Contestable Markets

Contestable Markets

Contestability theory is associated with Baumol who argues the mere threat of new firms entering a market impels existing firms to act competitively ie earn normal profits and deliver allocative and productive efficiency.

Imperfectly competitive markets can be made contestable - another policy, alongside privatisation and deregulation, for introducing competition into transport industries.
Contestable market theory is based around four concepts:

i Barriers to entry: the technical or economic factors preventing firms from entering an industry and competing with existing firms

i Sunk costs are the costs associated with leaving an industry. Firms entering an industry incur costs. Those expenditures that cannot be recovered on exit eg promotion and R&D are known as sunk costs. Sunk costs act as a barrier to entry because new entrants know that if they are unsuccessful then some set up costs are lost

i A franchise is the legal right to operate a given service for a given period of time.

Franchisees make a lump sum payment to buy a franchise, must meet quality standards as set out in a contract and invest their own capital in providing the service. Because franchises are time limited there is the threat of a potential entrant when the franchise next comes up for tender ie contestablility. However, short-term franchises that introduce contestability into transport markets also deter long-term investment where firms feel they may lose their current franchise and experience sunk costs. For this reason, the latest franchise agreements are for longer periods eg 15 years. 15 year franchises create uncontested legal monopolies.

i Hit & Run Rival firms attracted by abnormal profits ‘hit’ ie enter an industry. As increased supply forces down prices, they then ‘run’ ie leave.

Making markets contestable by reducing barriers to entry into the market means potential entrants are able to enter market quickly if abnormal profits are made. This process helps ensure normal profits only, are earned in the long run – irrespective of the number or size of firms.

It is important to understand that contestability theory does not require firms to enter the market. The theory of contestable markets argues that changing the behaviour of existing monopolist is not actual but the threat of potential competition.

A contestable market has

i One or only a few firms in the industry ie a pure monopoly or oligopoly market structure
i No or minimal barriers to entry eg - firms can enter or leave an industry freely
i Minimal sunk costs ie the costs of entry and exit are zero or minimal

The government has sought to create contestable markets in the rail, bus, ferry and air industries through deregulation (buses) and short franchises (trains).

However, contestablility is an inappropriate policy in natural monopolies like Network Rail and NATs, where regulation is more appropriate.