Assessing the degree of competition in a market is not a simple matter. Moreover, in the case of the London bus market, there are two different concepts that must be distinguished.

A market is normally said to be competitive if customers can choose from a range of products and no producer has market power over them. As noted previously there is a distinction between customers in the sense of bus passengers and the customer in the sense of London Buses' procurement department. The former are restricted to the bus operators in their local area but may also choose other modes of transport. The latter buys only bus services but may attempt to seek tenders from operators outside the area in question.

When considering whether there is competition to obtain London bus contracts it is necessary to consider the extent to which any firm might seek to obtain one, wherever it presently operates. When considering whether there is competition to serve passengers, on the other hand, one must consider services available in a particular local area.

The Director General of Fair Trading (DGFT), together with the utility regulators, has set out guidelines as to how market power is likely to be assessed under the 1998 Competition Act. The following excerpts from the guideline OFT 415 Assessment of Market Power provide a succinct statement of the criteria used. Market shares are an important indicator, but they are not the only one.

In the remainder of this section we therefore consider:

• the market shares of the various bus operators;
• their profitability;
• the choice of contractors available to London Buses; and
• barriers to entry to the market.

In the context of market shares it is worth noting not only:

• the 50% share at which the European Court considers dominance can be presumed and
• the 40% share below which the DGFT considers individual dominance unlikely, but also
• the 25% (combined) share threshold below which an anti-competitive agreement would not normally have an appreciable effect and
• the 25% share threshold for the definition of a monopoly or complex monopoly under the 1973 Fair Trading Act.

In order to calculate a market share it is first necessary to define the market. This is often a difficult process and a further competition act guideline OFT 403 Market Definition is devoted to it.

The standard test to help define the market is that of the "hypothetical monopolist". Consider a group of products, starting at the smallest level. If one firm produced all these products (i.e. if, hypothetically, there were a monopolist) could it raise prices significantly above competitive levels and gain by doing so? A significant rise is normally taken to mean 5-10% for a period of about a year. If it could not do so, because customers would switch to other products, the market is redefined to include those products and the test done again. The market is usually the smallest group of products that satisfies the test.

A market will usually include two dimensions, a product and a geographic area, but in some industries (including transport) time may also be relevant.

A journey is from one particular point to another and a change in price of the journey would need to be quite significant to prevent its being made or cause another journey to be made, as opposed to changing the mode of transport used. Travel costs can change the shops to be visited, or even the job or place to live chosen, but they are not dominant.

However, a transport service will not normally coincide with an individual's point to point journey, for which there may be a number of possible routes that can be used and between which there can be substitution.

Moreover, a market could cover transport services in quite a large area through what is known as a chain of substitution. As OFT 403 puts it:

This concept is of obvious relevance in defining the geographic bounds of a transport market.

In considering whether a hypothetical monopolist could raise prices, the possibility of other suppliers entering from adjacent markets must also be considered. OFT 403 gives an example.

However, in this case the degree of common ownership between the London bus market (and parts of it) and related markets limits the possibility of supply side substitution.

From the point of view of the passenger buses represent only one of the options available. The 1991 London Area Transport Survey found that only 9% of trips in London were by bus or coach. Nearly half (49%) were in a car, 19% on foot, 9% by tube, 7% by train, and 7% by other road use such as vans, bikes and taxis.

However, estimates of the price elasticities of demand for the various modes of transport suggest that the hypothetical monopolist test would probably put them in different markets. Kennedy, Glaister and Martin ("London bus tendering" LSE 1995) found an own-price elasticity of minus 0.67. Goodwin and Dargay (in a forthcoming IPPR publication) suggest that the long run elasticity is fairly close to -1, when lost volume would exactly offset the price rise. It is, however, noteworthy that London Buses uses minus 0.35, a figure that would strongly indicate the existence of a separate bus market.

In any event, there would still be a cost saving and so a gain to the hypothetical monopolist from a price rise. Supply side substitution is unlikely to change that judgement since, although there has been entry by a rail company, there is substantial bus/rail common ownership and there is only one tube company, which is constrained from entering the bus market.

It is useful to consider the market position across the capital, particularly from the point of view of competition for contracts, although the passenger sees a much more local market. In London as a whole no company has a market share of 25%, but three firms together hold over 52%, and the four firm concentration ratio is over 70%. The Herfindahl index is 0.15, rather above the standard comfort threshold of 0.1, and within the range of 0.1-0.18 in which the US Department of Justice guidelines say mergers will be scrutinised carefully to determine their competitive impact.

