Unit 3: Contestable Markets - introduction notes

Introduction to contestability theory

A contestable market has no entry barriers - firms can enter or leave an industry costlessly. The threat of potential entry may be enough competition to ensure imperfectly competitive set price and output at or close to the competitive price and output.

Imperfectly competitive markets can be contestable. Contestability theory is associated with Baumol who argues the mere threat of new firms entering a market means existing firms act competitively ie lowest costs, prices and profits. The theory of contestable markets argues that what is important is not actual but potential competition.

A market is perfectly contestable when the costs of entry and exit are zero where any entry costs can be recovered on exit ie there are no sunk costs.

In a contestable market the threat of entry by potential rivals will ensure that the firm or firms in the industry will earn normal profits and deliver allocative and productive efficiency:

· Few barriers to entry into the market means potential entrants are able to enter market quickly if abnormal profits are made. This process helps ensure normal profits only, are earned in the long run;

· The size of firm is irrelevant;

· Price competition is unlikely, although it may occur for short periods;

The government has sought to create contestable markets in the rail, bus, ferry and air industries through deregulation (buses) and short franchises (trains).

However:

· Significant entry barriers may exist and incumbent firms can often scare potential entrants away from entering.

· Sunk costs refer to expenditure that cannot be recovered if a firm leaves an industry and represent a barrier to entry. If potential entrants anticipate high sunk costs contestability theory is less effective in lowering price and profits

· Short-term franchises introduce contestability into transport markets but deter long-term investment where firms feel they may lose their current franchise and experience sunk costs. For this reason, the latest franchise agreements are for longer periods eg 15 years. 15 year franchises create uncontested legal monopolies.

· Road haulage: many small one-lorry owners. Monopolistically competitive?

· Bus: after deregulation early competition mergers have created three oligopolies. Many regional bus monopolies are local monopolies. London Bus is a franchised monopoly. A national oligopoly and regional monopoly?

· Rail operators 28 TOC's are regional monopolies with a time-limited franchise. Extensive price discrimination on fares.

· Airlines: Bilateral agreements giving way to open skies resulting in an increase in the number of low cost operators and flights. Monopolistically competitive? Duopolies giving way to monopolistic competition

· Infrastructure natural monopoly argument means one regulated operator eg Railtrack and NAT's