SOME ISSUES IN MICROECONOMIC REFORM (draft #1)

The purpose of this speculative paper is to identify contextual issues which may need to be considered in future implementation of micro economic reform.

The paper first outlines the need for microeconomic reform as demonstrated by the Industry Commission, and then suggests a number of unresolved issues. Those issues are:

· the need to be very clear about why more competition is needed now;

· whether competition is enough (and if not what else is needed);

· how to introduce competition without eroding government's non-economic roles;

· the need for an informed response to East Asian economic styles

It is concluded that micro-economic reform (through introducing competitive markets) will increase economic efficiency. However whether this is sufficient to deal with all current challenges is (as yet) unknown.

1. the case for reform

The Industry Commission's 1994/95 Annual Report demonstrated the need for microeconomic reform through the creation of competitive markets as follows:

Growth is important to the economy. Sound macro-economic policy can aid growth, but removal of structural rigidities is also important to raise productivity (which is the major source of increased income). Productivity improvement can reduce employment but also allows prices to fall, and sales to expand.

Microeconomic Reform Can Help: There are limits to what government can do (though they have an important role in establishing an institutional, regulatory, and policy framework conductive to competition, entrepreneurship and investment). Measures to improve performance include: increasing competition; removing interstate trade barriers; improving accountability; ensuring pricing practices which encourage efficient investment and consumption; and address issues of ownership, monopoly and access to networks. The Commission has studied the scope for government intervention to improve on market failures (eg the need to make public research better directed and less discriminatory; and to make government purchasing more efficient - with greater administrative competence). Governments' desire to provide welfare services and health and safety can be aided by more accurate pricing systems. Many reforms can help. Reform would also allow Australia to be more competitive internationally (noting the need for this due to removal of restrictions on international trade). Unilateral removal of restrictions on productivity of our own industries is needed. Australia has traditionally run a current account deficit, for which the best solution is macroeconomic policies to boost savings (rather than efforts to subsidise exports or reduce imports, which reduce productivity and real income). Australia must be an attractive place to invest. The 1995 Governmental Agreement on competition will expose previously sheltered sectors to competition (though much work is still required in establishing access regimes and prices oversight). The task is harder if trade and industry policies are inconsistent.

Competition is central to an Effective Micro-economy: Competition provides a powerful stimulus for efficiency. It also motivates response to market changes, and innovation to contain costs or develop new products. Competition has been the mainstay of Australia's micro-economic reforms. The rate of reform varies, but all governments have introduced competition and encouraged the private sector to participate in traditional public sector activities.

Implementing National Competition Policy: The Hilmer Report in 1993 proposed a competition policy framework, which resulted in government agreements in 1995. This requires work on: structural reform of public monopolies; access to essential facilities; and prices oversight. Consistency with other policies is also required. Australia has been exposed to greater international competition by tariff reforms. However other industry support measures (budgetary outlays, government procurement, anti-dumping measures, and restrictions on trade in services) all need attention.

2. Some Questions

The Industry Commission (IC) argument seems valid as far as it goes (ie introducing competition will improve economic efficiency), but it leaves unresolved a number of other important questions.

(a) Why is competition needed now more than in the past?

The IC Annual Report does not explain why countries like Australia now have to become more competitive to achieve growth. The reason presumably lies in the poor growth prospects and declining terms of trade of Australia's traditional resource based industries. However because the background was not mentioned, the IC has not demonstrated that its prescription is adequate in the current international environment where the nature of the competition and of the requirements for success are no longer what they were. .

(b) Is competition enough?

A number of factors suggest that exposing entities to competition may not be sufficient to allow them to compete effectively, and that it may be impossible for those entities individually to deal with this.

Firstly some non-competitive practices have their origins overseas, and it may be beyond Australia's ability to prevent these disadvantaging local enterprises. For example, an observer suggested that competition amongst stevedores at the Port of Brisbane was limited by restrictive agreements which have their origin overseas, and that this prevents entry by new competitors. Furthermore Section 2(d) below suggests that some restrictive arrangements originate in East Asian cultures which Australia's legal system can not influence. This issue is very important for Queensland as Australia has been said to have the highest level of foreign ownership of any OECD country (while Queensland has the highest level in Australia).

