Contestable Markets
A contestable market occurs when there is
freedom of entry and exit into the market. Thus in a contestable market, there
will be low sunk costs.(Costs
which can’t be recovered when leaving the market)
Factors which
determine the contestability of a market
When considering the contestability of
markets it is important to consider the different barriers to entry a new firm
may face
- Sunk Costs. If Sunk costs are high this makes it difficult for new firms to
enter and leave the market. Therefore it will be less contestable. For
example, if a new firm had to purchase raw materials, that it wouldn’t be
able to resell on leaving the market, this may act as a deterrent.
- Levels of advertising and brand loyalty. If an established firm has significant brand loyalty such as Coca
Cola, then it will be difficult for a new firm to enter the market. This
is because they would have to spend a lot of money on advertising which is
a sunk cost. Even if they spend money on advertising it may not be
sufficient to change customer loyalty to very strong brands. It depends on
the industry, customer loyalty would be fairly low for a product like
petrol because it is quite homogenous. But, for soft drinks people have
greater attachment to their ‘brand’
- Vertical Integration If a firm does not have access to the supply of a good then the
market will be less contestable. E.g. Oil firms could restrict the supply
of petrol to petrol stations, making it difficult for new firms to enter.
If you wish to sell electricity to domestic customers, a big issue is
whether you can gain access to the electricity grid. The national electric
grid is a natural monopoly, but government regulation can make sure firms
have a fair access to the grid. Giving access to different stages of
production can make the market more contestable.
- Access to technology and skilled labour For some industries like car production it is difficult for new
firms to have the right technology. Nuclear power may require skilled
labour that is difficult to get. This makes the market less contestable.
If you wished to compete with Google, you may find it hard to employ the
best software engineers because Google pays its employees a very good wage
and is seen as an attractive company to work for.
- Vertical barriers to entry in the
airline industry - If you want to set up
an airline company, you may be able to rent some planes and employ pilots
and air stewards. This makes the sunk costs relatively low. Therefore, in
theory, this market should be reasonably contestable. However, a barrier
to entry may be gaining access to landing slots at major airports.
If you wanted to set up an airline company flying
from London Heathrow to JFK, I’m pretty certain you wouldn’t be able to fly
from Heathrow. All the landing slots are taken, there is no space at Heathrow
for new companies. Therefore, this is a kind of vertical barrier to entry, you
can’t have access to the infrastructure (airport) necessary for entering the
market.
Low cost airlines have tended to fly from less
popular airports, like Stanstead and Luton, there are more landing slots
available here.
As well as looking at barriers to entry,
there are other factors that might indicate the competitiveness of a market.
- The level of profit. If the market is highly
profitable, this suggests the market is less contestable. In theory, if
firms are making supernormal profit, it would attract new firms into the
market. The persistence of supernormal profits suggests that hit and run competition is not
possible and there are barriers to entry.
- The number of firms. A contestable market
could have a low number of firms – as long as there is the threat and
possibility of new firms entering. However, if there are only a few firms
and it has been many years since any new firms have entered, then it is
likely to be less contestable. If there are recent examples of firms
entering the market, then it is likely to be more contestable.
It is important to remember that
contestability is not a clear cut issue, there are degrees of contestability,
some markets having more capacity for new firms to enter. In practice, few
industries are perfectly contestable.
Example – UK
Banking industry
- There are high sunk costs in getting a network
of banks set up around the country..
- Brand loyalty to existing banks is high.
Customers are not so willing to switch. Therefore a new firm may have to
spend a lot on advertising to attract new customers, which is a sunk cost,
therefore not contestable.
- Existing banks make very high profits, suggesting
hit and run competition does not occur.
These issues suggest banking is not
contestable. However, other factors may suggest greater contestability.
- The introduction of the internet has reduced
set up costs and enabled new firms to enter the market for online banking
e.g. EGG, Virgin business.
- The government is trying to introduce
regulation to reduce the time and costs of switching to another current
account.
Contestable Markets and the public interest
Contestable markets can bring the benefits of
competitive markets such as
- Lower prices
- Increased incentives for firms to cut costs
- Increased incentives for firms to respond to
consumer preferences
However there could also be significant
economies of scale because the theory of contestable markets doesn’t require
there to be 1000s of firms
- Therefore policy makers should not just look
at the degree of concentration, but also the degree of contestability and
how easy it is to enter the market.
- Regulators in the privatised industries have
often focused on removing barriers to entry, rather than breaking up big
firms
Methods to
Increase the Contestability of Markets
- Remove legal barriers to entry. Royal Mail used to be a legal monopoly but now firms are allowed to
enter the market for sending letters and parcels.
- Force firms to allow competitors to use its
network For example when BT was privatised, OFTEL
forced BT to allow other companies to use its network. This has also
occurred in the Gas and Electricity industries and has made them more
contestable. A firm can now gain access to the national network of gas /
electricity infrastructure
- Legislation against Predatory Pricing If a firm can engage in predatory pricing it can force new
firms out of business and make it less contestable.
- OFT can legislate against abuse of Monopoly
power. If a firm abuses its monopoly power by
restricting supply to certain firms the OFT can intervene to overcome this
restriction on contestability.
- A government firm. In the banking industry,
the government has even toyed with creating its own company to help
increase competition and increase bank lending to small firms. This could
be a last resort where private firms face insurmountable barriers to
entry.
Note, there are many barriers to entry that
the government can’t solve. The government can’t alter the economies of scale
in an industry.
