William Baumol developed the theory of contestable markets in 1982. The theory is based on the idea that a firm's behaviour is determined by potential competition, as opposed to actual competition.
- A market may have a high concentration ratio (the market share is divided between a few firms/one firm) but still face competitive pressure.
- A perfectly contestable market is one where no barriers to entry/exit exist.New firms face the same costs as existing firms and there is no brand loyalty. The existing firms do not adopt any aggressive pricing tactics to remove new firms.
There are three main conditions for perfect contestability:
- Perfect information
- Absence of sunk costs
- No barriers to entry
In reality, no market is perfectly contestable. However, where contestable markets exist, competition should be strong for these reasons:
- New firms can easily enter the market if they see that they can make profit
- Non-price competition will exist
However, existing firms do not want new firms to enter the market and take some of the market share. Therefore they take on some tactics to increase barriers to entry and threaten new firms
Entry-limit pricing occurs when incumbent firms try to outprice their new rivals to force them out of the market.
- When a new firm enters, they want to make a lot of money quickly, without pricing their goods above their rivals as this would stop consumers from buying their products.
- Incumbent firms use this fact to their advantage. They lower their prices to attract consumers away from the new firm.
- The new firm follows this price fall, not wanting to lose consumers.
- Eventually the price falls to a point where the firms are now making a loss on every product that they sell.
- This forces the new firm out of the market, and the existing firms can push their prices back up to a profitable, competitive level.
The existing firms can survive these short-term losses while they force out the new firm because they probably have savings and investments that they can rely on to maintain their business. The new firm does not have this back-up, relying on the money they make from their sales, so they have to shut down.
This is only true in the short-term. If the firms kept trying to out-price each other, in the long-term the whole market could collapse.
Hit-and-Run Competition occurs when firms enter a market for a very short period of time, making abnormal profit and then leaving the market again if incumbent markets react aggressively to this.
- Because there are little or no sunk costs (entry costs that cannot be recovered) involved it is very easy to enter the market i.e sunk costs are effectively a barrier to entry.
- Potential new firms will react to a signal from the market in the form of high normal profits or abnormal profits, suggesting that there is a profit to be made if they enter the market now.
Existing firms may try to create artificial barriers to entry to stop this behaviour:
- Heavy advertising
- Investing in Spare Capacity
This sends a signal to entering firms that the market is prepared for a price war (entry-limit pricing)
Broadcasting Case Study
In 2005 the UK witnessed a huge boom in take-up for broadband technology.
OFCOM believes that the retail market for broadband is now sufficiently competitive market so that it can operate without price regulation. In the past, industry regulators in recently privatized industries where monopoly power remained have used their powers to impose price regimes on the major utilities. But as competitive forces have strengthened, so the role of the regulator has moved towards a broader role of monitoring the scale and quality of competition within a market.
As part of the current legal arrangements in the UK telecoms sector, BT is required to provide regulated wholesale access to broadband products so that other service providers can sell broadband to households and business customers. OFCOM has intervened to reduce the access charges that BT can make to these other suppliers, and this too has been important in reducing barriers to entry in the market and thereby making the industry more contestable. For example, just over a year ago, Ofcom announced proposals set a maximum price of £81.85 that BT can charge its competitors to rent a fully unbundled local loop. The ceiling is designed to promote competition in the broadband market by ensuring that BT's charge is fair, reasonable and cost-oriented.