Download - Perfectly Contestable Market

8/10/2019 Perfectly Contestable Market

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MarindaAsihRamadhaniah

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Perfectly Constable Market

1. Definition of Constable Market

Contestable market occurs when there is freedom of entry and exit into the

market. Thus in a contestable market, there will be low sunk costs (costs that have

been committed by a business cannot be recovered once a firm has entered the

industry).

It is important to remember that contestability is not a clear cutissue, there are

degrees of contestability, some markets having more capacity for new firms to

enter. Inpractice few industries are perfectly contestable.

2. Factors Which Determine The Contestability Of A Market

When considering the contestability of markets it is important to consider the

different barriers to entry a new firm mayface :

1. Sunk Costs. If Sunk costs are high this makes it difficult for new firms to enter and

leave the market. Therefore it will be less contestable. For example, if a new

firm had to purchase raw materials, that it wouldnt be able to resell on leaving

the market, this may act as a deterrent.

2. Levels of advertising and brand loyalty. If an established firm has significant

brand loyalty such as Kentucky Fried Chicken, then it will be difficult for a new

firm to enter the market. This is because they would have to spend a lot of money

on advertising which is a sunk cost and this advertising may not be sufficient to

change customer loyalty to very strong brands. It depends on theindustry,

customer loyalty would be fairly low for a product like petrol because it is quite

homogenous. But, for fast food people have greater attachment to their brand.

3. Vertical Integration. If a firm does not have access to the supply of a good then

the market will be less contestable. For example, Oil firms could restrict the

supply of petrol to petrol stations, making it difficult for new firms to enter.

Giving access to different stages of production can make the market more

contestable.

4. Access to technology and skilled labor. For some industries like car production it

is difficult for new firms to have the right technology. Nuclear power may require

skilled labor that is difficult to get. This makes the market less contestable. If youwished to compete with Google, you may find it hard to employ the best software
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engineers because Google pays its employees a very good wage and is seen as an

attractive company to work for.

As well as looking at barriers to entry, there are other factors that might indicate the

competitiveness of a market.

The level of profit. If the market is highly profitable, this suggests the market isless contestable. In theory, if firms are making supernormal profit, it would

attract new firms into the market. The persistence of supernormal profits

suggests that hit and run competition is not possible and there are barriers to

entry.

The number of firms. A contestable market could have a low number of firms as

long as there is the threat and possibility of new firms entering. However, if there

are only a few firms and it has been many years since any new firms have

entered, then it is likely to be less contestable. If there are recent examples of

firms entering the market, then it is likely to be more contestable.

3. Difference between Contestable Markets and Perfect Competition

Contestable markets are different from perfect competitive markets. For

example, it is feasible in a contestable market for one firm to have price-setting

power and for firms in a market to produce a differentiated product.

There are three main conditions for pure market contestability:

Perfect information and the ability and/or the right of all suppliers to make use of

the best available production technology in the market.

The freedom to market / advertise and enter a market with a competing product. The absence of sunk costs this reduces the risks of coming into a market

4. Increasing TheConstability Market

1. Remove legal barriers to entry. Royal Mail used to be a legal monopoly but nowfirms are allowed to enter the market for sending letters and parcels.

2. Force firms to allow competitors to use its network For example when BT wasprivatised, OFTEL forced BT to allow other companies to use its network. This has

also occurred in the Gas and Electricity industries and has made them morecontestable. A firm can now gain access to the national network of gas /electricity infrastructure

3. Legislation against Predatory Pricing If a firm can engage in predatory pricingitcan force new firms out of business and make it less contestable.

4. OFT can legislate against abuse of Monopoly power. If a firm abuses its monopolypower by restricting supply to certain firms the OFT can intervene to overcomethis restriction on contestability.
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5. A government firm. In the banking industry, the government has even toyed withcreating its own company to help increase competition and increase bank lendingto small firms. This could be a last resort where private firms face insurmountablebarriers to entry.

Note, there are many barriers to entry that the government cant solve. The

government cant alter the economies of scale in an industry.

5. The Effect Of The Competition Toward A Firms Behaviour

Figure 1.

In the figure 1 above a pure monopoly might price at P1 the profit maximisingequilibrium.

If a market iscontestable,there is downward pressure on price, because the presencesupernormal profits signals for new firms to enter the market and if the existingmonopolist is producing at too high a price or has allowed their average total costs todrift higher, entrants can undercut the monopolist and some of the abnormal profit willbe competed away.

Normal profit equilibrium occurs when average revenue equals average total cost (atoutput Q2 and price P2). A lower price and higher output causes an increase inconsumer surplus.

When markets are contestable we expect to see lower profit margins than when amonopoly operates without competition. The threat of competition may be just aspowerful an influence on the behaviour of the existing firms in a market than the actualentry of new businesses.

If a market is contestable, industry structure and firm behaviour is determined by the

threat of competition - 'hit-and-run' entry. The market will resemble perfectcompetition, regardless of the number of firms, since incumbents behave as if therewere intense competition
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6. A Contestable Market Is Depicted In Figure 2.

Note that although only three firms are in the industry, they all produce where

price equals marginal and average cost. For the industry as a whole, price is equal to

the minimum on the long-run average total cost curve. Each firm produces one-third

(q) of total industry output (3q). Production at an efficient rate of output andmarginal cost pricing, then, does not require the atomistic markets of the perfectly

competitive model. A perfectly contestable market will do.

Figure 2. A contestable market

The market is composed of three firms, each producing output q, which minimizes

average costs. Total industry output is Q = 3q. Any attempt by the three firms to

reduce output and increase market price will lead to entry by new firms and the

dissipation of profits.

What industries might this model fit? The air travel industry is one candidate.

Many major markets are served by only two or three airlines. Yet if an airline with

a dominant position in a particular regional market attempted to set price well

above costs, entry would quickly follow. Airplanes can be shifted from one market

or use to another with ease. New entrants do not appear to be at a cost

disadvantage relative to existing firms. If the conditions for a contestable market

were indeed met, then we would expect the air travel industry to be

characterized by marginal cost pricing and zero economic profits. It is always

difficult to determine whether or not price is equal to marginal cost; one

indication that contestability characterizes the air travel industry is that prices do

not appear to be higher in markets with fewer actual competitors. The zero-profitoutcome also describes the air travel industry reasonablywell.


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SOURCES :

McKenzie, Richard B. and Dwight R. Lee.Microeconomics for MBAs: The Economic Way ofThinking for Managers, Second Edition.http://www.cambridge.org/us/download_file/163490/(diaksestanggal 10 November2014)

Pettinger, Tevjan R. Contestable

Market.http://www.economicshelp.org/microessays/contestable-

markets/(diaksestanggal 09 November 2014)

Riley, Geoff. Contestable Market. 23 September 2012.

http://tutor2u.net/economics/revision-notes/a2-micro-contestable-markets.html

(diaksestanggal 09 November 2014)
http://www.cambridge.org/us/download_file/163490/http://www.economicshelp.org/microessays/contestable-markets/(diakseshttp://www.economicshelp.org/microessays/contestable-markets/(diakseshttp://www.economicshelp.org/microessays/contestable-markets/(diakseshttp://tutor2u.net/economics/revision-notes/a2-micro-contestable-markets.htmlhttp://tutor2u.net/economics/revision-notes/a2-micro-contestable-markets.htmlhttp://www.economicshelp.org/microessays/contestable-markets/(diakseshttp://www.economicshelp.org/microessays/contestable-markets/(diakseshttp://www.cambridge.org/us/download_file/163490/