Contestable
Markets
_______________________________________________
William Baumol (1980s) – theory that the number and size
of not only competitors but potential
competitors can affect a firm’s behaviour.
Contestability
is measured by the extent to which the gains from market entry for a firm
exceed the cost of overcoming barriers to entry, with the risks of failure
taken into account (affected by barriers to exit).
In
other words, a contestable market exists when a market is said to have low sunk
costs and therefore low barriers to entry and exit – this means that new firms
can quickly enter an industry to exploit supernormal profits before leaving the
industry – ‘hit and run’ profits.
Types of competition:
·
Perfect
competition:
perfect competition is perfectly competitive.
·
Monopolistic
competition: this
type of competition has minimal entry barriers although small firms need to
build up a customer base and meet certain government regulations – it is highly
but not perfectly contestable.
·
Oligopolies:
these are much
less contestable due to high barriers to entry and exit.
·
Monopolies:
these are not
very contestable at all, for example in a legal monopoly such as the Post
office (to an extent) the market is not contestable. This can also be an issue
where a firm has the protection of a patent.
What is a sunk cost?
·
A
sunk cost is a cost which cannot be recouped on exiting the industry.
·
The
main examples of sunk costs are advertising, research and development etc.
·
In
other words, sunk costs are the costs of anything which cannot be sold second
hand.
How the threat of new entry influences the behaviour of
firms
Firms
may alter their behaviour with the threat of new entry, causing them to use
price or non-price strategies to deter new entry.
Price strategies:
1.
Predatory
Pricing:
·
This
is an anti-competitive strategy in which a firm sets price below average
variable cost in an attempt to for a rival or rivals out of the market and
achieve market dominance.
·
This
is an extreme strategy because firms generally shut down when they don’t cover
their average variable cost.
·
The
consumer might benefit in the short-run, however in the long run the firm would
be likely to try to make up for the losses made by significantly increasing
price (once competitors had been driven out).
·
In
some cases even the threat of predatory pricing will be enough to drive out
competition, if credible.
·
Whether
entry will be deterred may depend on the potential entrant – a new firm may
think that if the dominant firm is willing to risk such losses then it must be
worthwhile to dominate the market – it may therefore decide to sacrifice
short-term profit in order to enter the market (especially if it is
diversifying from other markets and has resources at its disposal).
·
It
is illegal under EU law.
·
One
example of predatory pricing is with easyJet in 1996:
-
easyJet
was a relatively new low-cost budget airline trying to establish itself
-
when
they started flying the London-Amsterdam route the incumbent firm (KLM) reacted
aggressively, driving its price below easyJet’s
-
easyJet
responded by launching legal action against KLM
2.
Limit
Pricing:
·
This
is less extreme.
· The
limit price is the highest price that an existing firm can set without enabling
new firms to enter the market and make a profit.
·
If
a firm is making supernormal profits in an industry, this will be attractive to
potential entrants.
·
If
a new firm joins the market, producing on a relatively small scale (so as just
to cover AC) the price will go down.
· As
the new firm is just covering AC it is making normal profits, and the previous
firm’s supernormal profits decrease.
·
The
firm could have guarded against entry by charging a lower price to begin with –
this way the new firm would have driven price down to a lower level, and
without the benefits of economies of scale it would make losses and exit the
market.
·
If
the existing firm has been in the market for some time it will have learned in
the process, and will have a lower AC than the new entrant – this means that
limit pricing can be used more easily.
· Therefore,
by setting a price below the profit maximising level, the original firm is able
to maintain its market position in the longer run.
· This
may happen in an oligopoly as well as a monopoly, as existing firms may group
together to limit price.
Non-price strategies:
Advertising
and publicity:
- Component
of fixed costs – advertising does not vary much with output.
-
If
firms spend heavily on advertising, it increases barriers to entry for new
firms as they must also heavily advertise in order to increase demand for their
product.
- Firms
may spend heavily on achieving a well-known brand image and therefore consumer
loyalty – they may invest in the design and packaging of their merchandise,
e.g. the TV campaign run by Sunny Delight when trying to gain entry into the
soft drinks market in the early 00s.
- Such
costs are also sunk costs, therefore they make the market less contestable by
raising barriers to exit too.
Research
and development:
-
In
some markets there is heavy expenditure on research and development.
- E.g.
the pharmaceutical industry, which spends a lot of money researching new drugs.
- This
is another component of fixed costs – it does not vary with the volume of
output.
- New
firms know that they will need to invest heavily in research and development if
they are going to keep up with the new better drugs constantly coming onto the
market.