A
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 which can’t be recovered when leaving the market)
When
considering the contestability of markets it is important to consider the
different barriers to entry a new firm may face
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 wouldn’t 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 Coca Cola, 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. Even if they spend money on
advertising it may not be sufficient to change customer loyalty to very strong
brands. It depends on the industry, customer loyalty would be fairly low for a
product like petrol because it is quite homogeneous. But, for soft drinks 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. E.g. Oil firms could restrict the supply of petrol to petrol
stations, making it difficult for new firms to enter. If you wish to sell
electricity to domestic customers, a big issue is whether you can gain access
to the electricity grid. The national electric grid is a natural monopoly, but
government regulation can make sure firms have a fair access to the grid.
Giving access to different stages of production can make the market more
contestable. (How
vertical barriers can restrict competition)
4. Access to
technology and skilled labour 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 you wished to compete with Google, you may find it
hard to employ the best software engineers because Google pays its employees a
very good wage and is seen as an attractive company to work for.
See
also: other
barriers to entry
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 is less 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.
It
is important to remember that contestability is not a clear cut issue, there
are degrees of contestability, some markets having more capacity for new firms
to enter. In practice few industries are perfectly contestable.
Example
– UK Banking industry
1. There are high
sunk costs in getting a network of banks set up around the country..
2. Brand loyalty
to existing banks is high. Customers are not so willing to switch. Therefore a
new firm may have to spend a lot on advertising to attract new customers, which
is a sunk cost, therefore not contestable.
3. Existing banks
make very high profits, suggesting hit and run competition does not occur.
These
issues suggest banking is not contestable. However, other factors may suggest
greater contestability.
· The
introduction of the internet has reduced set up costs and enabled new firms to
enter the market for online banking e.g. EGG, Virgin business.
· The
government is trying to introduce regulation to reduce the time and costs of
switching to another current account.
Contestable
Markets and the public interest
Contestable
markets can bring the benefits of competitive markets such as:
· Lower
prices
· Increased
incentives for firms to cut costs
· Increased
incentives for firms to respond to consumer preferences
However
there could also be significant economies of scale because the theory of
contestable markets doesn’t require there to be 1000s of firms
· Therefore
policy makers should not just look at the degree of concentration, but also the
degree of contestability and how easy it is to enter the market.
· Regulators
in the privatized industries have often focused on removing barriers to entry,
rather than breaking up big firms
Methods to Increase the Contestability of Markets
1. Remove legal
barriers to entry. Royal Mail used to be a legal monopoly but now
firms 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 was
privatised, 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 more
contestable. 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
pricing it can 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 monopoly power by restricting supply to certain firms the OFT can
intervene to overcome this restriction on contestability.
5. A government
firm. In the banking industry, the government has even toyed with creating its
own company to help increase competition and increase bank lending to small
firms. This could be a last resort where private firms face insurmountable
barriers to entry.
Note,
there are many barriers to entry that the government can’t solve. The
government can’t alter the economies of scale in an industry.
Article from: Economics Help Blog
8 comments:
Sir
As per my understanding, it is very important for a market to be contestable i.e. to have free entry and free exit in order to sustain a perfect competition in a market. There are many hindrances also to the free entry in a market like sunk cost [ like cost on advertising ].Advertising here, is very big example of the sunk cost because if our product turns out to be a failure even after advertising a lot then we will not be able to cover the cost of the advertising because eventually the expected return i.e. promotion of sales did not take place and hence, even after entering freely in a market ,the exit is a forced one. In the case of advertising the firms entering the market can make sure that first of all ,there advertisement reach the target consumers and they understand the basic gist of it i.e should be easily understandable and finds a connection to the thought of the people also. It can be very unique just like the plausible work done by cadbury, it is commendable the way they put their ads. Also, there are other hindrances to entry like if already a established firm is there in the market and the brand loyalty to that product is very high. Again, here I would like to pose the example of cadbury. Other brands of chocolate tried entering the market but were very unfortunately had to exit the market or now have very high sunk costs.So, in the end there will be a lot of hindrances and there willing firms to have a stay in the market in the long run will have to face these hindrances very skillfully i.e. will have to weigh all the pros and cons and act upon the best of the solutions to these problems but no where the solution to it will be not taking the risk of entering the market because for entering any market the first rule is to take risk .