Market shares have remained fairly stable over the last few years, although that of the market leader (Arriva) has fallen from 25.1% in 1997 to 20.6% now. The offsetting rise in market share has been mainly among smaller operators outside the largest six who now account for 90% of the market, whereas the eight corresponding companies in early 1998 had a share of 94.4%

London Buses has calculated market shares in five sectors of London - North West, North East, South East, South, and South West, although the comment made with regard to the London-wide comparison applies. In two of these areas (South and South West) the largest company has a market share of over 50% and in the South East area the share is 40%. Market shares in both the northern areas are all below 40% but the three-firm concentration ratios are 91% and 77%. The Herfindahl indices range from 0.225 to 0.507. The US Department of Justice would almost always challenge a merger that took the index above 0.18.

In order to see what the position is at a level more appropriate to the passenger, the analysis was taken to that of the thirty-five local area guides produced by London Transport.

Some 540 routes were analysed covering almost 200 million miles a year and assigned the mileage in proportion to the number of local areas through which the routes passed. This enabled a figure to be assigned for route mileage in each area to each of the six major companies and to other operators, and so to derive market shares. This clearly involves approximation in that the mileage in any particular route will not be split in that simple ratio in reality and in that the market share in unanalysed routes is assumed to be split similarly between the various companies. However, the approximations are reasonable.

The results are detailed in Appendix A. The total London market share figures derived for each company show that the method produces a result close to that produced by London Buses more rigorous analysis of contracted mileage. The results for the First Group differ from the London Buses figures by a little more than those of the other companies. The figures for Croydon do not sum to 100% because three routes in the area have not been allocated to operators. However, the aim was only to obtain a broad indication of market shares; the overall figures provide a reasonable basis for that analysis.

It appears that there is not significantly more concentration at the local area than in the broad five sector analysis. The average Herfindahl index over the thirty-five areas was 0.37, compared with 0.34 for the five areas. However, both figures are large and well above the US Department of Justice trigger point.

In terms of market share there are ten areas where a company's share exceeds 60% and a further ten where a company has a share between 50% and 60%. Thus more than half the areas have companies with shares where dominance "can be presumed in the absence of evidence to the contrary". In a further ten areas the leading share exceeds 40% and there are only five where all the shares are below 40%, of which only one - Central London - has all the shares below 25%. Not surprisingly this area is the only one with a Herfindahl index (at 0.16) below the 0.18 threshold.

From the perception of the customer as passenger, it would seem that bus operators have significant market power and that, while they are not in a position to raise prices to customers, they are likely to have an economic incentive to under-provide quality, see panel overleaf Monopolists and Quality.

This conclusion is important because it implies that provision of the appropriate level of quality requires incentives to the operator over and above retention of the fare paid by the passenger. Even with a net cost contract (where the operator retains the fare) further measures to ensure quality are likely to be needed.

However, analysis at this level does not necessarily imply that the degree of competition for contracts from London Buses is inadequate. The fact that particular companies tend to be successful in each local area indicates that they may well have an advantage there. The analysis reveals how contracts have been awarded and suggests that particular companies may have an advantage in each area but, without the addition of other evidence, does not prove a lack of competition for the contracts.

A frequently quoted statistic is the margin, with operating profits expressed not as a mark-up on operating costs but as a percentage of revenue. This statistic can only be compared between similar activities, because margins can vary between industries, and even then care must be taken. The recent Competition Commission report on supermarkets commented on the effect of higher land and buildings prices (and differences in capital output ratios) as explaining differences between supermarket margins in the UK and those in other countries.

Tables 2.1 and 2.2 show margins for the major operators' London Busesinesses for 1997/8-98/9. They were of the order of 10%-15% in 1997-98, although one was 18%. White (also in the forthcoming IPPR publication) calculates a margin of 15.6% for the profit margin outside London in that year. This is larger than the 12.3% weighted London average. White calculates that bus profitability outside London has risen during the 1990s from a margin of under 2% in 1988/9 to 16.1% in 1998/9.

