Unit 3: How to reduce contestability

A good article in The Economist recently, arguing that firms may be cramming markets in order to keep rivals out. Raising barriers to entry serves to reduce the levels of competition in markets, or makes them less ‘contestable’.

I’ve been interested in business clusters and the idea of external economies of scale for a long time, and if you read the article you’ll see that there’s a long history of trying to understand firms’ location decisions: locate too near a rival and ferocious competition hits profits; edge too far away and too large a chunk of the market is lost. But this analysis goes even deeper: more outlets soak up demand, so that outsiders’ gains from entering a market. When there are big costs to setting up shop, “pre-emption” of this sort can keep rivals out.

This helps explain not just the physical proximity of some firms’ outlets, but also the similarity of products sold by a single company. Breakfast cereals are an example: in 1950 America’s six big producers offered around 25 types of cereal; by 1972 it was around 80. Competition authorities suspected that the proliferation was not just a response to shoppers’ varied tastes. Rather, the market was being crammed with options in order to reduce the “space” for new entrants.
If anything, according to the author, worries about proliferation are greater today, as waves of mergers have left fewer, larger firms. Opening multiple outlets might be profitable for a chain as a whole if that keeps rivals at bay. The article offers an interesting case study into the branded hotel business in Texas, where the six firm concentration ratio is 91%.

Customers tend to favour particular brands. It doesn’t make much sense to open a similar hotel next to one you already operate: that will dent a rival’s entry profits by only 5%, but perhaps means a 10-12% profit drain for you. Instead, hotel chains seem to “fill” the market another way. Rather than opening lots of identical hotels, they open differentiated lodgings, with the six largest hotel groups operating 32 brands. Though some of these vary in quality, many compete head-to-head: Courtyard and Fairfield, both owned by Marriott, cater to similar budgets, as do Comfort Inn, Econo Lodge and Quality Inn, all part of Choice Hotels.

Something here for fans of interdependence in oligopolistic markets, game theory and so forth.