Secondly, competition in itself (which provides incentive for competition) does not ensure adequate economic capabilities for competing effectively. For example, Australia's private sector (especially Queensland's) is relatively ineffective despite being subjected to competition. And eighty percent of new small businesses fail in the first five years, while 95% of new franchisees succeed. Clearly something more than a competitive environment is needed for success. This question has direct significance for government because GBEs are to be exposed to competition (and significant quantities of government revenues depend on their success).

Thirdly, individual enterprises do not unilaterally determine their own performance, because each depends on outside support (business services, suppliers etc). Whilst enterprises may wish to respond to market changes (eg with innovation) their ability to do so depends to a significant extent on the economic system as a whole. The necessary support structures (eg in an industry cluster) may be very slow to emerge because of a `chicken and egg' problem. Some of Australia's competitors (eg in East Asia as outlined below) appear to have methods to overcome this constraint.

Fourthly, the key requirement for productivity is no longer efficiency (traditionally gained through deployment of capital for mass production). Rather it involves the effective deployment of knowledge. Knowledge (eg of technologies, markets) is at the centre of current theories of long term economic growth, and of many firms' competitive strategies. Whilst competition stimulates efficiency, it does nothing to boost knowledge (and, to the extent that knowledge constitutes a 'public good' as speculated in new growth theories, competition may inhibit mobilising knowledge).

Finally there is current uncertainty about what type of industrial structure would allow Australian firms to be effective. The business community is calling for mergers to be allowed which provide `critical mass' (though they reduce competition).

'One of their (ie businesses') main objectives was to get a softening of trade practices law. ... The BCA wants a version of the Trade Practices Act which regulates corporate mergers with an eye to allowing companies to achieve critical mass . ... They are also critical of the competition watchdog, the ACCC, for regulating mergers more stringently than they believe is necessary to protect competition ... The ACCC (according to Industry Commission) ... was actually working against mergers which would improve the economic efficiency of Australian companies' (Murphy K. `Big business wants bigger business', Financial Review, 9/7/96).

The possible need for 'critical mass' emerges from the nature of the international competition. For example, it was recently said that:

Sumitomo had 'become a leading world player in copper ..., from mines to phone lines, not just in copper futures and options and other fancy trading instruments. The copper wire that carries telephone conversations, the copper coils in compact disk players and the copper in car radiators may all have been supplied by Sumitomo. ..... This could mean that Sumitomo's copper trading influenced prices and supplies in ways that probably benefited its business in mining and smelting, as well as the physical copper business'. (WuDunn Sheryl, ' Behind the Sumitomo Scandal: The Drive to be Copper King', Financial Review, 9/7/96)

Such international competitors operates under principles which are quite different to those envisaged by the IC (as outlined in Section 2(d) below).

(c) What effect does competition have on government's non-economic roles?

Before the industrial era, which introduced economic and social goals, governments already had many important functions (eg defence, law and order, leadership). These (rather than service delivery) are government's core functions.

Governments have acquired responsibilities for the provision of goods and services over the past century, and these may now account for 95% of government's resource usage. It is to the improve these provision of goods and services that competition is proposed by the IC. However many of those same resources have been used also to support government's core roles, and considerable care is needed in the application of competition to 'goods and services' functions to ensure that support for government's core roles is not eroded (eg reliable policy advice requires sharing of information and co-operation amongst different functions; which competition amongst them discourages).

Governments also have social responsibilities (many of which involve redistributing wealth to avoid the normal outcomes of a competitive market). There seems international evidence that competitive markets on their own result in maldistribution of wealth (ie because individuals' pre-existing advantages / disadvantages are amplified rather than being reduced). The IC notes that creating correct pricing structures can (at times) improve the achievement of social goals, but the implications for equity have apparently not been evaluated.

The NCP Agreement specifies that competition will be introduced where benefits outweigh the costs (taking into account ecological sustainable development, social welfare / equity including CSOs; occupational health and safety; economic and employment development; consumers; business competitiveness; and efficient resource allocation). However no one seems to have assessed the equity effect of increasing competition, which has the effect of reducing government's informal redistributive roles.

This is increasingly significant in Queensland as pockets of relative disadvantage are growing (with adverse social consequences).

(d) Have the implications of East Asian development been considered?

