Contestability Essay for Wednesday 7th

This is a decent if dated piece from tutor2u.

http://www.tutor2u.net/economics/content/revessay/contestability.pdf

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

1. 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.

2. 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’
3. 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.
4. 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.
5. 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

1. There are high sunk costs in getting a network of banks set up around the country..
2. 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.
3. 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

1. 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.

2. 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

3. 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.

4. 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.
5. 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.

http://www.economicshelp.org/microessays/contestable-markets/ 

What is the theory of contestable markets?

As Chapter 9 explains, in recent years, much of the debate about the best way of dealing with the problems posed by monopoly has reflected the growing influence of contestable market theory. Before the advent of this theory (and of the wider free-market revival of which the theory of contestable markets is a part), competition policy was generally interventionist. Increased intervention was justified by the alleged need to countervail the growing power of large business organisations.

By contrast, contestable market theory is now used to justify a much less interventionist approach.The theory suggests that monopoly should be defined not by the number of firms in the market or by concentration ratios, but rather by the potential ease or difficulty with which new firms may enter the market. Actual competition in a market is not essential; the threat of entry by new firms (or potential competition) is quite enough to ensure efficient and non-exploitative behaviour by existing firms within the market.

For a market to be perfectly contestable, in the long run there must be zero costs of entry and exit and firms must be able to enter or leave it quickly. This means there must be no barriers to entry and no sunk costs. Sunk costs are costs that must be incurred to enter the market, but which cannot be recovered if the firm decides to leave the market. In these conditions, hit-and-run market activity is likely to occur. ‘Hit and run’ describes a situation in which a new firm enters or hits the market to see if normal profit can be made. If profit is insufficient, then given the absence of sunk cost, the firm leaves or runs from the market.

Investigation into the Cocoa Market

http://www.bbc.co.uk/news/uk-england-11136797 - Fair Trade Video

http://www.bbc.co.uk/news/business-10682433 - Speculator activity

http://www.bbc.co.uk/news/business-11316915 - Disease in Cocoa Supplies

You may wish to take in the movie "Trading Places" as part of you research - NB - note what happens to frozen orange futures!

Use the above links to investigate the chocolate market.

Choose you own angle!

The Spalding Pumkin Patch

http://www.bbc.co.uk/news/uk-11450538

The market for pumkins in the UK grown as the UK.

a. What factosr have affected the demand for Pumkins? Explain each.
b. What would happen to the market for Pumkins if the juice from pumkins was found to have magical properties? Explain the short term and long term effects. be precise about what the ST and the LT is for this market.
c. What might happen to suppliers of pumkins in the future if these properties were found to be a hoax?

The Impact of Markets - Connaught

http://www.bbc.co.uk/news/uk-england-devon-11257374

The demise of Connaught has led to the rapid acquisition of the efficient parts of the business. This story from the Beeb explaind part of the story.

How does it relate to efficiency and the power of markets?