Contestability recap

Lesson objectives

Recap how markets can become more contestable Differentiate the level of contestability between markets

and what determines it using industry examples Explain using a diagram the implications of contestable

market theory on firms in the industry Introduce the economic underpinnings of “competition

policy”

Contestable Markets Recap – New entrants

‘Hit and Run’ tactics – enter the industry, take the profit and get out quickly (possible because of the freedom of entry and exit)

Cream-skimming – identifying parts of the market that are high in value added and exploiting those markets

Contestable Markets Recap

Key characteristics: No (low) barriers to entry or exit No (low) sunk costs

Firms’ behaviour influenced by the threat of new entrants to the industry

Firms may deliberately limit profits made to discourage new entrants entry - limit pricing

Firms may attempt to erect artificial barriers to entry – e.g…

Note that the threat of

new entrants

may encourage positive OR

negative behaviour

by incumbents

Contestable Markets

Over capacity – provides the opportunity to flood the market and drive down price in the event of a threat of entry

Aggressive marketing and branding strategies to ‘tighten’ up the market

Potential for predatory or destroyer pricing

Find ways of reducing costs and increasing efficiency to gain competitive advantage

Barriers to Contestability

No market is perfectly contestable – there are always some barriers!

Existing firms can engage in predatory behaviour to make entry more costly to new rivals

Raising rivals’ costs– Vertical integration means that some firms act as component

suppliers to other firms in their industry – they have control over the supply-chain (also known as vertical restraint)

– The use of import tariffs to increase the relative prices of overseas output

Reducing rival’s revenues – “bundling” A monopoly can use profits in one market to boost market

power in another (cross-subsidisation)

Bundling – Anti-Competitive Behaviour?

Product bundling is a marketing ploy of giving away a relatively cheap product with a relatively expensive one to attract customers

Bundling can have the effect of tying the consumer to both products

This is particularly prevalent in computer manufacturing where the product comes with specific items of software already pre-loaded

Banking

Where are the opportunities to skim or hit and run?

Barriers to entry? Barriers to exit?

Use your checklist sheet

Banking

Where are the opportunities to skim or hit and run?

Barriers to entry?– Brand loyalty– Marketing– Legal– Financial

Barriers to exit?

Evaluating Contestable Markets

There are no perfectly contestable markets What matters is the degree of competition / contestability The idea is that what matters is not so much competition within a

market, but rather competition for a market. What also matters is the threat of entry of new suppliers – but this

may not be enough to affect the behaviour of existing firms The absence of competition in a market over a long period of time

does not necessarily suggest a lack of contestability Structural changes in costs in different industries can change the

degree of contestability Contestability may force existing firms away from profit-maximising

behaviour (e.g. towards sales-revenue maximisation)

Over to you…

– Draw Monopolist’s profit maximising equilibrium

– How might the monopolist react to the threat of hit and run entry by removing the new entrants’ incentive?

Output (Q)

Revenue

Normal Profit Contrasted with Profit Maximisation

If the monopolist charges the profit-maximising price, then - if the market is contestable – the firm will be vulnerable to hit and run entry

The only way the monopolist can avoid this happening is to set the price equal to average cost, so that there are no supernormal profits to act as an incentive for entry

Output (Q)

Price

ARMR

MC

ATCP1

Q1

P2

Q2

No one in the industry

has any advantage

over anyone

else

Got this far in this lesson

Implications of contestable market theory

The number of firms in an industry is irrelevant in terms of economic efficiency

Abnormal profits attract new entrants driving down prices and ensuring economic efficiency

All markets (excluding natural monopoly) can be efficient so long as they are contestable

Shifts the emphasis of government competition policy away from number of firms towards reducing barriers to entry in an industry

Potential competition may be more important for economic efficiency than actual competition

Contestable Markets

Examples of markets exhibiting contestability characteristics:– Financial services– Airlines – especially flights

on domestic routes– Computer industry – ISPs, software, web

development– Energy supplies– The postal service?

N.B.

Exam board likes the topic of contestability

Remember the threat of competition can be as effective as actual competition

Key is the relationship between sunk costs and the degree of contestability

Contestability

10 minute essay “To what extent is the UK banking market a

contestable market” Agree a structure as a group Divide up the work amongst yourselves Write the bullet points of an essay

Government intervention to maintain competition in markets

Why does the Government intervene to

maintain competition?

ORWhy does the Government seek to make markets more contestable?

Competition Policy

Promote Competition

ProtectConsumers

Enhance

Efficiency

Toughened since 1997

Assumption is that competition

eliminates x-inefficiencyBetter resource

allocationvs.

Economies of scale

Competition Policy

At the heart of competition policy is the comparison between Perfect Competition and Monopoly

Draw the two LR equilibrium diagrams

PC Consumer Surplus

Thank You!

PC and “Multi-plant” Monopoly compared

Quantity

Price

D=AR

LRS (=LMCm)

Pm

Qm

Ppc

QpcO

B

E

C

MR

Big Assumption!No cost difference between the two market structures

PC firms prepared to supply any

quantity at this price

The Monopolist at constant returns to scale can continue to supply with no

change in MC

PC firms supply Qpc at price Ppc

Monopolist supplies Qm at price Pm

Part of consumer surplus transferred to Monopoly as

profits

Deadweight loss = cost on society

Government Remedy =

Increase Competition!

Homework

Read and make notes on Anderton Ch 58 P380-382 Be prepared to hand in your notes at next

lesson

Define the term “Competition Policy” and explain why it exists

Plenary