affect the behaviour of businesses in the market-place.

What is a contestable market?

William Baumol defined contestable markets as existing where “an entrant has access to all production techniques available to the incumbents, is not prohibited from wooing the incumbent’s customers, and entry decisions can be reversed without cost.”

For a contestable market to exist there must be low barriers to entry and exit so that there is always the potential for new suppliers to come into a market to provide fresh competition to existing suppliers. For a perfectly contestable market, entry into and exit out of the market must be costless

The reality is that no market is perfectly contestable (there are always some “barriers to contestability” – see your revision notes on barriers to entry). That said it is also true that virtually every market is contestable to some degree even when it appears that the monopoly position of a dominant seller is unassailable. This can have important implications for the competitive behaviour (conduct) of existing firms and clearly then affects the performance of a market from an economic efficiency viewpoint (e.g. allocative, productive and dynamic efficiency)

Contestable markets and perfect competition - the differences

Contestable markets are different from perfect competitive markets. For example, it is feasible in a contestable market for one firm to dominate the industry, have price-setting power and also for firms in a market to produce a differentiated product both of which run counter to the assumptions behind the traditional model of perfect competition.

There are three main conditions for pure market contestability:

1. Perfect information and the ability and/or the right of all suppliers to make use of the best available production technology in the market
2. The freedom to market / advertise and enter a market with a competing product
3. The absence of sunk costs – this reduces the risks of coming into a market

Sunk costs – a barrier to contestability

Barriers to market contestability exist when there are sunk costs. These are costs that have been committed by a business cannot be recovered once a firm has entered the industry. It might be easier to think of sunk costs as costs that are unavoidable once they have been committed at a particular moment in time – a classic example being the money that the telecoms firms committed to winning the 3rd generation mobile phone licences at auction in 2000. When sunk costs are high, a market is more likely to produce a price and output similar to monopoly (with the risk of allocative inefficiency / market failure that follows on from this).

The Increasing Contestability of Markets

One feature of the British and European economy in recent years has been an increase in the number of markets and industries that are genuinely contestable. Several factors explain this development:

Entrepreneurial Zeal

It is often the case that markets become more competitive because of the persistence of entrepreneurs who simply do not accept that the existing market structure is a given. Decisions to enter markets where there are already dominant businesses with significant industry experience involve taking risks – but a new supplier may have the advantage of product innovation or a more competitive business model based on different pricing strategies.

De-regulation of markets – Also known as market liberalisation, de-regulation involves the opening up of markets to competition by reducing some of the statutory barriers to entry that exist. Good examples of recent deregulation include the main utilities such as gas and electricity and also the liberalisation of telecommunications and postal services as part of the European Union competition initiatives.

In postal services, all EU countries must open up business and household mail delivery services so that there is at least one competing supplier to the dominant national postal service provider. The liberalisation is scheduled to be completed by 2007. Already the Royal Mail is negotiating agreements with other postal service companies to deliver their pre-sorted mail “the final mile” to consumers. The UK postal services market was opened up to full competition in January 2006. The latest UK market review is available here.

In telecommunications, the advent of pre-carrier selection means that there is now increasing competition for land-line telephone services. British Telecom (BT Group) is now facing much greater competitive pressure from Just Talk, Talk-2, Talk-Talk (Carphone Warehouse) and other providers.

The retail clothing market in the UK has also undergone rapid change not least with the arrival of a group of western European retailers such as Primark who have taken market share from the established businesses together with the rapid entry of the supermarkets into discount clothing. Likewise, new technology has been at the forefront of a much more competitive and contestable market in DVD rentals.

Competition Policy

Tougher competition laws acting against predatory behaviour by existing firms are designed to make markets more contestable. In both the UK and the EU this has included tougher rules against price fixing cartels. When market contestability is weak, there is nearly always greater scope for cartel-type behaviour by the existing firms, particularly if the market structure in which they operate comes close to an oligopoly.

The European Single Market

The development of the Single European Market has opened up the markets for member nations. A good example of this is home and car insurance and also the entry of Western European clothes retailers onto the UK high streets and shopping malls. The abolition of block-exemption for car dealerships within the EU should also help to make the retail car market more contestable in the UK in particular and may help to bring down further the prices of new cars.

Technological Change (including the e-mergence of e-commerce)

The impact of new technology is having a huge effect, not least because it have brought down some of the entry costs in some markets (leading to an increase in capital mobility). The rapid expansion of e-commerce for example has lead to the emergence of new players in the travel sector and online bookselling, insurance and many other markets.

Technological spill-over can lead to the development of rival products that copy or imitate the characteristics of the products of the incumbent firms. Just a few years after the launch of Viagra, the anti-impotence drug, Levitra, the first market rival to the hugely profitable Viagra, is now being manufactured by the German firm, Bayer AG, and marketed by the British firm GlaxoSmithKline.

 

Contestable Markets and the Performance and Conduct of Businesses

How might the contestability of a market affect the conduct and performance of businesses? It is worth emphasising in essays and data questions that it is the actual behaviour of agents in the market that is more important that a simple picture of market share.

In the diagram above a pure monopoly might price at P1 and reach a profit maximising equilibrium. If a market is contestable, there is downward pressure on price, because the existence of supernormal profits provides a signal 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, then entrants can undercut the monopolist and some of the monopoly profit will be competed away. Normal profit equilibrium occurs when average revenue equals average total cost (at output Q2 and price P2).

From an economic welfare point of view, a lower price and higher output implies an improvement in consumer welfare (which could be illustrated by an increase in consumer surplus).

When markets are genuinely contestable – we expect to see lower profit margins (i.e. lower “mark-ups”) than when a monopoly operates without competition.  Indeed 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 dominant firm in a contestable market knows that new suppliers may come in – this may be sufficient for them to charge a price closer to the level we might expect from a competitive market structure.

Key revision points for contestable markets:

• Be familiar with the barriers to entry and exit that might exist in any given industry
• Understand how the threat of competition can affect current price and output decisions of firms within a contestable market
• Understand that market share is not a reliable guide to market contestability. We need much more detail on aspects such as price elasticity of demand, the costs of suppliers etc
• Be aware that the UK and Competition Authorities are increasingly turning their attention to the determinants of market contestability rather than a narrow focus on market share and the profitability of businesses. The emphasis of government competition policy is mainly towards opening-up markets and encouraging the entry of new suppliers (both domestic and international)