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Contestability of Indian-cuisine restaurants in Batam

To what extent are the Indian-cuisine restaurants in Batam operating in a contestable market?

Subject: Economics

Word Count: 3994

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Contents Page

Title Page………………………………………………………………...…………………....1 Contents Page……………………………………………………………..………………….2 1 -

Introduction………………….…..……………………………………………...….3-5 1.1 Goal and Hypothesis……..……..………………………...……………………...3 1.2 Why I chose this topic and its significance…………………………………..….4 1.3 Method…………….……..………………………………………………………..5

2 Theory and Analysis……………..……………………………………………….6-27 - 2.1 Overview………………………………………………………………………….6 2.1.1 Theory and Realism of Contestable Markets …………………………………....6 2.1.2 Overview of the Indian-cuisine Restaurants in Batam…………………………..6 - 2.2 Assumptions of Theory and Analysis………………………………….….…….7 2.2.1 Barriers to entry for potential entrants …………………………………………..8 2.2.2 Sunk Costs……………………………………………………………………...11 2.2.3 Pool of Potential Entrants……………………………………………………....13 2.2.4 Perfect knowledge……………………………………………………………...15 - 2.3 Implications of theory and Analysis…………………………………………...16 2.3.1 Normal Profit due to hit-and-run entry………………………………………...16 2.3.2 Productive and Allocative Efficiency………………………………………….20 2.3.3 Competition present; Collusion absent………………………………………26 3

Conclusion and Evaluation………………………………….…………………….28-30 - 3.1 Conclusion……………………………………………………………………….28 - 3.2 Evaluation……………………………………………………………………….28

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Bibliography………………………………………………………………………..31-32 - 4.1 Books…………………………………………………………………………….31 - 4.2 Researches, academic journals and other publications ………………………31 - 4.3 Internet…………………………………………………………………………..31

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Appendix……………………………………………………………………………33-43 - 5.1 Appendix 1………………………………………………………………………33 - 5.2 Appendix 2………………………………………………………………………39 - 5.3 Appendix 3 ……………………………………………………………………...43

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1 Introduction The Batam city of Riau Islands in Indonesia is one of the fastest developing cities 1 in the world. It is a popular residential area for expatriates, including Indians, due to its calm political and economic climate2. Tourism statistics for 2017 show that 3000-70003 Indians visit Batam every month. Hence, there is an increasingly high demand for Indian food, which has been incentivizing the establishment of multiple Indian-cuisine restaurants in Batam. With one that had its inauguration on August 2017, Batam now has 8 Indian-cuisine restaurants.

1.1 Goal and Hypothesis The rapid establishment of new Indian restaurants indicates a potential threat of competition for incumbents, which is a characteristic observed in contestable markets. Hence, this research investigates the extent to which Indian restaurants in Batam abide the model of a contestable market.

The following research question has been developed: To what extent are the Indian-cuisine restaurants in Batam operating in a contestable market?

Contestable markets revolve around potential threats of competition rather than the existing competition in the market.4 For this market to be contestable, it must illustrate characteristics that catalyse potential threats of competition.

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Massy-Beresford, H. (2015, November 18). Where is the fastest growing city in the world? Retrieved June 17, 2017, from https://www.theguardian.com/cities/2015/nov/18/where-is -the-worlds-fastest-growing-city-batam-niamey-xiamen 2 Expat Living in Batam, Indonesia. (n.d.). Retrieved June 22, 2017, from http://www.expat.or.id/info/batam.html 3 Monalisa, Y. (2017). Jumlah Kunjungan Wisatawan Mancanegara Berdasarkan Negara Asal Kota Batam, Provinsi Kepulauan Riau(pp. 1-7, Rep.). Kota Batam, Kepulauan Riau. 4 E. (2013, December 23). Retrieved June 22, 2017, from https://www.youtube.com/watch?v=phnDunnl_Uw Y2 26) Contestable Markets

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Based on the statement above, the following hypothesis has been developed: The Indian-cuisine restaurants in Batam are surrounded by potential threats of competition, and therefore, operate in a contestable market to an agreeable extent.

The goal of this essay is to answer the pre-mentioned research question and conclude whether the hypothesis holds true.

1.2 Why I chose this topic and its significance The availability of Indian food is a significant factor for Indian expatriates. These restaurants in Batam have catalyzed the ability of many Indians to settle in Batam, including me.

