contestable+markets

== =**Contestable Markets** -- By Sarah Deville=

= =
 * How come that there are more and more food quality certifications?
 * Why are airplane tickets so expensive?
 * Why is it that companies need to differentiate their products and strategies in order to keep on making profit?

After a few weeks studying managerial economics, we probably all know that the answer to the questions above is related to the concepts of market and competition. In chapter 8, we have discovered what monopolistically competitive markets are, and we were taught that such markets could only take place if there was free entry and free exit for outside companies. But what does that mean? How do we define this freedom to enter or leave a market? How is it measured? Is it the same for all the markets? As future managers, how can we use this notion of contestable market to anticipate external environmental threats? This article will help you keep the essential concepts related to markets, competition and free entry/exit. The first part is meant to clarify the basic concepts before getting any further, whereas the second part is more technical and focused on the actual definition of contestable markets in different contexts. The multiple choice will serve as a conclusion and review of the concepts introduced.

**__A summary of the basic concepts__**
When we are in a situation where companies can entry and exit the market freely, we are in a //contestable market//. This means that the market already existing can be contested or questioned by any company willing to.

Indeed, competitors can come in and out of the market whenever they want, since: - all the companies have access to the same technology - the demand is very elastic and consumers react rapidly to price changes - there are no sunk costs, companies do not need to get in debt to enter the market. - the companies that are already in the market cannot respond to new companies' entry by lowering their prices quickly enough

All these elements prevent the market from becoming noncontestable, that is to say, a monopoly. In a contestable market, the suppliers have no power over consumers, no matter how rare or numerous the suppliers are.

__**Now, let's get a little more technical...**__
Since we are done with the reviewing of basic concepts, we will now go one step further in our understanding of contestable markets. As Dickens and Philippatos explained, the theory of contestable markets was first developed by Baumol in 1982 to try to understand why some industry structures that are not perfectly competitive can still be optimal. Indeed, in the case of a contestable market, even if there is only one firm -- which in theory should be considered a monopoly--, there is still competitive pricing, which confirms that a non perfectly competitive environment can still be optimal. The following illustration summarizes well how contestable markets and other types of markets differ, and it recapitualates what the main characteristics of a contestable market are:

As shown in the illustration above, if a firm raises their selling price above the marginal costs in a contestable market, this will trigger unusually high profit making and potential entering firms will be interested to get into the market in order to make the same high profits. Because the already existing firm can respond by lowering their selling price and thus getting the equilibrium price back to normal, this keeps the market contestable and is usually defined as the "hit and run" phenomenon. This allows markets with only one firm to stay competitive and reactive, thus, optimal. And this is probably what differentiates perfectly competitive markets from contestable ones. In a contestable market and as we already discussed it above, it is possible for one firm to dominate the industry as well as to be the one who sets the prices and produces differentiated products.

__So, how can we apply these concepts to the real world?__
The theory of contestable markets can help us understand how some specific markets work. For example, the airlines are often cited as an industry in which contestability can be discussed. Indeed, Fawcett and Farris explain that an attempt to deregulate the airline industry in the USA had already taken place in 1978 but despite this act, the airlines ended up adapting and changing their competitive environment so much that they gained control over its contestability. The consequences of this are obvious: airlines used to be a more contestable market before the Airline Deregulation Act of 1978. However, and even if there should in theory be open entry and exit as well as pricing freedom, the airlines have gained control on their market by erecting barriers, developing economies of scope, of density and of information, and they imposed switching costs for potential entrants, that is to say, substantial expenses to enter the market. All this led to a noncontestable market, whereas most of the economists were hoping to see the airline market becoming contestable. So what does this example tell us? This example demonstrates that a market can have a behavior of its own that one could not have expected. Indeed and as this example shows us, managers should be aware that an industry has the ability to regulate itself if most of its components happen to be willing to go in the same direction. If economies of scale are possible, then the chances of contestability of a market are very low and one should probably think twice before entering this market. Similarly, if the barriers to entry are very low and no big company seems to be taking advantage of their market power, then the entry of this market should be more beyond a new company's reach. Another example of a contestable market could be how this definition is now used against accusations of monoploy. For example and as Rodda explains in his article, the Microsoft company, when accused of being a monopoly, they responded the entry and exit of their market was free since the only element needed was a computer. Consequently, they work in a definitely contestable market and shall not be accused of monopoly. As the examples above both emphasized, there are some limitations to the theory of contestable markets. Indeed, the change, the entrepreneurship and the uncertainty of markets are usually not taken into account, which makes this theory incomplete for many economists. Also, the theory of contestable markets is sometimes used inadequately or partially, as in the Microsoft example. If a company is doing their best to limit the entry of competitors and consciously placing bareers, then the market is not contestable.