RUPAL - PLS INSERT TABLES 2.1/2.2 HERE AND RENUMBER IF NECESSARY

The range in 1998/9 was 8%-12% with a weighted average of 11.1%. Also shown in the tables is the proportion of operating costs not attributable to labour, to check that parent companies are not requiring unusually large transfer payments to be made to them for corporate services. The proportion is lower for some companies but the range (27%-36%) is not very large and may reflect difference in treatment of depots. Many of the subsidiaries do not carry land & buildings assets and so might be expected to be liable for a payment for the use of those assets.

Most companies quote profit or margin figures in terms of operating profit before interest and tax, as a percentage of total turnover - contract income and any associated allocation of passenger revenue. Target profit margins do not appear to have changed significantly over the last five years in percentage terms, and in fact may be falling, although the absolute profit per operated mile in current tenders is going up appreciably in real terms.

Margins cannot be used to determine whether an industry is making super-normal profits, although a comparison with margins achieved at different times or in similar industries or in the same industry elsewhere will be helpful. We have therefore attempted to calculate returns to capital employed and compare them with an estimate of the required cost of capital for the industry. These figures are more meaningful as an indicator of profitability but are less easy to derive and, in some cases, require the use of additional, sometimes heroic, assumptions. Tables 2.4 and 2.5 show returns to capital.

It is relatively easy to express profits as a return to historic cost assets (HCA), since companies provide historic cost balance sheets listing their assets. However, the figures derived are of limited use. Inflation (or other relative price movements) can mean that the economic value of the asset base can differ substantially from what is recorded in the historic cost accounts.

We have therefore also calculated a current cost value (CCA) for the vehicle stock using the values and asset lives in table 1 and assuming straight-line depreciation over their life. We calculated an average age for non-Routemaster double deckers on the assumption that all stocks of Routemasters are on average 40 years old, and assumed that each Routemaster has a CCA value of £100,000 for and does not depreciate.

We assume that land and buildings figures in the accounts, the main other element of fixed assets, are sufficiently often revalued and do not require any recalculation. Current cost depreciation has been estimated but no adjustments have been made for monetary working capital.

The object is to calculate a return to capital, both fixed and net current assets, to compare with an estimated cost of capital. We have therefore shown a return to total assets employed (both equity and long term debt) as well as a return to fixed assets, which implicitly treats current assets as a source of finance.

The return to capital that has been achieved must then be compared with an estimate of what is required by investors. The Competition Commission's reports on Sutton and East Surrey Water and Mid-Kent Water, published in September this year, give a recent authoritative view on the assessment of the cost of capital. This can be used to derive a figure to compare with those in tables 2.4 and 2.5.

Estimating a cost of capital is a rather technical subject. The assumptions used in a "Capital Asset Pricing Model (CAPM)" calculation are listed in table 2.6 so that those familiar with the subject may check our work, but we do not consider that this report would benefit from a detailed description.

The average number of bids for each tender offered fell to between two and three in late 1996 and has been at that level since that time. This represented a marked decline from the 1995 average of a little over 6 bids per tender.

Kennedy, Glaister and Travers (op. cit.) found no significant relationship between the level of bid and the number of bidders, and the insignificant relationship was positive rather than negative. However, the level of subsidy did begin to increase in 1998/99 and 1999/2000 (see Section 4 for further details).

An average of 2-3 bids seems uncomfortably low, but may be sufficient if there are no barriers to entry by others should the level of bids become too high. However, if there are barriers, a system of repeated bids from a small number of players, and with much of the bidding information subsequently published, could be conducive to the formation of a complex monopoly. The legal definition of a complex monopoly is where two or more persons control, either by agreement or by the conduct of their business, at least 25% of particular goods or services in the UK. A danger of repeated auctions is that they may make control through conduct, without written agreement, easier.

Competition in the London bus market presently operates through auctions. Auction theory (of which Klemperer Journal of Economic Surveys 1999 provides a recent summary) can provide helpful insights. We do not analyse the (first-price sealed bid) system used in general, but only remark that, from the point of view of a company wishing to use market power in an auction process, a particularly important consideration is the cost of using a bid for "signalling" to other players in the market compared with the benefits of doing so. It may be that frequent tendering of small amounts of service lowers the cost of such signalling. Signals might, for example, indicate a willingness to engage in predatory pricing. If each bid is for a comparatively small amount, the loss to a company of failing to obtain the contract or of obtaining it at the "wrong" price will be less and so the likelihood of its choosing to gain benefits from signalling is greater.

There may be barriers to entry to the London bus market caused by the concentration of ownership of bus depots, access to buses, or the scale and timing of the letting of contracts.