Looking at the rapid establishment of new Indian restaurants and the market’s significance as a determinant of Indian tourism and residence in Batam, I became curious about new restaurant openings, government intervention, price and non-price determinants for customers, and competition among incumbents in the market. Since the market was readily accessible, I decided to assess its contestability.

This research is significant as it can predict new restaurant openings, entry and exit barriers in the market, significance of price and non-price factors, profit levels, level of competition among incumbents, and most importantly, shine light at this underrated market.

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1.3 Method A deductive approach5 has been used.

First, the theoretical assumptions and implications of a contestable market are explored through textbooks and online sources. These are low barriers to entry, low sunk costs, a pool of potential entrants, perfect knowledge, normal profit, productive and allocative efficiency, and competitive practices. The extent to which the market abides these assumptions determines the market’s contestability.

I conducted primary research by interviewing all the restaurant owners to understand the entry and exit barriers, profit levels and threat of competition in the market. To ensure reliability in their responses, I assured them of data confidentiality. Then, I followed Simple Random Sampling6 to survey 51 Indian customers and acquire data on customer preferences. Instead of online and group surveys, I visited every customer individually to ensure their responses reflect their opinion. The confidence interval7 was used to determine the sampling population of 51.

Then, the primary data is analyzed to form a conclusion, evaluation, and deduce the degree of contestability. I occasionally acquired secondary data from public institutions in Batam to assist my research.

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Inductive and deductive approaches to research. (n.d.). Retrieved June 22, 2017, from http://deborahgabriel.com/2013/03/17/inductive-and-deductive-approaches-to-research/ 6 Staff, I. (2015, April 24). Simple Random Sample. Retrieved August 28, 2017, from http://www.investopedia.com/terms/s/simple-random-sample.asp 7 Sample Size Calculator. (n.d.). Retrieved October 28, 2017, from https://www.surveysystem.com/sscalc.htm#one

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2 Theory and Analysis 2.1 Overview 2.1.1 Theory and Reality The contestable market theory is not a distinct theory in the neo-classical spectrum. Instead, any market comprising of a few firms that are characterized by competitive equilibria due to threat of potential entrants can be classified as a contestable market. This theory was developed by William Jack Baumol in 1982.

Diagram 1, illustrating the relationship between contestable markets and the neo-classical spectrum

Realistically, every market has a degree of contestability as the “firms need not to be small or numerous or independent in their decision making or produce homogenous products” 8 for the market to be contestable. The degree of contestability depends on how much a market abides the theory.

2.1.2 Overview of Indian restaurants in Batam Some owners have requested anonymity in the research. There are 8 Indian-cuisine restaurants in Batam. The table presents them in order of their establishment:

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Baumol, W. J. (2006, July 4), p.4. Contestable Markets: An Uprising in the Theory of Industry Structure[PDF]. American Economic Association.

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Name of Restaurant

Year of establishment

Martabak Har Nagoya

19909

Maharaja Curry House

200710

Martabak Har Jodoh

201011

Chennai Restaurant

201312

Empire Restaurant

201513

Taj Indian Cuisine

201614

Indian Delights

201615

Martabak Har Batam Center

201716

Table 1. The Indian-cuisine restaurants in Batam and their year of establishment

Martabak Har is not a franchise and restaurants named “Martabak Har” are operated by individuals who bear no personal connections 17 with each other. Therefore, all restaurants are assumed to be operating independently.

2.2 Assumptions of theory and Analysis Before analysis, it is important to assume that Indonesian restaurants are not potential entrants in the Indian restaurant market. While the two cuisines have similarities, the ambience and culture conveyed inside an Indian and Indonesian restaurant highly differs. Furthermore, Indonesian restaurants have a much larger customer segment. This assumption is evident as none of the 8 Indian restaurants initially sold Indonesian food.18 This assumption is important because one may argue that Indonesian restaurants can start selling Indian food,

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Mr. Abdullah, owner of Martabak Har Nagoya. (2017, Sep 21). Personal Interview. (n.d.), owner of Maharaja Curry House. (2017, Sep 21). Personal Interview. 11 Mr. Mohammad, owner of Martabak Har Jodoh. (2017, Sep 21). Personal Interview. 12 (n.d.), owner of Chennai Restaurant. (2017, July 23). Personal Interview. 13 (n.d.), owner of Empire Restaurant. (2017, Sep 23). Personal Interview. 14 Mr. Rafiq, owner of Taj Indian Cuisine. (2017, Sep 21). Personal Interview. 15 (n.d.), owner of Indian Delights. (2017, Sep 23). Personal Interview. 16 (n.d.), owner of Martabak Har Batam Center. (2017, Sep 21). Personal Interview. 17 Mr. Mohammad, owner of Martabak Har Jodoh. (2017, Sep 21). Personal Interview. 18 Personal Interviews with restaurant owners 10

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with negligible barriers and perfect knowledge, and are therefore potential entrants in the Indian restaurant market. In such a case, contestability would be extremely high, but the assumption falsifies this argument.