__Did I really get everything? A few multiple choice questions for the road__
Good luck! (Explanations follow)

1. What are sunk costs?

a. Sunk costs are the same as marginal costs b. Sunk costs are costs that a company has to pay to enter a market, and that are non-recoverable c. Sunk costs is the price to pay to differentiate the company's products d. None of the above, an essential piece of information is missing

2. What kind of barriers to entry can we find?

a. A lack of technology b. The existence of economies of scale which makes it harder for new suppliers to compete with c. A high investment needed to reach the same level of production as the competitors' d. None of the above

3. Which of the following is a good summary of the concept of contestable markets?

a. A contestable market is a market where there is monopolistic competition b. A contestable market is one where the threat of entry of other firms makes the already existing firms moderate their prices. c. A contestable market is a market where there is economic efficiency. d. A contestable market is a market where there is perfect competition.

4. What are the main arguments against the theory of contestable markets?

a. It is not taking entrepreneurship into account b. It is not taking uncertainty and change into account c. a and b d. None of the above, the theory of contestable markets has not been criticized so far.

5. Which of the following is not part of the characteristics of a contestable market?

a. The ease of entry/exit b. The non-existence of sunk costs c. The heterogeneity of the products available d. The widespread access to the same technology


 * Anwers**

1. b) Sunk costs are defined as "costs a new entrant must bear that cannot be recouped upon exiting the market" (Baye, p.341) 2. a) b) c) As explained in the "summary of basic concepts" and "let's get more technical". 3. b) c) As defined in the "summary of the basic concepts". 4. c) As we discussed in the paragraph "how can we apply these concepts in real world", there are limitations to the theory of contestable markets and the main objections to it are that it might be missing some crucial aspects of the implications of entrepreneurship, uncertainty and change. 5. c) As we established in the paragraph "A summary of the basic concepts" and "Let's get a little bit more technical", the only element which is not part of the characteristics of a contestable market is the heterogeneity of the products available.

__References__
Bayes, M. (2006), Managerial economics and business strategy, McGraw-Hill & Irwin, New York, NY.

Brätland, J. (2004), Contestable market theory as a regulatory framework: An Austrian postmortem, The Quarterly Journal of Austrian Economics Vol.7 No.3, pp. 3-28.

Calem, P.S. (1987), Entry and entry deterrence in penetrable markets, Economica Vol.55, pp.171-83.

Capul, J. Y. and Garnier, O. (2002), Dictionnaire d'économie et de sciences sociales, Hatier, Paris.

Dickens, R.N. and Philippatos, G.C. (1994), The impact of market constestability on the systematic risk of US bank stocks, Applied Financial Economics Vol.4, pp. 315-22.

Fawcett, S.E. and Farris, M.T. (2007), Constestable markets and airline adaptability under deregulation, Transportation Journal, Vol.29, pp. 12-24.

Riley, G. (2006), Contestable markets affect the behavior of businesses in the market place, Available at http://www.tutor2u.net/economics/revision- notes/a2-micro-pricing-power.html, Last retrieved Oct 23, 2007.

Rodda, C. (2007), Contestable markets, Available at http://www.cr1.dircon.co.uk/TB/2/monopoly/contestablemarkets.htm, last retrieved Oct 31, 2007.