How does the threat of competition affect a firm’s behaviour?

Topic 3.3.10

How does the threat of competition affect a firm’s behaviour?

Topic 3.3.10

Students should be able to:• Define contestability and understand how the threat of new

entry may influence behaviour and market performance of existing firms.

• Understand the relationship between sunk costs and the degree of contestability — examples may include banking, airline industry and petrol retailing.

Key Concepts – Contestable Markets

Contestable MarketWhere an entrant has access to all production techniques available to incumbents and entry decisions can be reversed without cost

Hit and run entryWhen a business enters an industry to take advantage of temporarily high (supernormal) market profits.

Sunk costsSunk costs cannot be recovered if a business decides to leave an industry. The existence of sunk costs makes a market less contestable.

• Contestable markets are constantly changing• Contestable markets can be seen at a local, regional,

national and international level• In a contestable market, the number of size distribution

of businesses in the industry is less important • More focus is given to the threat of entry from rivals• Almost all markets are contestable to some degree• Technology has the potential to change contestability• E.g. the barriers to entry in many markets are widely

thought to have lowered because of digital advances• Contestable markets often show high dynamic efficiency

Contestable Markets

Absence of sunk costs Access to technology

Low consumer loyalty Low legal barriers

• Pool of new entrants willing and ready to enter the market

• No significant entry or exit costs

• Access to the available technology

• High rates of customer churn

Conditions for a Contestable Market

Contestable Markets in Action!

• Nov 2015: Apple 'to launch peer-to-peer payment app' in competition with PayPal

• Nov 2015: The Gym Group, one of the UK's low-cost fitness chains and it is now listing on the stock market to fund future expansion

• Nov 2015: Uber taxi app to launch in Edinburgh• Nov 2015: Amazon begins a new chapter with opening of

first physical bookstore• Oct 2015: Metro Bank Takes Step Towards £1bn Listing• Oct 2015: Argos launches Same Day Delivery• Oct 2015: Sainsbury's tests out 'micro-stores' for busy

shoppers

Leading global generic drug manufacturers by market share 2013

Top 10 generic drug manufacturers - worldwide market share in 2013

Note: Worldwide

Teva Pharmacetical

Novartis

Actavis

Mylan

Aspen Pharmacare

Sun Pharmaceutical

Hospira

Daiichi Sankyo

Sanofi

Lupin

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%

13.4%

11.9%

9.1%

8.6%

4%

3.9%

3.5%

3.2%

3.1%

2.5%Market share

Each medicine has an approved name called the generic name. For example, paracetamol is a generic name. There are several companies that make this with brand names such as Panadol®, Calpol®

Generic Drugs and Contestability

Market share of mobile handset manufacturers in the UK in June 2014

Samsung Apple Nokia Sony HTC RIM Motorola LG Other0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%31.8%

22.9%

16.9%

6.7% 6.1%

3.7%2.4% 2.1%

7.4%

Mar

ket s

hare

A Contestable Oligopoly?

5 firm concentration ratio = 84.4%

Hotel rooms & Airbnb listings in New York

2012 2013 2014*0

20000

40000

60000

80000

100000

120000

94,235 97,400 99,250

6,58510,963 12,446

Hotel rooms Airbnb listings

Num

ber o

f ava

ilabl

e ro

oms

Sunk Costs• Sunk costs cannot be recovered if a business decides to leave an

industry. Examples include:– Capital inputs that are specific to an industry and which have little or no

resale value.– Money spent on advertising, marketing and research and development

projects that cannot be carried forward into another market or industry.– Money spent in building expensive and complex IT systems that are

subsequently ditched because they are unworkable• When sunk costs are high, a market becomes less contestable.

High sunk costs act as a barrier to entry of new firms because they risk making huge losses if they decide to leave a market.

• In markets such as fast-food restaurants, sandwich bars, hairdressing salons and local antiques markets there are low sunk costs so the barriers to exit are low.