2.2.1 Barriers to entry for potential entrants Barriers to entry are legal, technological and market forces that discourage or prevent new firms from entering an existing market and compete with its producers. High barriers to entry hinder entrance, whereas, low barriers increase the number of potential entrants in a market. Barriers to entry include high start-up costs, monopolization, government regulation, brand loyalty and economies of scale.

High start-up costs, usually expenditure on technology and land, reduce potential threat of competition by reducing affordability of potential entrants. However, the suppliers can negotiate 5-year contracts 19 for land, where rent is payed monthly. This significantly reduces start-up costs. “The contracts are flexible depending on the land-owner.”20 Technological requirements 21 such as stoves, furniture, air-conditioners are fulfilled through affordable whole-sale marts in Batam, such as Lotte Mart. Therefore, start-up costs – a critical barrier – can be concluded as low.

According to theory, a firm is the industry in a monopolized market.22 Market share data, calculated using monthly sales figures provided by the suppliers, shows there are no

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Mr. Mohammad, owner of Martabak Har Jodoh. (2017, Sep 21). Personal Interview. (n.d.), owner of Martabak Har Batam Center. (2017, Sep 21). Personal Interview. 21 (n.d.), owner of Empire Restaurant. (2017, Sep 23). Personal Interview. 22 Blink, J., & Dorton, I. (2012), p.112. Economics: course companion. Oxford: Oxford University Press. Barriers to entry created by a monopoly 20

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monopolies in the market, and hence, an absence of monopolistic barriers that “stop[s] new firms from entering the industry”23 to maintain the monopoly.

Name of Restaurant

Monthly Sales (millions of Market share Indonesian rupiah) (%) Martabak Har Nagoya 320 24.7 Martabak Har Jodoh 300 23.2 Maharaja Curry House 210 16.2 Indian Delights 105 8.1 Chennai Restaurant 100 7.7 Empire Restaurant 90 6.9 Taj Indian Cuisine 90 6.9 Martabak Har Batam Center 80 6.2 Total 1295 100 Table 224. Monthly sales and market share of the restaurants

Economies of scale are “factors that cause the average cost of producing something to fall as the volume of its output increases”25. The Indian restaurants ‘cook to order’, eliminating the chance to exploit economies of scale by ‘mass -cooking’, like a caterer. Monthly sales are not high enough to support the existence of economies of scale either. Hence, incumbents cannot construct barriers through economies of scale.

A license must be issued before establishing a restaurant in Batam. While this seems a legal barrier, the restaurant owners claimed it was “easy to get”26 and cheap. With no expiration date and government intervention, legal barriers are low.

23 Blink, J., & Dorton, I. (2012), p.112. Economics: course companion. Oxford: Oxford University Press. Barriers to entry created by a monopoly 24 Personal Interviews with restaurant owners 25 Economies of scale and scope. (2008, October 20). Retrieved July 04, 2017, from http://www.economist.com/node/12446567 26 (n.d.), owner of Indian Delights. (2017, Sep 23). Personal Interview.

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The only critical barrier to entry is brand loyalty. This deters entrance because potential entrants cannot infiltrate the market without heavy expenditure on marketing and advertising. When the survey asked why a restaurant was their favorite, 26 out of 51 customers included their relationship with staff/owner, or another form of brand loyalty as the reason. Mr. Mohammad, the owner of Martabak Har Jodoh, also asserted that brand loyalty is high in the market.

However, this barrier seemed insignificant when the customers were asked: “If a new Indiancuisine restaurant opens in Batam, will you go and try their food?” The responses are shown below:

Number of customers

Graph showing the customer response to "If a new Indian-cuisine restaurant opens in Batam, will you go and try their food?" 24 22 20 18 16 14 12 10 8 6 4 2 0 Yes, of course. I will go there.

Most likely.

Maybe.

No, I will not go there.

