Contestable markets

4_1_5 What is a Contestable Market?

One in which there is one firm (or a small number of firms)

Because of freedom of entry and exit, the firm faces competition and so operates like a perfectly competitive firm

The threat of “hit and run entry” from new firms may be sufficient to keep the industry operating at a competitive price and output

The key requirement for a contestable market is the absence of sunk costs - I.e. costs that cannot be recovered if a business decides to leave a market

When sunk costs are high, a market is more likely to produce an price and output similar to monopoly (with the risk of atlocative inefficiency because P>MC)

A perfectly contestable market occurs only when entry and exit into and out of a market is perfectly costless

Contestable and Perfectly Competitive Markets

Contestable markets are different from perfect competitive markets

It is possible for one incumbent firm to dominate the industry (i.e. have a monopoly position)

Each existing firm in the market can and does produce a differentiated product (i.e. goods and services are not perfect substitutes for each other)

There are 3 conditions for contestability

Perfect information and the ability / right to use the best available technology

Freedom to market I advertise and enter a market

The absence of sunk costs

What are Sunk Costs?

Sunk costs are those costs which a business incurs in setting up or running a business that are irrecoverable to the owners of the firm should it decide (a) to close down or (b) leave the market

A past outlay or loss that cannot be altered by current or future actions

Sunk costs represent a barrier to entry in an industry because they scare potential entrants from entering -should they fail, they would have wasted all the sunk costs.

Making Markets More Contestable

Many countries have used government intervention to make markets more contestable in recent years - through competition policy

Main approaches

De-regulatlon - I.e. markets opened to competition by reducing statutory (legal) barriers to entry (examples include the main utilities, telecommunications and postal services)

Tougher competition laws acting against predatory behaviour by existing firms in a market / tougher rules against cartels

The changing nature of technology

Technological progress has brought down the high entry costs in some markets (an increase in capital mobility)

E.g. Desktop publishing for magazines

E-commerce - emergence of new players in travel and online bookselling

Household utilities (new entrants able to supply gas and electricity and bill households and business users at Lower cost)

UK Markets That Have Become More Contestable

Internet Service Providers (e.g. the entry of Freeserve in 1999)

Home Banking and Financial Services (home & car insurance)

Electricity and Gas Supply - OFGEM has now lifted price caps because it believes contestability has reached an acceptable level

Parcel delivery (soon to be extended to household mail services)

Opticians (the statutory monopoly for opticians ended in mid 1980s)

Low cost domestic airlines (Go, Buzz, BMI-Baby, Ryan Air)

Domestic Retail Clothing Industry - discount stores now enjoy 15% of the UK clothing market (Matalan, TK Maxx and Primark)

Case Study: Parcel Deliveries

Market was deregulated in the 1980s and is now highly competitive - even though most of the market is in the hands of major national and international players

4,000 operators are already in business offering competitive services

Local parcel courier businesses often operate profitably in individual towns and cities

Move towards greater contestability strengthened by development of the European Single Market

Strong competition in price and non-price terms

PostComm announced in 2002 that the markets for business and household mail deliveries will be fully opened to competition by the end of 2004 (two years earlier than expected)

Barriers to Contestability

Rarely is a market perfectly contestable. Existing (incumbent) firms can engage in predatory behaviour to make entry more costly or exit more expensive

Raising rivals’ costs

Vertical integration means that some firms act as component suppliers to other firms in their industry - they have control over the supply-chain

Reducing rival’s revenues - I.e. through the practice of “bundling”

A monopoly can use profits in one market to boost its market power in another (cross-subsidisation)

Bundling: Anti-Competitive Behaviour

Bundling is a marketing ploy of giving away a relatively cheap product with a relatively expensive one to attract customers

Bundling can have the effect of tying the consumer to both products

This is particularly prevalent in computer manufacturing where the product comes with specific items of software already pre-loaded

Here's an essay on contestable markets

From wiki:

In economics, a contestable market is a market served by only one firm, but with mandated "competitive" pricing, so as to second the monopoly held by said firm on said market. Its fundamental feature is low barriers to entry and exit; a perfectly contestable market would have no barriers to entry or exit. Contestable markets are characteristed by 'hit and run' entry. If a firm in a market with no entry or exit barriers raises its prices above marginal cost and begins to earn abnormal profits, potential rivals will enter the market to take advantage of these profits. When the incumbent firm(s) respond by returning prices to levels consistent with normal profits the new firms will exit. In this manner even a single-firm market can show highly competitive behaviour.

The theory of contestable markets has been used to argue for weaker application of antitrust laws as simply observing a highly concentrated or monopoly market does not mean that the firm is harming consumers by earning super-normal profits. The applicability of the theory to real world situations has been questioned, however, particularly as there are very few markets which are completely free of sunk costs and entry and exit barriers.

Low cost airlines are commonly referred to as an example of a contestable market. Entrants have the possibility of leasing aircraft and should be able to respond to high profits by quickly entering and exiting. In practice there may be barriers to entry and exit in the market associated with terminal leases and availability and predatory pricing by incumbents, signalled through built-in overcapacity.

Revision from TSR

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