3.4.7 Contestability PDF

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Contestability notes...

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3.4.7 Contestability A contestable market is a market where there is freedom of entry to the industry and where costs of exit are low. firms looking over their shoulders High B to E—> Surrogate competitor American market losing out to cars, already lost solar panels to China Slow rate of obsolescence: tech invested you want to last for years Monopoly can control themselves against external obsolescence Thyroid drug example of abuse of monopoly power by concordia company, £4.46 2007 1 pack in 2017 £256.19 1 pack A contestable market has low barriers to entry and exit (perfect competition and monopolistic competition). In reality most industries are dominated by oligopolies and monopolies, with high barriers to entry and exit and a low level of contestability. Contestability has a significant influence on a firm’s behaviour. Characteristics of a neo-classical contestable market: •

Firms are short-run profit maximisers, producing where MC=MR

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Abnormal profits can be earned in the short-run

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Only normal profits can be earned in the long run

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Firms compete rather than collude to fix prices

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There is perfect knowledge

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Firms produce either homogenous or differentiated goods

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The number of firms varies from many to one

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Firms are productively and allocatively efficient

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Firms are dynamically efficient (though a non-contestable market may be more so!)

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There are no barriers to entry and exit (including sunk costs) Absence of sunk costs

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Greater entrepreneurial activity

Natural monopolies are characterised by innocent or structural entry barriers such as very high capital and exit costs. Behavioural barriers are deliberate and include predatory pricing; limit pricing, collusion… some of which are illegal. The development of a brand usually takes many years and involves considerable sunk costs (marketing). The competition authorities are not concerned by the level of market concentration but by how contestable the market is i.e. the level of potential competition. A firm could enjoy monopoly power but if it is exposed to potential competition then it will behave competitively – maintain low prices, high quality, strive to maximise efficiency to reduce costs and so on. They will act in the consumers’ interest if they are looking over their shoulder at potential entrants, including importers.

Threat of entry

If there are low barriers to entry the incumbents are susceptible to hit and run competition – firms can enter the market at low cost attracted by high profits and then leave the market at low costs when profits fall. Abnormal profits will be competed away leaving only normal profit. No market is perfectly contestable. In the absence of potential competition the authorities can act as a surrogate competitor. Faced with fines and other legal action for the abuse of market position, firms will behave as if a real competitor existed.

Barriers to market entry and exit Examples of barriers to entry include: • Economies of scale • Limit pricing

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Legal barriers (patents etc) Sunk costs (advertising…..)

Students will be expected to discuss the significance of barriers to entry and exit to firms operating in different market structures Barriers to entry are designed to block potential entrants from entering a market profitably. They seek to protect the monopoly power of existing (incumbent) firms in an industry and therefore maintain supernormal (monopoly) profits in the long run. Barriers to entry have the effect of making a market less contestable A firm’s behaviour is influenced by the number and size of its competitors (actual and potential) Markets will be more contestable if the cost of entry (overcoming barriers to entry) is substantially below the expected gains (post-entry profit) Threat of entry will encourage incumbent firms to be efficient and operate at ‘competitive’ levels of price and output – theoretically making a normal profit (AC=AR)

Firms will aim to profit maximise (and so produce where MC=MR) but in the long run more firms will be attracted into the industry by the presence of supernormal profits and so any supernormal profits will be competed away. This means that the long run equilibrium will be where AC=AR (just

Contestability varies between industries and market structures. Perfect competition is perfectly contestable.

Highly contestable

Very low contestability

Hit and Run - in a highly contestable market without limit pricing and low exit costs, new firms can enter and grab some of the industry’s abnormal profit before the dominant firms have time to react e.g. by using predatory pricing.

Double-glazing is a prime example. New firms (including ‘cowboys’) frequently enter and then leave the market – competing against household names such as Everest

Firms will carefully evaluate the cost of entering a market, the post-entry profit and the cost of failure (80% of firms fail in the first 18 months!) The deregulation of markets increases contestability – for example the Big Bang – a sudden deregulation of the financial markets in London in 1986. Formerly protected jobs and businesses were opened to competition leading to a boom in the financial market and an expansion of the City to Canary Wharf. Many old firms were taken over by large foreign and domestic banks.

First mover advantage – the first firm in a market has an opportunity to establish a strong brand reputation, making their product price inelastic. It may be difficult to transfer to alternative suppliers – for example having paid for an iTunes library why swap to a different platform. Eventually technology catches up and music is now free on demand on mobile phones, but Apple ruled the market for many years. Late entrants can take advantage of the mistakes made by the first movers and use new technologies – they haven’t invested in what might become obsolete plant and machinery.

Barriers to entry:

Capital expenditure and expertise e.g. oil industry

Economies of scale – incumbents have a cost advantage (asymmetry of costs)

Research and development – also has important spill-over effects that improve production processes

Patents - Giving the firm the legal protection to produce a patented product for a number of years

Control of inputs – De Beers own most of Africa’s diamond mining land

Information asymmetry – information is costly to obtain. Small firms have an information gap.

Advertising / Brand loyalty – high sunk costs to compete e.g. v Nike...