The IC has not mentioned the East Asian communitarian economic style, despite rapid development and growth in the region, and increasing debate about the different styles of market economies which now exist (eg Thurow, 'Head to Head')

East Asia appears to adopt radically different informational and organisational strategies to those of the West. Fundamental differences appear to arise in the nature of economic motivation, markets, power, government and strategy. For example, community welfare as perceived by traditional leaders (who may not be politically prominent) is the normal economic goal (rather than consumer welfare). Power is based on hierarchical position, with the strategic use of knowledge to influence how others think (rather than as a means for rational decision making by leaders). Markets are an extension of long term social relationships, rather than being based on arm's length relationships under contracts and law. Government is by bureaucratic elite, not by democratic politics. Strategy includes effective long term components through influencing the way things are done, and also through encouraging naive opponents to take steps which weaken their long term position ('The Art of War').

Thus Japan's economics (for example) has quite different features to that in the West. Competition is encouraged, but 'too much' competition is discouraged. Market share is maximised, rather than profitability (resulting in 'strategic conquest' of markets rather than maximising return to investors - according to Thurow). Strategic pricing (where profits from one sector are used to underprice competitors in other sectors) is feasible within business groups (resulting in what is described as 'dumping'). . Vertical integration (which is quite contrary to the competitive principles of microeconomics) is implicit in the 'social' basis of commercial relationships; and can not be eliminated through 'law' because it is based on cultural, rather than contractual, arrangements. And sector wide agreements can be orchestrated amongst competitors, which has been said to have cost Australia many billions of dollars in coal exports (ref). One observer has suggested that Japan's current strategy involves creation of `global natural monopolies' in various sectors, which might permanently resist outside competition (Fingleton., `Blindside')

A key point may be that in East Asia (which has an ancient Chinese heritage, rather than the West's classical Greek heritage) economics is founded on the notion that causal relationships in a social / economic system can be changed, rather than being modelled, which is the basis of Western economics (with its desire to be seen as a 'positive' science like physics).

There is no certainty which approach will 'win' as yet. There are (for example) seeds of economic, political and social instability in some East Asian economic management styles. And government's like those in Australia probably can not do much more than the IC suggests (ie create market framework, and promote competition), but as some government's in East Asia have apparently been able do more, the question of what response is adequate needs more consideration in assessing the appropriate approach to micro economic reform.

16/7/96

not argument about j as establishing global natural monopolies - what use if TPC if competition is prevented by global strategies; likewise what of multinationals. - perhaps the basic point is that competittive market tends to ----

Government carries considerable weight as a purchaser, and can by its decisions (say where centralised purchasing is involved) have a considerable impact on reducing scope for competition (eg by enterining into arrangements for preferential supply from a small number of suppliers).

it is assumed that productivity enhancement would not improve the current account deficit (because spending could increase to match earnings, so that savings did not rise). However it is not mentioned that: there is no necessary connection between savings and investment; and that investment may not necessarily be productive (without well developed economy). Woirld Bank view was that in East Asia growth led to savings, not the other way around. The point is that relationships are complex, and furthermore they are not given (ie changing community attitudes would allow productivity improvement - ie income to feed into savings)

(d) Are the principles of micro economics soundly based?

The IC bases its recommendations for the creation of competitive markets on micro economics. However there is some debate about the validity of conventional economics. For example:

· some observers have claimed that economics has not had useful prescriptions over the past 2 decades (references - death of economics etc)

· some have questioned whether economics can usefully be a prescriptive science (ref)

· it was recently suggested that economics is not a science based on natural law, but is based firmly in the context of the existing capitalist social order (Hielbroner and Milberg `The Crisis of Vision in Modern Economic Thought', ref)

The latter point perhaps illustrates why the question about the adequacy of economics has not been resolved, ie because it is still assumed that the choice is between socialism and capitalism, rather than amongst different styles of capitalism.

The IC takes a similar approach, because it conceives of (and rejects) government intervention in terms of subsidies and regulatory restrictions (which is the conventional form of intervention in Western societies). But it does not consider intervention in terms of the apolitical strategic leadership (ie vision development and administrative guidance) which apparently accelerated economic 'learning' in Japan over the past century (ie where the 'currency' of intervention is knowledge).