Contestable Markets

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 incumbents 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. Blueback Taxis The London taxi-cab market has just been shaken up by the arrival of a new, heavily branded competitor. Blueback aims to become the Starbucks of the taxi market. What strategy is it using to enter the market? The London taxi market is highly fragmented - i.e. supplied by numerous small operators and is largely unbranded. The objective of Blueback is to rapidly grow market share by launching a clearly branded service that will encourage taxi drivers to switch to the company. Blueback has taken a leaf out of low-cost airline Easyjets strategy book with the way it has developed its new service. Blueback has one, up-front pricing policy and runs only one type of vehicle, the Fiat Multipla. Each vehicle carries the same, distinctive blue and silver livery. The drivers wear the same uniform and offer customers newspapers and mobile phone chargers as part of the onboard service. All drivers go through Bluebacks driver training programme and are licensed by the PCO. The Blueback service was developed from marketing research that asked people what they wanted from taxi hire. This covered areas such as ordering, pricing and experience of the service. The long-term objective of the company is to have a fleet of 1000 vehicles within the next few years and to be the market-leading taxi operator in London Adapted from Business Caf, Tutor2u (February 2004) 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 ecommerce 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 market case study the market for broadband in the UK 2005 was the year when finally the market demand for broadband services took off! Having lagged well behind most other western European countries in our use of broadband, the UK witnessed a huge boom in take-up for broadband technology. The telecommunications industry is an excellent one to study, not least because of the important role played by the industry regulator, OFCOM in opening up the market to fresh competition and acting as a catalyst for the successful entry of new firms into the broadband market. OFCOM believes that the retail market for broadband is now sufficiently competitive market so that it can operate without price regulation. In the past, industry regulators in recently privatized industries where monopoly power remained have used their powers to impose price regimes on the major utilities. But as competitive forces have strengthened, so the role of the regulator has moved away from direct price controls, towards a broader role of monitoring the scale and quality of competition within a market. As part of the current legal arrangements in the UK telecoms sector, BT is required to provide regulated wholesale access to broadband products so that other service providers can sell broadband to households and business customers. OFCOM has intervened to reduce the access charges that BT can make to these other suppliers, and this too has been important in reducing barriers to entry in the market and thereby making the industry more contestable. For example, just over a year ago, Ofcom announced proposals set a maximum price of 81.85 that BT can charge its competitors to rent a fully unbundled local loop. The ceiling is designed to promote competition in the broadband market by ensuring that BT's charge is fair, reasonable and cost-oriented. The importance of local loop unbundling Unbundling the local loop has been of pivotal importance in creating a contestable market for broadband services. Local Loop Unbundling (LLU) enables telecoms operators to connect directly to the consumer via BT's own copper local loops and then add their own equipment to offer broadband and other services. This process involves operators accessing BTs local exchange buildings to connect to BTs network of copper lines which connect them to homes and businesses. Most homes in the UK are within one mile of a local telephone exchange. Main service providers in the UK broadband market We can see the contestable nature of the broadband market by looking at a growing list of main service providers and also the changing balance of market share by total sales. Britain has more than 100 suppliers of broadband although aggressive price discounting is likely to see this number fall as some businesses drop out of the market because they cannot make a profit. The effects of increased contestability on the market for broadband Demand and take-up: Broadband penetration among household consumers has increased significantly. Falling prices: Average UK residential subscription prices have fallen sharply with some service providers claiming to offer free broadband as part of a package of telecommunications services. It has become clear though that there is no such thing as a free lunch broadband services are rarely if ever free! Speeds: Broadband speeds are increasing as the broadband suppliers roll out the effects of increased investment in high speed cables and servers. Evolving market shares: The market shares of the broadband providers continue to change. In the year 2000, the market share of the top three providers (BT, NTL and Telewest) was 87%. By 2002 this had declined to 79% and in 2004 OFCOM reports that the concentration ratio of the leading three firms had declined further to just 55%. Suggestions for more reading on the battle for market share in broadband BBC news articles on broadband Ofcom on the UK broadband market The broadband boom and you (BBC)

Contestable Markets and the 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 Performance 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.

If a market is contestable, industry structure and firm behaviour is determined by the threat of competition - 'hit-and-run' entry. The market will resemble perfect competition, regardless of the number of firms, since incumbents behave as if there were intense competition. Key revision points for contestable markets: o o o 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 o 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)

ContestableMarkets
A contestable market is a market where there is free and costless entry and exit. Therefore incumbent firms will always face the threat of new firms entering the industry. Therefore such a market will have a competitive equilibrium, even if there are a small number of firms. A perfectlyContestableMarkethas the following three features: Absence of Sunk costs Perfect information Freedom to advertise and a legal right to enter the market

SunkCosts : These are costs which are non-recoverable such as advertising

Hit and Run Competition

If there are low entry and exit costs then firms can engage in hit and run tactics. This means that if an industry is making supernormal profits then a firm can enter and take advantage of high prices, If prices fall and the industry is no longer profitable then the firm will leave. Therefore in a contestable market a firm should be satisfied with normal profits otherwise it would encourage hit and run tactics

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 doesnt 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. Removelegal barriersto entry Royal Mail used to be a legal monopoly but now firms are allowed to enter the market for sending letters. 2. Forcefirmsto allowcompetitorsto 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. 3. LegislationagainstPredatoryPricing If a firm can engage in predatory pricing it can force new firms out of business and make it less contestable. 4. OFTcanlegislateagainstabuseof Monopolypower If a firm abuses its monopoly power by restricting supply to certain firms the OFT can intervene to overcome this restriction on contestability.

Essay: Contestable Markets

A contestable market occurs when there is freedom of entry and exit into the market. Thus there will be low levels of sunk costs. When considering the contestability of markets it is important to consider the following points. 1. SunkCosts. If Sunk costs are high this makes it difficult for new firms to enter and leave the market. Therefore it will be less contestable.

2.

Levelsof Advertisingandbrandloyalty.

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. 3. The level of Profit If a firm is making very high profit, this is an indication that the market is not contestable, because hit and run competition should enable new firms to enter and reduce the profitability 4. VerticalIntegration If a firm does not have access to the supply of a good then the market will not be contestable. E.g. Oil firms could restrict the supply of petrol to petrol stations, making it difficult for new firms to enter. E.g. for airlines a big issue is whether you can get a landing slot at a big airport.

5.

Accessto technologyandskilledlabour 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.

Conclusion
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.

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 unwilling to switch. Therefore a new firm would have to spend alot on advertising, which is a sunk cost, therfore 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 the introduction of the internet has reduced set up costs and enabled new firms to enter the market for online banking e.g. EGG. Therefore the banking industry has become more contestable in recent years, although the big 5 banks still dominate on the high street.