoted to fighting such practices. However, while any serious anti-trust authority would certainly attack a cartel or an explicit agreement among competitors to set prices, or share markets, there might be divergences as to the standard of proof required in less blatant infringements of the law, and as to the treatment of cases where firms manage to keep prices high without overtly colluding.

The main purpose of this chapter is to identify the main mechanisms behind collusion, to study the factors which facilitate it, and to explain which behaviour should be treated as an infringement of the law and which one should not. I shall also analyse what actions anti-trust authorities should take in order to deter and break collusion.

The chapter is structured in the following way: Section 4.1.1 briefly sketches the main features of collusion from an economic point of view. Section 4.2 investigates the industry features, contractual characteristics, and other factors that make collusion more likely to occur.

WHAT ARE VERTICAL RESTRAINTS?

In most markets, producers do not sell their goods directly, but reach final customers through intermediaries, wholesalers and retailers. Further, the final good is often produced in several stages, from raw material, to intermediate good, to final product. Very often, firms at different stages of the vertical process do not simply rely on spot market transactions, but sign contracts of various types in order to reduce transaction costs, guarantee stability of supplies, and better co-ordinate actions. These agreements and contractual provisions between vertically related firms are called vertical restraints. This chapter analyses the welfare effects of vertical restraints as well as of vertical mergers, that is mergers between vertically related firms.

To gain some initial insight on the topic, consider the classical example of the vertical relationship between a manufacturer and a retailer which distributes its products. In general, both the manufacturer and the retailer decide on different actions, and what is an optimal action for one is not necessarily optimal for the other. As a result, a party can try to use contracts and clauses so as to restrain the choice of the other and induce an outcome which is more favourable to itself. (To put it another way, each party's actions create an externality on the other. Vertical contracts might be used to try to control for these externalities.)

For instance, the manufacturer would like the retailer to make a lot of effort in marketing its products (such as advertise its products, put them in evidence on shelves, employ specialised personnel who assist potential customers, offer post-sale assistance and so on), but the latter might have a lower incentive to do so, as effort and services are costly to provide. The manufacturer might then decide to use contractual provisions (that is, vertical restraints) in order to induce higher marketing effort from its retailer.

Recently, competition policy (or anti-trust policy, as it is more often called in the US) has often made the first pages of newspapers. High-profile cases both in the European Union and in the US have attracted the attention of society at large. Among the possible examples, there are US v. Microsoft (see Chapter 7 for a discussion), where the Department of Justice at one point asked for such a drastic measure as the split of the software giant into two separate companies; a few cartel cases with an international dimension (such as those involving the producers of lysine, vitamins, or the famous auction houses Sotheby's and Christie's), that resulted in prison sentences for some of the firms' managers involved; and some EU merger cases, such as General Electric/Honeywell (see Chapter 6), which was followed by public opinion on both sides of the Atlantic (and most people were surprised when eventually the European Commission blocked the deal between the two American companies).

What Competition Policy Is and Why We Need It Rather than starting by defining competition policy in abstract terms, in the book I first provide the reader with an idea of what competition policy is about through a historical approach (see Chapter 1). Only after having briefly described competition laws in the US and in the EU, do I give a formal definition of competition policy (see Chapter 2) as “the set of policies and laws which ensure that competition in the marketplace is not restricted in such a way as to reduce economic welfare”.

In this definition two elements should be underlined. The first is that firms might restrict competition in a way which is not necessarily detrimental (for instance, this is the case for most vertical restraints, that is, restrictive clauses between a manufacturer and a retailer, see Chapter 6). The second is that economic welfare, a standard concept for economists (see Chapter 2) is the objective that competition policies should pursue.

INTRODUCTION

As we have seen, the concept of market power is central to competition policy. So far, we have dealt with this concept from a theoretical point of view. This chapter introduces the reader to the issue of how market power should be assessed in practice. Many competition law investigations will start with such an assessment.

Ideally, one would like to estimate directly the extent to which a firm has (or increases its) market power. In merger cases, for instance, one might want to understand whether the merging firms will be able to profitably raise prices above the current level. Some modern econometric techniques (briefly analysed in the technical Section 3.3.2) allow us to do precisely that.

However, in many circumstances these econometric exercises are not feasible for lack of reliable data, and even when they are feasible, it might be a good idea to complement their results with the more traditional approach that evaluates the market power of firms by analysing the market in which they operate. In turn, this requires defining the “relevant market”, that is the set of products and geographical areas to which the products of the merging firms belong. It is such a set of products (and areas) that might create competitive constraints to the firms under analysis.

In this perspective, the definition of the market (both from its product and geographical points of view) is a preliminary step towards the assessment of market power.

In this chapter, I first discuss how to define a market (Section 3.2) and then how to assess market power (Section 3.3) so as to mimic the sequence that cases often follow in many anti-trust jurisdictions. Nevertheless, it should be stressed first that market definition is not of interest by itself, but only as a preliminary step towards the objective of assessing market power.

OVERVIEW OF THE CHAPTER

The basis of competition policy is the idea that monopolies are “bad”. Indeed, Section 2.2 shows that a monopoly causes a static inefficiency: for given technologies, monopoly pricing results in a welfare loss. Further, there generally is an inverse relationship between market power (the ability of firms to set prices above marginal costs), of which monopoly power is the most extreme form, and (static) welfare.

Sections 2.3 and 2.4 show that by looking only at allocative inefficiency one might actually underestimate the welfare loss from market power. A monopoly (more generally, high market power) might also result in productive and dynamic inefficiencies. Not only does a monopolist charge too high a price, but it might also have too high costs and innovate too little, since – sheltered from competition – it is not pushed to adopt the most efficient technologies and to invest much in R&D.

One might be tempted to conclude that if having one firm (or very few firms) leads to welfare losses, then competition policy should try to increase the number of firms, which operate in the industry (for instance subsidising and protecting less successful firms). Section 2.3 shows that such a conclusion would not be correct, because keeping less efficient firms artificially alive would distort the allocation of resources and reduce economies of scale, thus reducing welfare. In short: (1) competition policy is not concerned with maximising the number of firms, and (2) competition policy is concerned with defending market competition in order to increase welfare, not defending competitors.

Although there is an inverse relationship between market power and welfare under static analysis, it is not clear that the same unambiguous relationship exists when productive and dynamic inefficiencies are considered. In any event, Section 2.4 argues that market power is certainly not per se bad. Indeed, the prospect of enjoying some market power (and profits) is the main incentive for firms to invest and innovate.