How is competition changing across the UK economy?

Competition creates an opportunity for new ideas to enter the economy, allows more dynamic entrants to displace inefficient incumbents and offers incentives for firms to keep innovating. A new Competition and Markets Authority report examines how competition in the UK has changed in recent decades.

Economists have long studied competition and the market power that firms wield in individual markets – that is, their ability to influence prices in a market. But more recently, the profession has become concerned that competition increasingly fails to work well for consumers across the whole economy.

For example, an influential study shows that one measure of market power – so-called cost markups (the difference between the cost of production and the selling price of a product) –have risen substantially across the whole US economy in recent decades (De Loecker et al, 2020).

The authors argue that this rise in measured market power has important economic consequences, including for the labour share (the proportion of national income going to employees and the self-employed) and the dynamism of the economy.

Cost markups are an attractive shorthand for market power, because they are firmly rooted in economic theory – they measure how much a firm can charge above the cost of the last unit of output produced. In addition, they can be estimated from firm-level data without knowing much about each firm’s market or how they compete.

But cost markups can also rise without competition necessarily weakening – for example, when firms need to cover large upfront costs such as software, branding or research and development (R&D). Other economists have therefore disputed whether we can say for certain that competition in the United States and elsewhere has weakened significantly.

The Microeconomics Unit at the Competition and Markets Authority (CMA) has recently published its third report on The State of UK Competition, which brings together new evidence to understand how competition has changed in the UK in recent decades.

Has aggregate market power increased in the UK?

In the UK, cost markups – economists’ preferred whole-economy summary measure of market power – have risen by about 10% since 1997 under the baseline assumptions (other approaches yield slightly higher estimates).

Most of this increase happened in the decade after 2002 (see Figure 1). This indicates that competition has possibly weakened slightly on average across the whole economy.

Figure 1: Overall market power as measured by cost markups

Source: CMA, data from the Annual Respondents Database X, 1997-2020 and Annual Business Survey, 2021
Note: Whole-economy mean cost markup series calculated via a production function estimation approach (described in the report); Calculations exclude standard industrial classification (SIC) sectors: A, B, D, E, K, L, O, P, Q, T, U; 100=1997 values

The firms that are driving the rise in markups can give us clues as to what forces are causing it. In terms of sectors, markups have been rising particularly in administrative and professional services, while those in manufacturing have been constant over time.

UK firms with larger markups are generally older, bigger and more profitable. They also seem to have a larger labour share, perhaps evidence that employers and employees in large firms share the profits arising from market power.

Another way to think about how competition has changed in the aggregate is to remember that the whole-economy markup is a weighted average. It can therefore increase either if individual firms’ markups increase, or if more weight shifts from low-markup firms to high-markup firms.

If efficient firms displace inefficient firms, the weight on high-markup firms can go up. In this case, it might look like competition is decreasing, because markups are going up on average, when the reverse is true.

But the CMA report highlights that the reallocation of market share to high-markup firms is responsible for a relatively small part of the overall change. This finding is more consistent with a weakening of competition.

Before we dig deeper into why competition may have weakened, we can think about competition in another way: business dynamism – the rate at which new ideas and businesses enter and displace old ones. This represents an important way in which competition contributes to growth. Indeed, political economist Joseph Schumpeter termed the process ‘creative destruction’.

By a range of measures, business dynamism has also fallen across the UK economy (see Figure 2). Firm entry and exit rates are lower now than in the early 2000s, the rate at which employment is reallocated from one firm to another has fallen, and so have the turnover and employment shares of young firms in the economy.

Figure 2: Measures of business dynamism, 2004-21

Source: CMA, data from Longitudinal Business Database (LBD)
Note: Young firms are less than five years old. Age of enterprises and establishments estimated using the year of first appearance on the LBD. Calculations exclude standard industrial classification (SIC) sectors: A, B, D, E, K, L, O, P, Q, T, U.

Some economists have linked this fall in business dynamism to the rise in markups. Incumbent firms may invest in branding or R&D to raise entry barriers, making it harder for new entrants to compete. As a result, entry rates fall and markups increase.

But when we look at the relationship between business dynamism and cost markups across industries, we find that business dynamism measures are higher, not lower, where markups are higher (this replicates US work by Albrecht and Decker). This outcome is more compatible with economists’ standard theories of firm entry: an opportunity for profit attracts potential entrants.

Of course, this does not mean that either rising markups or falling business dynamism are not a problem for the UK economy. Overall, business dynamism has fallen, reducing an important channel for productivity growth. The positive relationship between markups and business dynamism only suggests that the two trends might be driven by different underlying factors.

What theories can explain the rise of markups?

Cost markups measure the extent to which firms can price above the additional (or, in the language of economics, ‘marginal’) cost of producing the last unit sold. This difference gives a sense of market power.

Under perfect competition, we would expect prices to come down to equal marginal cost; firms with market power price above marginal cost and therefore earn higher profits. But firms may also price above marginal cost because they need to cover the costs of upfront investments, such as software, branding or R&D.

Economists have two explanations for why cost markups may have risen across the whole economy in recent decades. One is a story of rising pricing power: maybe markets have become more concentrated (dominated by a small number of companies) and firms are getting better at exploiting their pricing power over consumers. Sometimes, this explanation is linked to arguments about rising merger activity across the economy and falling competition enforcement.

The other is a story about the changing nature of production: perhaps technologies have changed in ways that have made upfront fixed-cost investments like branding, software and R&D more important. If this is the case, firms across the economy spend more upfront, but can then produce additional units more cheaply or even for free (for example, in the case of software products).

