Discuss the likely effectiveness of ‘measures to open up and increase competition’ in the UK energy market

Edexcel A-Level Economics Paper 1 June 2018 Extract

With reference to Extract A, discuss the likely effectiveness of ‘measures to open up and increase competition’ in the UK energy market. (12 marks)

A 'temporary price cap' is likely to be effective as it should make the UK energy market more allocatively efficient. Allocative efficiency occurs when firms are producing at the point where average revenue equals marginal cost (AR=MC). This leads to a fall in price from p1 to p2 as shown in the diagram below and a policy like this would also lead to more consumer surplus, as more consumers can afford and enjoy energy without having to worry about affordability as much. They would not be paying more than they would be willing and able to. This is especially important as energy is a necessity and if firms have monopoly power, it is very easy for them to exploit customers, as demand is likely to be price inelastic.

However, these price caps are temporary and the assumption that it will increase competition may not necessarily work and these new rules implemented might affect the firms as the CMA investigation found no evidence of anti-competitiveness by firms — it might therefore make it worse for the producers and by reducing profits might lead to inefficiencies.

Secondly, the database and the smart energy meters are designed to improve transparency and make it easier for customers to switch energy suppliers. This makes it easier for new firms to attract customers which can allow for price wars to happen. This means that larger firms that previously had monopoly power and were charging high prices will be forced to lower their prices as they might otherwise lose customers. This leads to lower prices for customers, as shown below.

However, the assumption that consumers act rationally might not hold true due to issues like lack of time, and computational weakness. Some customers may be too busy and not see the value in researching various energy firms, and some may not understand how to use the database or other comparison sites, which might mean that they do not switch to cheaper firms. Also, customers might have habitual behaviour or demonstrate inertia, which means that larger energy companies can maintain high prices and continue to exploit customers.

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