A2 Economics – Contestable Markets

I covered this topic today at the Cambridge A2 Economics revision course. The degree of contestability of a market is measured by the extent to which the gains from market entry for a firm exceed the cost of entering (i.e. the cost of overcoming barriers to entry), with the risks associated with failure taken into account (the cost associated with any barriers to exit). Accordingly, the levels of barriers to entry and exit are crucial in determining the level of a market’s contestability. Barriers to exit consist of sunk costs, that is to say costs that cannot be recovered when leaving the market. The contestable markets approach suggests that potential entrants consider post‑entry profit levels, rather than the pre-entry levels suggested by neo‑classical theory.

Obviously no market is perfectly contestable, i.e. with zero sunk costs. In modern economies it is the degree of contestability which is relevant, some markets are more contestable than others. Also just because there have been no new entrants to a market over a given period of time does not mean that this market is not contestable. The threat of entry will be enough to make the existing (incumbent) firms behave in such a way as to recognise this, i.e. by setting a price which doesn’t attract entry and which only makes normal profits.

Markets which are highly contestable are likely to be vulnerable to ‘hit and run competition’. Consider a situation where existing firms are pricing at above the entry‑limit level. Even in the event that existing firms react in a predatory style, new entry will be profitable as long as there is a time lag between entry and the implementation of such action. Having made a profit in the intervening period, the new entrant can then leave the market at very little cost.

In a contestable market there are no structural barriers to the entry of firms in the long-run. If existing businesses are enjoying high economic profits, there is an incentive for new firms to enter the industry. This increases market competition and dilutes monopoly profits for the incumbent firms. Market contestability requires there are few sunk costs. A sunk cost is committed by a producer when entering an industry but cannot be recovered if a firm decides to leave a market.

Entry limit pricing

The fear on the part of existing firms of rendering the market contestable (stimulating new entry) by making high levels of profit is likely to lead to the adoption of entry limit pricing, a concept introduced in the previous unit. This is essentially a defensive strategy, with existing firms setting prices as high as possible but not so high as to enable new corners to enter the industry. If the existing firms set price at P2 and output at Q2 (see diagram below), it would be possible for a new firm to enter the industry and supply Q1. Total market supply would then be Q3 (Q1 + Q2), the price would be P3 and the new firm would be covering its costs. If, instead, the existing firms chose to produce at Q3 (with price level P3), the new firm producing Q1 (total market supply would now be Q4 at price P4) would not be covering its costs and would have to exit the industry in the long run.

The video below on the Airline Industry in the US from Commanding Heights series is a good example of breaking down monopoly power.

Source:

Anforme – A2 Level Economics Revision Booklet.

Ludicrous regulations of the US Airline Industry and Contestable Markets

With Auckland now at COVID-19 Alert Level 3 and schools operating online we continued going through the A2 syllabus and discussed Contestable Markets using Webex. I used this clip from Commanding Heights to show how regulated the US airline industry was during the 1970’s. Regulations meant that major carriers like Pan Am never had to compete with newcomers. However an Englishman named Freddie Laker was determined to break this tradition and set-up Laker airways to compete on trans-atlantic flights. He offered flights at less than half the price of what Pan Am charged. Alfred Kahn was given the task by the then President Jimmy Carter to breakup the Civil Aeronautics Board (the regulatory body) and he wanted a leaner regulatory environment in which the market was free to dictate price. There is a piece in the clip that shows how ludicrous some of the regulations were:

When I got to the Civil Aeronauts Board, the biggest division under me was the division of enforcement – in effect, FBI agents who would go around and seek out secret discounts and then impose fines. We would discipline them. It was illegal to compete in price. That means it was illegal to compete in the discounts you offer travel agents. So we regulated travel agents’ discounts. Internationally, since they couldn’t cut rates, they competed by having more and more sumptuous meals. We actually regulated the size of sandwiches. Alfred Kahn

When the CAB was closed down competition was the rule and the industry had vastly underestimated the demand for air travel at lower prices – a very elastic demand curve – see graph below.

