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.

Define industrial policy

Industrial policy is the name used for the elements of government policy that aim to make industries,markets, and firms within the markets function better. Industrial policy is microeconomic rather than macroeconomic. From the 1950s until 1979, UK industrial policy was interventionist rather than antiinterventionist,reflecting the Keynesian and mixed-economy assumption that, left to themselves,markets are prone to market failure (see Chapter 10). The Keynesians believed that government intervention to subsidise and protect industries, particularly in the fields of research and development and regional location, generally made markets function better.

However, ever since the free-market revival in the 1970s, government intervention to prop up uncompetitive industries (often called ‘lame ducks’, ‘hospital cases’, ‘geriatric industries’ or ‘sunset industries’) has gone out of fashion. The free-market view is that business people, rather than civil servants, know best, and that, far from creating a level playing field for domestic firms to compete with foreign rivals, government aid to industry results in the waste of taxpayers’ money and government failure caused by picking losers rather than winners.

UK industrial policy is administered by the Department for Business, Enterprise and Regulatory Reform (BERR), until recently known as the Department of Trade and Industry (DTI). Over the years,and in response to the pro-free-market anti-interventionist view, the money spent on UK industrial policy by the BERR has fallen and is now only a very small part of total government spending.

Immediately after the 2005 general election, a rather odd sequence of events occurred. In its third term of office, the New Labour government decided the DTI (as it was then called) needed rebranding as the Department of Productivity, Energy and Industry (DPEI). However, this name lasted only a few days. The government realised it would be difficult to justify spending hundreds of thousands of pounds renaming government buildings and reprinting office stationery. However, this unfortunate experience did not prevent the department being rebranded as the BERR in June 2007.

Regulation in Markets

Imperial Tobacco fined £112m and Co-op and Asda were penalised by £14m each

http://www.guardian.co.uk/business/2010/apr/16/oft-levies-225m-for-cigarette-price-manipulation

• How does price fixing affect consumer surplus and producer surplus?
• Does fining firms for such exploitation stop them for doing the same thing again?