Contestable markets

Last updated: Mar 14, 2021

The entry of new firms into a market is universally accepted as providing a benefit to national economies in terms of efficiency, innovation, growth, supply-side performance and prosperity. However, entry into markets depends on certain conditions being met. Markets where entry and exist are costless are called ‘contestable’ markets.

Contestable market theory (CMT) is closely associated with American economist William Baumol who, in 1982, along with John Panzar and Robert Willig, published Contestable Markets and the Theory of Industrial Structure.

Contestable markets are, essentially, ones that firms can freely enter and leave. This means that the costs of entry and exit are zero. According to Baumol, a key feature of a contestable market is that both existing firms (‘incumbents’) and potential entrants have access to the same technology to enable production and distribution. Firms are also free to leave, with no sunk costs – which are costs that are not recoverable after a firm leaves a market.

There is also the assumption that incumbent firms cannot immediately reduce their prices when a new firm enters or threatens to enter – usually as a result of contractual obligation or other constraints – in other words, prices are ‘sticky’.

Barriers to entry

Contestability ultimately depends upon the absence of barriers to entry – if firms cannot enter they cannot leave, by definition. Economists have for many years debated exactly what constitutes an entry barrier. According to American economist, Joe Bain, a barrier to entry is anything that allows incumbents to raise prices above marginal cost, which usually entails above-normal profits, without inducing entry of new firms. Barriers are defined in a slightly different way by the George Stigler (Chicago School) who suggested that a barrier exists is if the conditions of entry for the incumbents were less difficult than for the new entrants. Though the emphasis is different, that barriers deter entry is central to all definitions. Barriers can be classified in several ways, but a useful method is to distinguish barriers which are a function of the industry – called structural barriers, and those arising from strategic planning by incumbent firms to gain a competitive advantage.

Structural barriers

Structural barriers that might limit contestability include:

Economies of scale

Economies of scale might deter entry if they are unavailable to potential entrants. For example, if a natural monopoly such as an energy supply company has control of the infrastructure and has extended it over the years, therefore lowering its average costs, a new entrant will not be able to gain from this existing infrastructure. However, not all economists accept that economies of scale are an entry barrier. In particular, Stigler (1968) argues that entrants and incumbents may both gain from the same scale economies as they expand their output. Therefore, in Stigler’s view, if new entrants have access to the same long run cost curve, economies of scale do not constitute a barrier to entry.

Switching costs

Customers of existing ‘incumbent’ firms may find it too expensive to switch to a new entrant, even if the entrants prices are below those of the incumbent. Switching costs include any monetary cost of changing supplier as well as costs in terms of time, and hence opportunity cost. For example, in terms of switching from one banking provider to a new entrant, there might be costs in terms of search time, and time to re-establish direct debits and standing orders. This is why, since 2013, banks in the UK have had to provide a free switching service to customers. This enabled ‘challenger’ banks like Monso (founded in 2015) and Starling (founded in 2014) to enter the market, gaining 13,500 and 6700 new customer respectively by 2019. (Source: FT).

Brand loyalty

Similarly, customers of existing firms may have built up a considerable amount of loyalty and attachment, and even the attractiveness of lower prices might not be enough to encourage to a move to alternatives. Own price and cross elasticity of demand may be very low between the prices of new entrants the demand for their products and those of their rivals.

This is supported by behavioural theories which point to a bias towards risk aversion – hence, consumers may continue their existing consumption patterns even when it is not rational to do so. However, contestability assumes that consumers are very sensitive to price changes.

Business start-up capital costs

Initial capital costs are clearly a cost of entry, which, by definition means that firms with considerable capital costs do not have ‘cost-free’ entry into a market. Knowledge advantages of existing firms In many markets, incumbents are likely to have built up considerable expertise in terms of understanding the market, in producing goods and services which satisfy consumer demand, and in terms of using technologies which might not be available to potential entrants.

Patents, licenses and legislative barriers

Patents which protect an invention or innovation are usually seen as temporary barriers to entry. However, it is generally accepted that patent protection limits entry but does not prevent it. Firms can still enter markets and compete so long as the product they offer does not infringe on the current patent, and offers something new. Legislation can also present barriers to entry, especially involving health and safety requirements – the airline and pharmaceuticals industries are perhaps the most heavily regulated global industry, and is, consequentially, ones with high barriers to entry.

Strategic barriers

Strategic barriers include:

Excess capacity

If incumbents build excess capacity it is likely to be interpreted by potential entrants as a threat because the excess capacity could be quickly deployed to increase output, reduce marginal cost and reduce price.

Advertising expenditure

Excessive advertising can be regarded as a deliberate strategy to deter entry. For example, if an incumbent regularly spends $1m on advertising new entrants might have to try to match that level of expenditure to achieve a given level of brand awareness to achieve sales revenue to, at least, cover costs.

Expenditure on R&D

Similarly, expenditure on research and development can be seen to be a symbolic statement to potential entrants that sufficient budgets are available for developing new products in the future.

Price discrimination

Pricing is clearly an opportunity for incumbents to deter potential entrants. Price discrimination, where consumers in sub-markets are charged different prices for the same product, can be used as a barrier to entry. For example, if a new entrant wishes to a enter a market via a low price strategy it is possible for an incumbent to reduce price in that sub-market, while maintaining a higher price for other sub-markets. The success of this depends upon the elasticity of demand of consumers in the different submarkets.