Dear Sonakshi,
You have very well developed ideas.
Great to know..
Warm Regards,
Arun
Sir
In my opinion as the name suggests contestable markets are those where everyone not only the sellers but also the buyers have liberty in the market regarding the purchase and selling of the good i.e the market where everyone can contest.Now talking about the barriers which contestable mrkt has say for ex advertising in beauty products like olay cream,fair and lovely fairness cream where the actors edorse the products and it becomes very difficult for the other companies to compete since actors charge high cost for advertising and also buyers also trust the actors which they like.also the buyers see majority of people where they are purchasing even if the new firm product is better and of good quality buyers will not go there this is because the old firm has more majority and is renowned.sometimes it also happens that some personality or great person name is attached to a firm it also leads to hindrance in setting of a new firm In a market
Sir,
In my views contestable market is in which there is contest in between the contestant in a market. In order the market to be more contestable there should be free entry to the market for any new contestant, which could be done through reducing the sunk cost. As particularly about India the sunk cost is high for any firm to get into the market, which discourage them to take part in it . Also the advertisement plays a key role for a new player in the market as had been described in the article due to the loyalty. I would like to pose an example - 3-4 years ago there was a time when in the smartphone network only samsung ruled, but then micromax came up with the strategy like in the advertisement field they knew that most of the youth is going to buy these phones so they made Hugh Jackman as there ambassador, which intern also produced a good effect and today micromax have tookover samsung in the smartphone network. Also government need to support entrepreneurship , as there are many entrepreneurs in the country with a well developed methods and ideas which would be more effective than which is pertaining today. Now a days there has been a new trend of startup , which is a individuals or a group come up with there idea and they need funding in order to execute their ideas , but it seems to find needle in a haystack kind of work , many of the good ideas are being wasted due to lack of funding. So government can intervene in order to help them to achieve their aim as this would also lead to contestable market .
Sir,
Acording to me, a contestable market is one with zero entry and exit costs. This means there are no barriers to entry and no barriers to exit, such as sunk costs and contractual agreements. For a market to be perfectly contestable, relevant industry technology would be readily available to potential entrants.The existence, or absence, of sunk costs and economies of scale are the two most important determinants of contestability. On the basis of these two criteria, natural monopolies are the least contestable markets.moreover if a firm earns supernormal profits than it would be an incentive for other firms to enter the market,which will eventually pull down the market price until the firms earn normal profit.therefore supernormal profits are not possible in a perfect competition market.
15bal043
Sir,
Acording to me, a contestable market is one with zero entry and exit costs. This means there are no barriers to entry and no barriers to exit, such as sunk costs and contractual agreements. For a market to be perfectly contestable, relevant industry technology would be readily available to potential entrants.The existence, or absence, of sunk costs and economies of scale are the two most important determinants of contestability. On the basis of these two criteria, natural monopolies are the least contestable markets.moreover if a firm earns supernormal profits than it would be an incentive for other firms to enter the market,which will eventually pull down the market price until the firms earn normal profit.therefore supernormal profits are not possible in a perfect competition market.
15bal043
Dear Saloni, Utkarsh, and Ayushi,
In order to appreciate your points, I will have to take these identified issues in class.
Proud to have you as part of my class.
Keep up the good work,
Warm Regards,
Arun
Contestable markets in the short-run show possible threats from potential competitors which exert a degree of pressure over the incumbents,who should be able to enter the market without any complications and have the same advantages as the incumbent firms, once inside the market.It is often the case that markets become more competitive because of the persistence of entrepreneurs who do not accept that the existing market structure is rigid. A new supplier may have the advantage of product innovation or a more competitive business model based on different pricing strategies.With no barriers to entry into a market, it can be argued that the threat of entry is enough to keep incumbents ‘on their toes’for innovating in every sphere possible.
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