REGULATING THE DEREGULATED BUS MARKET Peter MACKIE Jonathan PRESTON Senior Lecturer Lecturer Institute for Transport Studies Institute for Transport Studies University of Leeds UK University of Leeds UK 1. INTRODUCTION In 1986, the British local bus industry was deregulated. Bus operators are now free to decide what bus services they wish to provide commercially and what fares they wish to charge. There is quality control of operators, drivers and vehicles, but no quantity or entry control. The only restriction on entry and exit is that the operator must register his service, giving 42 days notice of the route and timetable which are to be offered. Local authorities may choose to supplement the commercial network by securing additional services via competitive tender. Prior to 1986, the industry had been run on public service principles and had been largely exempted from the provisions of competition and restrictive practice legislation. The basic economic argument for deregulation was the contestability hypothesis. The industry, it was argued, was characterised by constant returns to scale and no significant sunk costs. Established firms would be forced to behave efficiently in terms of cost minimisation, resource allocation and innovation, if they were to prevent more efficient new competitors from entering their markets successfully. Competitive discipline would be maintained by the threat of entry to punish greedy or inefficient monopolists. From the point of view of regulatory control of industry, high market contestability has a number of desirable properties. The equilibrium prices and output in the market should be the same, irrespective of the market structure. A single firm cannot dominate the market, nor is there any incentive to merge with or acquire rival firms so as to reduce actual competition. Neither is there any incentive to predatory behaviour, since the loss of profits involved in reducing prices and/or raising output relative to competitive levels would be irrecoverable. A theoretical perfectly contestable market can therefore be left to run itself. The Government, however, did not take this purist line at the time of deregulation, preferring a more pragmatic approach. It required the National Bus Company to be sold not as a single large firm but to be split into 70 local subsidiaries for privatisation. Moreover, the exemption from competition and restrictive practice legislation was removed; the bus industry was now subject to competition law, administered by the Office of Fair Trading (OFT) and the Monopolies and Mergers Commission (MMC), like the rest of the private sector. Indeed, it has turned out that the bus industry, which accounts for no more than one per cent of GDP, has been the focus of extraordinary attention from the regulatory control agencies during the last five years. The purposes of this paper are to describe briefly the nature of this regulatory activity, and to see 1709 STO1 what lessons can be learned both for competition policy in Britain and for the economic character of the bus industry. 2. ANTI-COMPETITIVE BEHAVIOUR Between 1986 and 1990, the OFT received 247 allegations of anti-competitive behaviour by bus operators (Dodgson, 1991). These fell into three main categories. First, there were complaints about bus station access and pricing. Clearly where the large incumbent operator owned the local bus station, he could potentially gain an advantage by excluding his competitors or by more subtle methods. In the one case considered by the OFT (that of Southern Vectis - see Table 1), the ruling was that exclusion of a small operator in this way was anti-competitive, and an undertaking was given by the major operator to permit access. The second category related to registration of commercial services in competition with tendered services. A typical chain of events might be as follows. A large incumbent might decide that one of his services was no longer profitable, and might then deregister the service. The local authority might then decide to invite competitive tenders for the service if they judged it to be socially desirable. The incumbent operator would be hoping for this, and would be expecting to win the tender. If, however, the tender was won by a small competitor the major firm might decide after all to operate a competing service commercially. The small firm might then complain to OFT that such behaviour was anti-competitive. The largest group of complaints (105) concerned allegations of predatory behaviour. On one definition, this occurs where incumbents deliberately make losses in order to eliminate a new entrant or to deter or delay entry. On another, "Predatory behaviour occurs when firms give up some of their maximum current profits after entry into one of their markets has occurred in order to eliminate the new competitor or deter or delay subsequent entry so that greater profits can be earned in the longer run" (Dodgson, Katsoulacos and Newton, 1991). This is a very strict definition because it implies that a firm operating profitably in the relevant market might still be guilty of predation. However, there are certain forms of behaviour (such as running a free bus to the same timetable as your small rival) which are clearly predatory on either definition. One possible response to the allegation of predatory behaviour would be to say that since in a contestable market, no sensible commercial firm would behave in such a manner, these must be the delusions of inefficient or misguided competitors. This has not been the chosen response however. The OFT has to date investigated four cases of alleged predation (Table 1). In doing so, it adopted the less strict definition in that for predation to be shown, the offender must incur losses, not merely forego profits. The OFT adopted a three stage approach by asking:- (i) is predation feasible? (ii) what are the relationships between prices and costs? 1710 Peter MACKIE, JONATHAN PRESTON (iii) what are the motives and intentions of the alleged predator? Predation is unlikely to be a feasible strategy in a highly competitive industry, nor is it likely to be observed in a strong natural monopoly where, misguided entrants can be left to perish of natural causes. From the literature (Joskow and Klevorick, 1979, Katsoulacos, 1991), predation is most likely to occur where:- (i) there are medium barriers to entry (ii) the market is highly concentrated and/or competition is localised (iii) incumbents operate in a multi-market industry where successful predation in one market helps to deter entry into other markets through a demonstration effect (iv) the incumbent possesses larger financial reserves than the entrant, so can use a "long-purse" strategy to finance the short-term losses. Do these conditions apply to the local bus industry? The market share figures in Table 1 indicate that all four incumbents were dominant in their local markets and had the ability to cross-subsidise from other routes. Contrary to the high contestability hypothesis, there are some entry barriers. There are some sunk costs in the form of acquiring knowledge of the market, of training employees, and of successfully marketing a new operator to a notoriously conservative public. Moreover, in the commercial part of the market, the incumbent does not have to set price at competitive levels to deter entry - the threat to do so post entry is sufficiently credible to constitute a barrier to entry (this is not such a problem in the tender market where the incumbent loses the contract for a finite period if he quotes an uncompetitive price). The desire to create a tough image - keep off our territory - has also been a feature of some operators' behaviour. It is our view that, to a greater or lesser degree, the local bus market exhibits all four of the above characteristics (Mackie and Preston, 1992). Predation is therefore a feasible business strategy; a view shared by OFT. All four of the cases therefore passed to the second stage - the price/cost relationship. The OFT took the view that pricing below short-run marginal or short run variable cost was clear evidence of predation - in effect an application of the Areeda-Turner rule (Areeda and Turner, 1975). Prices between short run marginal costs and average total costs could not be unambiguously ascribed to predatory behaviour and evidence on intent would then be required. In deciding the cases, the OFT encountered some technical difficulties. In one case (West Yorkshire), the price cut had been made so as to match the new entrant's price on the competed section of a route. The data required to estimate the revenue/cost ratio on the relevant section of route was not available, and inevitably given the existence of joint products, joint costs and overheads, were subject to a degree of arbitrariness. In another case (South Yorkshire Transport), the question of how to treat spare capacity in costing the service came up. Here, the OFT argued that these resources had an opportunity cost in that they could be deployed profitably elsewhere. In this case, prices did not even cover short-run variable costs. The most substantial of the four cases was that of Highland Scottish in Inverness. Here, prices were found to be between short run marginal and average total cost, and 1711 STO1 evidence of intent came into play. It was found that the company's Business Plan indicated a willingness to sustain losses - the "smoking gun". The case was referred to the Monopolies and Mergers Commission (MMC) which reported in July 1990, 22 months after the initial complaint. The MMC agreed with the OFT's view that Highland Scottish's conduct had been anti-competitive and against the public interest. However, in the interim, the competitor (Inverness Traction) had eventually been taken over by a larger parent, Stagecoach Holdings, and a "less hectic form of competition emerged".