Limit pricing

Incumbents may deter entry by choosing a price that is low enough to provide a signal to a potential entrant’s that expected revenues will not cover its entry costs, and is likely to make a loss. A price that prevents entry is referred to as a ‘limit’ price. The effectiveness of the limit price is influenced the ability of the entrant to react - if the reaction time of the entrant is short, the price is likely to be set at the average cost of the entrant. If the reaction time is long, the incumbent can set the price above the limit price and continue to derive a super-normal profit in the short run.

For example, in the diagram below the new (or potential) entrant and incumbent face the same long run cost curve (at LRACe and LRACi respectively.) The industry price is currently set by the incumbent, at AR, with a price of $35. The incomebent produces 120m units, at an average cost of £15 per unit (making a super-normal profit of $20 per unit, and the new entrant can make a rofit of $10 per unit at 60m units.

The incumbent could reduce price to $25 per unit, and still make a profit of $10 per unit, but at $25 per unit the new entrant would just break even. Hence, any price below $25 per unit would force the entrant to make a loss. So, we could argue that the 'limit price' is just below $25 per unit. At $24 per unit, every unit sold by the entrant would add to losses and is likely to deter entry. Once the new entrant is deterred, the incumbent can simply push the price back up. (n.b. the price line - AR - curve is shown as a horzontal line to enable a simple comparison of the two scenarios.)

Limit pricing diagram

Barriers to exit

Contestability also relies on the absence of barriers to exit. Examples of exit barriers include:

Sunk costs

Sunk costs are cost which cannot be recovered once a firm leaves a market. Examples include:

  • Use of specialist fixed factors -  if the firm uses specialist machinery it may only achieve a fraction of its true value when sold at auction.
  • Marketing and general promotional materials - the cost of producing these cannot be recovered as they are specific to the exiting firm, and have no resale value .
  • Stocks - sales of stocks of unused components or finished goods are unlikely to attain their full cost value when a firm winds down.
  • Severance costs - some exit costs are associated with the severance of workers, such as redundancy payments, and are not recoverable.

Contracts

Many firms will have contracts which need to be honoured and which take time to run down. Hence, exiting the market quickly will not be possible without suffering additional litigation costs.

Hit and run strategy

If a market is perfectly contestable it is possible for a firm to enter and leave quickly. Entrants could use both a high or low price strategy to enter the market, depending on the nature of the market. A possible scenario is for a firm to enter the market with a low price strategy (where limit pricing is not possible by the incumbent) generate volume sales, and then on quickly – a so-called ‘hit-and-run’ strategy through ‘penetration pricing’.

A high-price entry strategy might also be possible and profitable, where the new entrant targets the ‘upper’ end of the existing market with what is called a ‘price skimming’ strategy. Of course, the ‘hit’ could be achieved through productive differentiation, rather than pricing, although this is likely to incur more development and marketing costs. However, differentiation could be based on method of distribution or packaging, in which case costs can be minimised.

Extreme cases

Natural monopolies

Natural monopolies represent an industry with, perhaps, insurmountable barriers. This is as a result of ownership of the infrastructure required to supply consumers. For example, domestic energy supply uses a network, or grid, to distribute electricity from the power generator to the end user. Once the incumbent has established control of this infrastructure is it highly unlikely that a rival supplier will enter, given the high capital costs involved in entry. If allowed, other barriers could be erected upon the threat of entry, including limit pricing. A common strategy for regulators is to force the owner of the infrastructure to ‘open-up’ and allow access to new entrants.

Pop-up stores

At the other extreme are so called ‘pop-up’ stores which take advantage of low or zero rents and appear and often disappear quickly. Many of these are highly innovative and often ‘testing’ the market before making a more permanent entry into the market. Read more on pop-ups.

Role of the internet

Over the last 20 years the internet has enabled large numbers of entrepreneurs to enter their chosen market at relatively low cost. For a few hundred dollars websites with eCommerce capacity can be set-up and managed. The existence of ‘The Long Tail’, as discussed by Chris Anderson (2007), is evidence of the fact that the internet has enabled the entry of small niche producers with very low break-even points, who may develop into larger enterprises, or who may leave quickly once a target level of profits have been achieved.

However, budgets for advertising have increased dramatically over the last few years which has tended to crowd out new entrants attempting to break into specific markets. Given the control of online advertising by Google, paid search (as opposed to organic search) is increasingly important to ‘guarantee’ that websites are listed, and his trend is likely to continue so that small independent firms will require increasingly large budgets to maintain a presence on the internet. For this reason it can be argued that the internet is now far less significant as a provider of space for new entrants.

CMT and regulation

The important question – from both a theoretical point of view and from the perspective of a regulator – is the extent to which perfect contestability will yield the same benefits as if the market was perfectly contestable. If this is the case, then even the threat of entry might be sufficient to keep the incumbent firms from exploiting their market power, pushing price towards marginal cost, and profits towards normal profits.

The emergence of CMT has meant that governments and regulators became less concerned with market structure and numbers of firms in a market. This is because contestability focuses more on ‘potential’ entry that actual market numbers. Despite the fact that it is highly unlikely that ‘perfectly contestable’ markets exist in the real world, the concept of contestability is an important one in shaping regulation.


Perfect competition

More on perfect competition.

Perfect competition
Oligopoly

What are the disadvantages of oligopoly?

Oligopoly
Game theory

How does game theory explain oligopoly?

Game theory

facebook link logo twitter link logo email link logo whatsapp link logo gmail link logo google classroom link logo