Contestable Market Theory

1
Contestable Markets
2
Aims

• Revise market structures
• Understand what contestable markets theory is
• Understand how it works
• Discuss some examples of markets
• Look at a practice question (if time)

Topic Reading Lawrence and Stoddard Chapter
6 Due Day 7
3
Draw the Monopoly and Perfect competition
diagrams.
4
Revision Perfect Competition
MC
Price
Price
AC
S
S1
MR D AR
P
D
Qpc
Quantity
Quantity
5
Revision Monopolies
MC
Price
AC
Pm
D
Quantity
Qm
MR
6
How many barriers to entry can you think of?
End
7
Revision Barriers to entry

• Patents
• Legal monopolies/nationalised industries
• Economies of scale
• Sunk Costs
• Fixed costs
• Integration
• Predatory pricing
• Branding
• Reputation

8
What is a contestable market?

• 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. Baumol
• W J Baumol, J C Panzar and R D Willig,
  Contestable Markets and the Theory of Industry
  Structure (New York, 1982)

9
What is a contestable market?

• A contestable market is one without barriers to
  entry or exit.
• According to contestable market theory actual
  competition is not necessary to reduce monopoly
  inefficiencies, only the threat of competition.

10
Requirements for a perfectly contestable market?

• No barriers to entry or exit
• Perfect information
• No collusion

11
How do they work?

• Traditionally we assume a monopoly behaves as a
  profit maximiser, producing where MRMC
• This allows abnormal profits
• Barriers to entry mean these profits can be long
  run

MC
Price
AC
Pm
D
Quantity
Qm
MR
12
How do they work?

• Abnormal profits attract competitors to the
  market.
• The lack of barriers to entry make the incumbent
  firm vulnerable to competition
• This competition could be from firms aiming to
  stay in the market long term or take the form of
  hit and run competition

13
How do they work?

• Abnormal profits attract competitors to the
  market.
• The lack of barriers to entry make the incumbent
  firm vulnerable to competition
• This competition could be from firms aiming to
  stay in the market long term or take the form of
  hit and run competition

Hit and run competition Entering the market for
a short time to take advantage of abnormal
profits. A firm usually aims to gain profit
before the incumbent can react through low
margin, high volume sales
14
The threat of competition

• This threat of competition forces a monopoly to
  behave as though it were actually facing perfect
  competition, and produce where ARAC
• The only other alternative is to create barriers
  to entry

MC
Price
AC
Pm
D (AR)
Qm
Quantity
MR
15
Results

• In a perfectly contestable market even
  monopolies/oligopolies will
• Make only normal profit
• Operate at minimum cost
• Therefore be allocatively efficient
• The result may be even better than perfect
  competition as we gain the benefits of greater
  economies of scale and dynamic efficiency (if
  there are some low barriers)

16
Implications

• The more contestable the market the greater the
  level of competitive behaviour, with or without
  actual competition.
• The presence of other firms in the market is not
  required for an efficient market
• Government should
• use contestability rather than concentration
  ratios to identify the need for intervention.
• intervene first to remove barriers to entry and
  only if this fails is direct regulation required.

17
Limitations

• It may be impractical to remove all barriers to
  entry
• How do you eliminate sunk costs from oil
  exploration?
• What about takeovers and mergers creating
  economies of scale
• Firms may protect themselves with intellectual
  property rights
• Theory ignores effect of limit entry pricing

18
Place the following industries in order of
contestability

• Airlines
• Oil refining
• Window cleaners
• Couriers
• Brewing
• Hairdresser

19
Practise Question

• Contestable market theory shows that government
  regulation of monopolies should focus solely on
  the removal of barriers to entry and exit.
• To what extend do you agree with the above
  statement? (20 marks)

20
What have the following done to contestability

• Internet

21
Revision Perfect Comp - Pros and Cons

• Pros
• Lowest price and highest output
• Allocatively efficient
• Productively Efficient
• Requirement to keep pace with competitors

• Cons
• Dynamically inefficient??
• No product differentiation

22
Revision Monopolies - Pros and Cons

• Pros
• Greater Ecs of Scale
• Minimum Efficient Scale
• Dynamic Efficiency
• (Reduced negative consumption externalities)

• Cons
• Higher price and lower output than Perfect Comp.
• Allocative inefficiency (DWWL)
• LR abnormal profit allows productive inefficiency