In the A2 course contestable markets is a popular essay question and is usually combined with another market structure.

What is a contestable market?

• One in which there is one firm (or a small number of firms)
• Because of freedom of entry and exit, the firm faces competition and might operate in a way similar to a perfectly competitive firm
• The threat of “hit and run entry” from new firms may be sufficient to keep the industry operating at a competitive price and output
• The key requirement for a contestable market is the absence of sunk costs – i.e. costs that cannot be recovered if a business decides to leave a market
• When sunk costs are high, a market is more likely to produce an price and output similar to monopoly (with the risk of allocative inefficiency and loss of economic welfare)
• A perfectly contestable market occurs only when entry and exit into and out of a market is perfectly costless
• Contestable markets are different from perfect competitive markets
• It is possible for one incumbent firm to dominate the industry
• Each existing firm in the market produces a differentiated product (i.e. goods and services are not perfect substitutes for each other)

There are 3 conditions for market contestability:

• Perfect information and the ability and or legal right to use the best available technology
• Freedom to market / advertise and enter a market
• The absence of sunk costs

Example
• Liberalisation of the US Airline Industry in the 1970’s and the European Airline Market in late 1990s
• Traditional “flag-flying” airlines faced new competition
• Barriers to entry in the industry were lowered (including greater use of leased aircraft)
• New Entrants – easyJet- Ryanair

A2 Economics – the need to move to more contestable markets.

The Economist had as its main Leader an article on the lack of competition in the global market place. Too many companies have  monopoly power and earn, what the economics textbooks call,  significant ‘abnormal profits’. In 2016 a survey found that more than half of young Americans no longer support capitalism. In the past governments have made it a more level playing field.

• US – at the start of the 20th century they broke up monopolies in railways and the energy industry. Ronald Reagan also unleashed the power of the market
• West Germany – created competitive markets to rebuild their post-war economy
• Britain – Margaret Thatcher exposed state-owned inefficient domestic industries to the dynamic foreign competition. She also privatised the Commanding Heights of the economy.

There are 3 tests that The Economist use to examine the market structure:

Concentration Ratios
A lot of firms have experienced inertia and become very comfortable whilst the tech firms are building significant amounts of market power. In the US Concentration ratios between 1997 and 2012 have risen in approximately 600 census industries, with the weighted average market share of the top 4 firms growing from 26% to 32%. 10% of the US economy is made up of industries where 4 firms have more than 66% of the market share. The concentration ratio is the percentage of market share taken up by the largest firms. It could be a 3 firm concentration ratio (market share of 3 biggest) or 5 firms concentration ratio.

Abnormal Profits
In a healthy economy you would expect profits to be competed down, but the free cashflow of companies is 76% above its 50-year average, relative to GDP. In Europe the trend is similar, if less extreme. The average market share of the biggest four firms in each industry has risen by three percentage points since 2000. On both continents, dominant firms have become harder to dislodge.

Openness
Of US firms that made very high profits in 1997, 50% still did in 2017. There is a reduction in new firms and with a lowdown in globalisation industries that are less exposed to trade have become more dominant in the market place – the domestic market. The current protectionist policies of the Trump Administration don’t help to breakdown the barriers to entry and as the high stock values of profitable firms show, investors believe their advantages will continue. Powerful firms tend to stay and of the total capital spending and R&D done by America’s leading 500 companies the top 20 firms account of 38% of this spending.

The Contestable Market – A2 Economics – Theory

The degree of contestability of a market is measured by the extent to which the gains from market entry for a firm exceed the cost of entering (i.e. the cost of overcoming barriers to entry), with the risks associated with failure taken into account (the cost associated with any barriers to exit). Accordingly, the levels of barriers to entry and exit are crucial in determining the level of a market’s contestability. Barriers to exit consist of sunk costs, that is to say costs that cannot be recovered when leaving the market. The contestable markets approach suggests that potential entrants consider post‑entry profit levels, rather than the pre-entry levels suggested by neo‑classical theory.

