Contestable Markets

Contestable Markets

1. Baumol definition - An entrant has access to all production techniques available to the incumbents, is not prohibeted from wooing the incumbent's customers, and entry decisions can be reversed without cost

2. A contestable market must have low barriers to entry and exit

   • So new suppliers can come into the market
     • In a perfectly contestable market - entry and exit is costless
       • No market is perfectly contestable but virtually all markets are contestable to some degree
         • This can have implications for the behaviour of existing firms and therefore affects the performance of the market in terms of allocative, productive and dynamic efficiency
       • Three main conditions for pure market contestability
         • Perfect information and the ability of all suppliers to make best use of the best available production technology in the market
         • Freedom to market and enter a market with a competing product
         • Absence of sunk costs
           • Reduces risks of entering the market
           • SC are the vosts committed by a business to enter a market that cannot be recovered if it chooses to exit

3. Different to PC market structure

   • A firm can have price-setting power in a contestable market
   • Firms can produce differentiated goods in a contestable market

4. The British and European economies has recently seen an increase in the number of markets with contestable characterisitcs

   • Entrepreneurial zeal
     • Persitence of entrepreneurs who don't accept the existing market structure. New firm may have product innovation or a more competitive business model based on different pricing strategies
       • E.g. King of Shaves challenging the brands of Gillette and WIlkinson Sword
   • Recession
     • Can have the effect of opening up markets to new businesses
       • E.g. 2009 demise of Setanta Sports allowed ESPN to purchase the rights to broadcast more sporting events. E.g. lead to an increase in the market share for Aldi and Lidl
   • De-regulation of markets
     • Opening up markets to competition
       • ↓ Statutory barriers to entry
         • E.g. deregulation and liberalisation of the telecommunications and postal services as part of EU competition initiatives
   • Competition policy
     • Laws against predatory behaviour by incumbent firms to ↑ contestability
       • E.g. tougher rules against price fixing cartels
   • EU single market
     • Opened up markets to member nations
       • E.g. entry of Western European clothes retailers onto UK high streets and malls
   • Tech change
     • New tech has ↓ some entry costs → ↑ capital immobility
       • Huge investments in open source software has ↑ constestability in the web browser market
   • Tech spillover
     • Emergence of products that imitate the charecteristics of the products of the incumbent firms
       • E.g. Manufactured by German firm Bayer AG and marketed by British firm GlaxoSmithKline, Levitra, was introduced to the market as a rival to Viagra just a few years after Viagra was introduced

5. It is worth emphasising that it is the actual behaviour of agents in the market is more important than a simple market picture

6. Pure monopoly might price at P1 – the profit maximising equilibrium. If a market is contestable, there is downward pressure on price, because the presence supernormal profits signals for new firms to enter the market and if the existing monopolist is producing at too high a price or has allowed their average total costs to drift higher, entrants can undercut the monopolist and some of the abnormal profit will be competed away. Normal profit equilibrium occurs when average revenue equals average total cost (at output Q2 and price P2). A lower price and higher output causes an increase in consumer surplus. When markets are contestable – we expect to see lower profit margins than when a monopoly operates without competition. The threat of competition may be just as powerful an influence on the behaviour of the existing firms in a market than the actual entry of new businesses If a market is contestable, industry structure and firm behaviour is determined by the threat of competion

   • 'Hit-and-run' entry. The market will resemble perfect competition, regardless of the number of firms, since incumbents behave as if there were intense competition

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