Core Examples of Sunk Costs1. Asset-write-offs – e.g. the expense associated with writing-off

the value of plant and machinery, stocks and the goodwill of a consumer brand

2. Closure or project cancellation costs including redundancy costs, contract contingencies with suppliers and the penalty costs from ending leasing arrangements for property

3. The loss of business reputation and goodwill - a decision to leave a market can seriously affect goodwill among previous customers, not least those who have bought a product which is then withdrawn and for which replacement parts become difficult or impossible to obtain.

4. A market downturn may be perceived as temporary and could be overcome if and when the economic or business cycle turns and conditions become more favourable

Examples of Sunk Costs

• Nov 2015: Redcar owner loses £530m on steel plant liquidation

• Lidl is following a strategy of rapid organic growth• Aldi - world’s leading limited assortment grocery, with

total sales of €61bn in 2013, followed by Lidl at €59bn• Together, the two German discounters have more than

20,000 stores across Europe, the US and Australia. Lidl is present in 26 European markets

• Majority of their products are own-label, rather than brands - gives them purchasing power with suppliers.

• The range suppliers are asked to provide is narrower – perhaps four to six products compared with 30-40 at a large grocer – driving efficiencies and big volumes

Retail Contestability – Rise of Aldi & Lidl

Contestable Markets – Price and Profit

• The more contestable a market is, the more likely that an allocatively efficient outcome is achieved

• The threat of entry affects the behaviour of firms• Often smaller disruptive businesses challenge the

monopoly power of existing businesses• The threat of entry is as important as actual

competition

Cost & Price

Output (Q)

Highly Contestable Market – Profit Maximising Output

AC

AR

MR

MC

In the left hand diagram draw in the profit maximising output and price (label it Q1 and P1.)

Q1

P1

C1

Price > Average Cost

Supernormal profits

High profits send signals to other suppliers

Pricing – Options in Contestable Markets

Cost & Price

Output (Q)

Highly Contestable Market – Profit Maximising Output

AC

AR

MR

MC

In the long run if the market is highly contestable whichlevel of price and output is probable? (Label this Q2 and P2).

Q1

P1

C1

When AC = AR, normal profits made, a return sufficient to keep factor inputs in their present use

P2

Q2

Pricing – Possible Long Run Equilibrium?

Cost & Price

Output (Q)

Highly Contestable Market – Pricing to Maximise Revenue

AC

AR

MR

MC

In the right hand diagram show the price and output for a firm that seeks to maximisetotal revenue

Pricing – Maximising Revenue

Cost & Price

Output (Q)

Highly Contestable Market – Pricing to Maximise Revenue

AC

AR

MR

MC

In the right hand diagram show the price and output for a firm that seeks to maximisetotal revenue

P1

Revenue maximised when marginal revenue = zero

Pricing – Revenue Maximisation

Cost & Price

Output (Q)

Highly Contestable Market – Pricing to Maximise Revenue

AC

AR

MR

MC

In the right hand diagram show the price and output for a firm that seeks to maximisetotal revenue

P1

C1

Revenue maximised when marginal revenue = zero

Still some super normal profits made

Lower price and higher output than MC=MR

Revenue max means a lower profit margin is made – usually good for consumer welfare – but profit has value too!

Pricing – Revenue Max – Lower Profits

Economies of scale Vertical integration Brand loyalty

Control of important technologies

Expertise and reputation

Key Barriers to Contestability

Asset write-offs Lost consumer goodwill

Redundancy costs

Exit Costs – Barriers to Exit

Deregulation of an industry Open up networks of monopolies

Tough rules on predatory pricing Policies on international trade

Policies to Increase Contestability

• The threat of competition may be a powerful an influence on the behaviour of existing firms

• If a market is contestable, industry structure and firm behaviour is determined by the threat of competition - 'hit-and-run' entry

• A highly contestable market will resemble perfect competition, regardless of the number of firms, since incumbents behave as if there were intense competition.

Contestable Markets – Evaluation Points

How does the threat of competition affect a firm’s behaviour?

Topic 3.3.10