Question unanswered

Choices Graph 1. Customer response to if they will try eating at new Indian restaurants 41 out of 51 customers would either “most likely” or definitely dine at a new Indian restaurant, while only 2 customers “will not go there”. Therefore, it seems that the customer segment provides opportunities to new entrants despite having a strong sense of brand loyalty.

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Nonetheless, ‘openness’ towards dining at new restaurants cannot be perceived as a desire to find new restaurants. The high level of brand loyalty towards incumbents indicates a lack of proactivity towards finding new restaurants. Therefore, entrants must inform customers of their establishment, which can incur considerable advertising costs for entrants. Empire Restaurant spent 200-300 million rupiah on advertising during its opening in 2015, approximately 20-30% of the initial investment in the restaurant.

In a perfectly contestable market, there are no entry barriers, increasing the market’s accessibility to potential entrants by making entry unimpeded. As brand loyalty is the only barrier that curtails contestability, it can be concluded that the Indian restaurants operate under low entry barriers.

2.2.2 Sunk Costs Sunk costs are incurred costs of a firm which “cannot be recovered by the firm when it exits the industry.”27 Money spent on capital equipment that cannot be resold upon exit or the investment in research & development are irreversible past choices and are examples of sunk costs. High sunk costs discourage potential entrants from entering a market as they become liable to huge financial losses should they egress it.

6 out of 8 suppliers refer to sunk costs as “reasonably low” as assets such as furniture, equipment and machinery can be easily sold in a second-hand market with a large pool of buyers for reasonable prices.28 This indicates that factor mobility is high.

27 Finamore, D. (2014), p.85-86. Economics: supporting every learner across the IB continuum. Harlow, Essex: Pearson Education Limited. 28 Personal Interviews with restaurant owners

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Empire Restaurant29 and Indian Delight30, however, would incur sunk costs of approximately 300 and 200 million rupiah if the restaurants stop operating. These are particularly advertising costs, and shall a firm cease their production, advertising costs cannot be reimbursed.

Considering that the customer segment consists of expats and tourists, customer turnover is high. Hence, in the long term, splurging capital on advertising is irrational for any entrant. In fact, the other 6 restaurants used mouth-to-mouth promotion during their inauguration, incurring minimal sunk costs in the process. Hence, expenditure on advertising is variable, depending on individual suppliers.

Sunk Costs are barriers to exit– “obstacles or impediments that prevent a company from exiting a market.”31. While they do not determine potential threat of competition, they are considered by potential entrants, making “absolute freedom of exit”32 or sunk costs “the obverse of freedom of entry”33. “If entry into a market entails no sunk costs, a potential entrant has no reason to fear retaliation by incumbents, since it can leave the market without loss if such retaliation materializes.” 34 It appears that rapid mobility of capital and low advertising costs in the market permits easy exit from the market, and hence, the sunk costs for Indian restaurants in Batam are low and “exhibit the easy entry and exit characteristics

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(n.d.), owner of Empire Restaurant. (2017, Sep 23). Personal Interview. (n.d.), owner of Indian Delights. (2017, Sep 23). Personal Interview. 31 Staff, I. (2010, September 14). Barriers To Exit. Retrieved June 24, 2017, from http://www.investopedia.com/terms/b/barriers-to-exit.asp 32 Baumol, W. J. (2006, July 4), p.3-4. Contestable Markets: An Uprising in the Theory of Industry Structure[PDF]. American Economic Association. 33 Bailey, E. E., & Baumol, W. J. (1984), p.120. Deregulation and theory of Contestable Markets. Retrieved July 16, 2017, from http://digitalcommons.law.yale.edu/cgi/viewcontent.cgi?article=1010&context=yjreg 34 Bailey, E. E., & Baumol, W. J. (1984), p.115. Deregulation and theory of Contestable Markets. Retrieved July 16, 2017, from http://digitalcommons.law.yale.edu/cgi/viewcontent.cgi?article=1010&context=yjreg 30

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needed for contestability.”35 2.2.3 Pool of Potential Entrants A “presence of potential competitors”36 who actively “seek to enter the market to take advantage of available profit opportunities (avoid economic loss)”37 is necessary to facilitate a potential threat of competition and thus contestability. Table 3. Showing the rapid establishment of restaurants since 2015 Name of Restaurant

Year of establishment

Empire Restaurant

2015

Taj Indian Cuisine

2016

Indian Delights

2016

Martabak Har Batam Center

2017

The rapid establishment of restaurants since 2015 indicates a presence of potential entrants as entrepreneurs have actively entered the Indian restaurant market.