In reality, both explanations are likely to be true to some extent, and of course even though the second seems more benign, it still raises challenges for competition agencies such as the CMA. Upfront investments – while perhaps necessary to produce certain goods and services efficiently – may still create barriers to entry and therefore entrench incumbent firms.

What might be behind the rise in aggregate market power?

Several pieces of evidence can give us clues as to whether technological change or pricing power might be behind the rise in markups. First, sales in the average UK industry are not more meaningfully concentrated now than they were 20 years ago. This means that the number of firms competing for buyers in the average industry has not changed substantially.

We should nevertheless treat this finding with a pinch of salt, because there are big challenges with measuring concentration for the whole economy. Standard industry classifications do not exactly correspond to the markets in which firms compete, and we completely miss the geographical dimension of competition.

Second, the number and value of mergers in the UK has risen across the economy over time. This may appear consistent with a story of rising consolidation and pricing power, but the evidence does not bear this out.

The industries with the biggest increase in mergers are not those that have seen their markups increase the most. Mergers are therefore unlikely to be an important driver of rising markups, indicating the effectiveness of merger control as a check on market power.

In addition to evidence that speaks to pricing power, we can also examine evidence that is directly relevant to the technology story. As the CMA Microeconomics Unit report shows, the UK has continued to de-industrialise over the past two decades, with its manufacturing sector shrinking and its services sector growing.

Since services generally have a higher fixed-cost share, this will tend to raise the importance of fixed costs across the economy. Even within industries, firms have become less responsive to material inputs over time, signalling technological change.

Finally, sectors with the largest rise in markups, such as administrative and professional services, do not see a corresponding rise in the profit share. This too indicates that the importance of fixed costs in the UK may be rising.

How does the UK compare to other countries?

Comparing the UK with other, similar countries allows us to put the change in competition across the economy in context. Across cost markups, concentration and measures of business dynamism, the trend in the UK is similar to that in other European countries.

For example, the rates of job creation and destruction are broadly similar across countries (see Figure 3). This suggests that wider structural trends may be partly at play.

Figure 3: Job creation and destruction rates across European countries, 1997-2021

Source: CMA; data from the Competitiveness Research Network
Note: Estimates of job creation and destruction; other countries include Belgium, Croatia, Czechia, Hungary, Latvia, Lithuania, Malta, Poland, Portugal, Romania, Slovakia, Slovenia and Switzerland. Denmark, Finland, France and Sweden are excluded. Calculations include statistical classification of economic activities in the European Community (NACE) sectors: C, F, G, H, I, J, L, M, N; 100=2011 values.

What do these developments mean for consumers and the wider economy?

Competition is important for growth, by providing incentives for firms to compete and innovate, and by allowing new ideas and firms to replace less efficient incumbents. But firms with market power may seek to create barriers to entry, thus slowing the diffusion of innovations throughout the economy.

The CMA’s report on the state of UK competition shows that not only have markups risen on average since the early 2000s, but they are also more dispersed now. This dispersion suggests that the frictions in the economy may have increased over time and slowed down the spread of new ideas and technologies.

What do whole-economy competition indicators miss?

Any one-dimensional competition indicator necessarily misses a lot of the nuance and complexity in how firms interact with each other, and with consumers. Businesses form part of complicated supply chains, and goods often cross national borders multiple times. Businesses are also linked by ownership networks, and many firms in the UK have market power not just in product markets, but also in labour markets.

Markups vary substantially depending on where firms sit in supply chains and by their exposure to international trade. Ownership networks are more common within than across industries, raising the possibility that common ownership may distort firms’ incentive to compete.

Finally, the CMA Microeconomic Unit’s earlier report on labour market power shows that employer market power in UK labour markets is common – meaning that powerful firms are able to set pay and other working conditions. But this is decreasing slightly over time.

What are some of the open questions?

There is still much that we do not know about competition and market power across the whole economy. First, cost markups can rise because prices rise or because costs fall. But the consequences for consumers can be quite different in both cases.

Even if we are sure that prices rise, is this because businesses are producing better products or because they are better able to exploit their pricing power? These questions matter for consumer welfare, and therefore for policy.

Second, if competition has weakened, who is most affected by this change? We know that markets (including labour markets) vary widely in their size and concentration, but more systematic evidence is needed. We also know too little about the redistributive effects of market power.

Finally, after a few decades of more sluggish innovation rates, there are signs that we might be at the cusp of a period of widespread technological change. A combination of increased data collection and use, and advanced analytics techniques, referred to as artificial intelligence (AI), is changing the way in which businesses and consumers interact with each other.

This change could have profound implications for how markets work, and how surplus is created and shared. For example, will AI lower or raise the barriers to entry? And who benefits when data become the most important input? Evidence on these questions is sorely needed.

Where can I find out more?

The state of UK competition report 2024: CMA analysis examining how competition is working across the UK economy.
The rise of market power and the macroeconomic implications: Jan De Loecker, Jan Eeckhout and Gabriel Unger estimate cost markups for the United States over the long run and make the case that this indicates growing market power that can explain many other secular economic trends, such as rising capital shares and declining business dynamism.
Industrial organization and the rise of market power: Nate Miller surveys the evidence and argues that technological progress is more likely to be behind the widespread rise in cost markups than an economy-wide rise in market power.
Do increasing markups matter? Lessons from empirical industrial organization: Steve Berry, Martin Gaynor and Fiona Scott Morton summarise what we can learn about the debate from studies of individual industries and point out some open questions.