Obviously no market is perfectly contestable, i.e. with zero sunk costs. In modern economies it is the degree of contestability which is relevant, some markets are more contestable than others. Also just because there have been no new entrants to a market over a given period of time does not mean that this market is not contestable. The threat of entry will be enough to make the existing (incumbent) firms behave in such a way as to recognise this, i.e. by setting a price which doesn’t attract entry and which only makes normal profits.

Markets which are highly contestable are likely to be vulnerable to ‘hit and run competition’. Consider a situation where existing firms are pricing at above the entry‑limit level. Even in the event that existing firms react in a predatory style, new entry will be profitable as long as there is a time lag between entry and the implementation of such action. Having made a profit in the intervening period, the new entrant can then leave the market at very little cost.

In a contestable market there are no structural barriers to the entry of firms in the long-run. If existing businesses are enjoying high economic profits, there is an incentive for new firms to enter the industry. This increases market competition and dilutes monopoly profits for the incumbent firms.
Market contestability requires there are few sunk costs. A sunk cost is committed by a producer when entering an industry but cannot be recovered if a firm decides to leave a market.

The video below on the Airline Industry in the US from Commanding Heights series is a good example of breaking down monopoly power.

Sources:

The Economist – The Next Capitalist Revolution – November 17th 2018

Anforme – A2 Level Economics Revision Booklet

A2 Economics Revision: Contestable Markets

In the A2 course contestable markets is a popular essay question and is usually combined with another market structure.

What is a contestable market?

• One in which there is one firm (or a small number of firms)
• Because of freedom of entry and exit, the firm faces competition and might operate in a way similar to a perfectly competitive firm
• The threat of “hit and run entry” from new firms may be sufficient to keep the industry operating at a competitive price and output
• The key requirement for a contestable market is the absence of sunk costs – i.e. costs that cannot be recovered if a business decides to leave a market
• When sunk costs are high, a market is more likely to produce an price and output similar to monopoly (with the risk of allocative inefficiency and loss of economic welfare)
• A perfectly contestable market occurs only when entry and exit into and out of a market is perfectly costless
• Contestable markets are different from perfect competitive markets
• It is possible for one incumbent firm to dominate the industry
• Each existing firm in the market produces a differentiated product (i.e. goods and services are not perfect substitutes for each other)

There are 3 conditions for market contestability:

• Perfect information and the ability and or legal right to use the best available technology
• Freedom to market / advertise and enter a market
• The absence of sunk costs

Example
• Liberalisation of the European Airline Market in late 1990s
• Traditional “flag-flying” airlines faced new competition
• Barriers to entry in the industry were lowered (including greater use of leased aircraft)
• New Entrants – easyJet- Ryanair

A contestable market gone wrong – Taxis in South Africa

Just covering contestable markets with my A2 and came across a relevant article in the Otago University EcoNZ@Otago magazine. Up to 1987 the transit authority in South Africa had a monopoly on public transport. It was near impossible for private taxi firms to operate and the use of public transport was very expensive – many spent 20% of their incomes on the commute. In this context the demand for taxi services was high and many illegal operations started to appear. The government, believing that a more deregulated transport market would improve its effectiveness, eased restrictions on private taxis.

A huge number of taxis appeared on the market of which the majority were large 15-seat vehicles (aka Kombis) and they ran late-night and rural services, and travelled to locations that busses and trains did not. However in order to reduce the running costs of the Kombi the road-worthiness of vehicles became a concern whilst passenger numbers grew considerably. With the transport authority basically giving a ‘free reign’ to operators and displaying no control over operation location or price, operators banded together and formed ‘taxi associations’ to compete over taxi drivers and routes. By 2003 60% of South African commuters used the taxi industry which was believed to be worth approximately R12 billion (NZ$2.2 billion) each year. Rivalry amongst taxi firms got out of hand and many resorted to violence and blackmail in order to secure rights over the most profitable routes. In fact the industry became more like something out of the ‘Sopranos’ with the hiring of hit men against rival associations.

By 1999, in response to this on-going problem, the South African government increased spending on public infrastructure and overhauled the taxi industry.

Taxi-related violence and deaths in South Africa – 1991-1999