Depot ownership is highly concentrated. Figure 4.3 of the 1997 MMC report on the Cowie/British Bus merger and the recent plan given to us by London Buses show a picture of London with each company's depots concentrated in their areas of dominance. It is difficult to use other properties as depots because planning permission is difficult to obtain and possible alternative uses raise the price of sites. It would also seem to be difficult for entrants to gain access to existing depots. There are no examples of this taking place and existing operators do not seem to be enthusiastic about the prospect.

It is difficult to exaggerate the importance of this factor. Room to store, wash, and fuel buses near to the routes being served gives incumbents a large advantage. A potential competitor without such a facility has a severe disadvantage.

This could be eroded by easing the establishment of more depots or parking arrangements, enforcing third party access to existing depots, or the gradual sale of existing depots for other uses as the development gain clawback provisions expire by 2004. This last change would represent a "levelling down" and would be likely to be expensive for the purchaser of bus services, albeit possibly more efficient for the economy as a whole (even though with the prospect of increased wasteful dead mileage).

It is likely that problems of financing the purchase of buses against a finite five year contract deters entry by small players and that the alternative of bus leasing is too expensive. This seems unlikely to be a significant barrier for most entrants, but may be an important consideration for small-scale entry. The difficulty is one common to that of setting up a small business in almost any industry.

It may be that the main barrier to under the Buses sub-heading is represented by access to Routemasters, where these are required for operation but are in short supply for competitors. The purchase of the stock of these vehicles by TfL may merit some investigation.

The system of letting contracts means that a potential entrant has to enter gradually. To the extent that there are economies of scale this would be a disadvantage, but the literature suggests that such economies are not a major feature of the bus industry. There is a possibility that there may be administrative economies of scale in submitting tenders.

There are varying opinions about the potential for economies of scale in the bus industry but the economic literature suggests that they are small or non-existent. Certainly once a minimum size threshold has been reached there are virtually no economies in terms of production. However, part of the reason for the lack of evidence found for economies of scale in the past has been the higher overheads, more generous staff conditions and more restrictive working practices which apply in larger, former public sector companies. These tended to counter-balance the advantages of scale in procurement and finance.

Within the London market, there have been mergers and acquisitions. However, this may well have been in order to retain or acquire market power rather than to achieve cost savings. With a single tendering authority and a largely uniform set of conditions, there is apparent scope for savings in overheads. All of the large groups have sought to combine management and certain administrative functions of their London subsidiaries.

However, the actual results of the process have been less clear cut. Companies which have been taken over were often "groomed" for sale including various cost cutting measures to boost short term margins. Such measures often proved unsustainable, and resources have since had to be added back reducing the apparent scale of savings.

Econometric studies of cost functions have generally not found economies of scale or have found limited returns over some ranges of output. We cannot be definite but would not expect economies of scale to be a major factor.

The guideline quoted at the start of this paper cited a number of indicators that can usefully be recapped.

• Market share: concentration is high at the local level and so from the passenger's point of view and there is clearly market power and a need for quality regulation; but market shares in London as a whole would not automatically attract the attention of UK regulators or even the US Department of Justice.
• Competition from existing players; movement of market shares; the concentration of depot ownership makes competition in other players' areas difficult and it is our understanding that market shares have not moved greatly other than by acquisition.
• Potential competition: Entry should in theory be easy, if there are few economies of scale, but there is concentration in the UK industry in general and the difficulty of obtaining access to depots militates against entry.
• The tendering system: This itself may act as a barrier to entry especially for larger players, for whom the route based system may act as a deterrent.
• Buyer power: London Buses is a monopsonist (single buyer) and exerts considerable countervailing market power.
• Economic regulation: although London Buses monitors performance and conduct and the OFT is active in the industry, there is no formal system of regulation.
• Conduct: there are no examples known to us of abusive conduct by London bus operators.
• Financial performance: bus operators' profitability does not suggest the exploitation of market power.

The concentration of bus provision in any area (and the lack of high demand or supply substitution between buses and other modes) are such that it would be in the economic interests of bus operators to under-provide quality unless they were incentivised to do so by the contractual system.

A deregulated market would need either to result in substantially lower market shares to operate effectively or to be subject to some form of control over price and quality.

There are comparatively few bidders available for routes but London Buses has countervailing market power and concentration does not seem to have resulted in super-normal profits. The market is potentially contestable but access to depots almost certainly provides a significant barrier to entry.