Contestable markets

28 October 2019 by Tejvan Pettinger

 A contestable market occurs when there is freedom of entry and exit into
the market.
 In a contestable market, there will be low sunk costs. (Costs which can’t be
recovered when leaving the market)
 Due to freedom of entry and exit – existing firms always face the threat of
new firms entering the market.
 This threat of entry is sufficient to keep prices close to a competitive
equilibrium and profits low – otherwise, new firms enter.
 In a contestable market, it is not the number of firms that is important, but
the ease by which new firms can enter the market.
Diagram of a contestable market

 If the market was a monopoly with high barriers to entry, the firm would
maximise profits at P1, Q1 (point A)
 If the market became perfectly contestable – with freedom of entry and
exit, then the existing firm would have an incentive to cut prices to P2
 (point B) – Otherwise, new firms would enter the market until normal profits
are made.
 Therefore, contestable markets will have lower profits than monopoly.
Contestable markets and the public interest

Contestable markets can bring the benefits of competitive markets such as:

 Lower prices (allocative efficiency)

 Increased incentives for firms to cut costs (x-efficiency)
 Increased incentives for firms to respond to consumer preferences
(allocative efficiency)
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 policymakers 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 privatised industries have often focused on removing
barriers to entry, rather than breaking up big firms.
Factors which determine the contestability of a 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 homogenous. 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 labour 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 of market becoming more contestable – 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.
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.

Monopoly
28 October 2019 by Tejvan Pettinger

Definition of Monopoly

A pure monopoly is defined as a single seller of a product, i.e. 100% of

market share.
 In the UK a firm is said to have monopoly power if it has more than 25% of
the market share. For example, Tesco @30% market share or Google
90% of search engine traffic.
Monopoly Diagram
A monopoly maximises profits where MR=MC (at point m). It sets a price of Pm
and quantity Qm.

Problems of Monopoly

1. Higher prices. Firms with monopoly power can set higher prices (Pm)
than in a competitive market (Pc). (Red area is supernormal profit)
 2. Allocative inefficiency. A monopoly is allocatively inefficient because in
monopoly (at Qm) the price is greater than MC. (P > MC). In a competitive
market, the price would be lower and more consumers would benefit from
buying the good. A monopoly results in dead-weight welfare loss indicated
by the blue triangle. (this is net loss of producer and consumer surplus)
3. Productive inefficiency A monopoly is productively inefficient because
the output does not occur at the lowest point on the AC curve.
4. X – Inefficiency. – It is argued that a monopoly has less incentive to cut
costs because it doesn’t face competition from other firms.Therefore the
AC curve is higher than it should be.
5. Supernormal Profit. A monopolist makes Supernormal Profit Qm * (AR –
AC ) leading to an unequal distribution of income in society.
6. Higher prices to suppliers – A monopoly may use its market power
(monopsony power) and pay lower prices to its suppliers. E.g.
supermarkets have been criticised for paying low prices to farmers. This is
because farmers have little alternative but to supply supermarkets who
have dominant buying power.
7. Diseconomies of scale – It is possible that if a monopoly gets too big it
may experience dis-economies of scale. – higher average costs because it
gets too big and difficult to coordinate.
8. Lack of incentives. A monopoly faces a lack of competition, and
therefore, it may have less incentive to work at product innovation and
develop better products.
9. Lack of choice. Consumers in a monopoly market face a lack of choice. In
some markets – clothing, choice is as important as price
see also: Disadvantages of Monopolies
Advantages of monopoly

1. Economies of scale
  If there are significant economies of scale, a monopoly can benefit from
lower average costs. This can lead to lower prices for consumers.
 In the above example If there were 3 firms producing 3,000 units at an
average cost of £17, average costs would be higher than a monopoly
producing 10,000 units, and an average cost of £9. Therefore, for natural
monopolies and industries with significant economies of scale, monopolies
can be more efficient.
2. Research & Development
Monopolies make supernormal profit which can be invested in Research &
Development. This is important for industries like medical drugs which require a
lot of risky investment. In many industries which require substantial investment –
a competitive industry with many small firms would be unsuitable.

3. A firm may gain monopoly power because it is the most efficient

Google gained monopoly power through offering innovative new products. It is
hard to argue Google has x-inefficiency because of its monopoly power. You
could make a similar case for firms, such as Apple and Amazon. In this case, it is
their market dominance which comes from being innovative and meeting a
consumer demand.

4. Global competition
A domestic monopoly may face competition from abroad, and therefore what
may appear as a monopoly may still face competitive pressures. Also, a
monopoly may face competition from related industries, e.g. Eurotunnel has a
monopoly on train services from London to Paris, but faces competition from
airlines.

see also: Advantages of Monopolies

Evaluation of monopolies

 It depends on the industry in question. For example, a monopoly is needed

in a natural monopoly like tap water. However, for restaurants, there are no
significant economies of scale and it is important to have a choice.
Therefore monopoly would be very inappropriate for restaurants.
 Some industries need a lot of research and development (e.g. building new
aeroplanes, research drugs). Therefore, a monopoly may be needed in this
industry.
 A government may be able to regulate monopolies to gain benefits of
economies of scale, without the disadvantages of higher prices.
How monopolies can develop

1. Horizontal Integration. Where two firms join at the same stage of

production, e.g. two banks such as TSB and Lloyds
2. Vertical Integration. Where a firm gains market power by controlling
different stages of the production process. A good example is the oil
industry, where the leading firms produce, refine and sell oil.
3. Legal Monopoly. E.g. Royal Mail or Patents for producing a drug.
4. Internal Expansion of a firm. Firms can increase market share by
increasing their sales and possibly benefiting from economies of scale. For
example, Google became a monopoly through dominating the search
engine market.
5. Being the first firm e.g. Microsoft has created monopoly power by being
the first firm.
Monopolies also need barriers to entry to protect them from new firms entering
the market. Barriers to entry can include – brand loyalty through advertising and
economies of scale

Monopolistic Competition –
definition, diagram and examples
27 February 2019 by Tejvan Pettinger

Definition: Monopolistic competition is a market structure which combines

elements of monopoly and competitive markets. Essentially a monopolistic
competitive market is one with freedom of entry and exit, but firms can
differentiate their products. Therefore, they have an inelastic demand curve and
so they can set prices. However, because there is freedom of entry, supernormal
profits will encourage more firms to enter the market leading to normal profits in
the long term.
A monopolistic competitive industry has the following features:

 Many firms.
 Freedom of entry and exit.
 Firms produce differentiated products.
 Firms have price inelastic demand; they are price makers because the
good is highly differentiated
 Firms make normal profits in the long run but could make supernormal
profits in the short term
 Firms are allocatively and productively inefficient.
Diagram monopolistic competition short run
 In
the short run, the diagram for monopolistic competition is the same as for a
monopoly.
The firm maximises profit where MR=MC. This is at output Q1 and price P1,
leading to supernormal profit

Monopolistic competition long run

 De
mand curve shifts to the left due to new firms entering the market.
In the long-run, supernormal profit encourages new firms to enter. This reduces
demand for existing firms and leads to normal profit. I

Efficiency of firms in monopolistic competition

Allocative inefficient. The above diagrams show a price set above marginal
cost
 Productive inefficiency. The above diagram shows a firm not producing on
the lowest point of AC curve
 Dynamic efficiency. This is possible as firms have profit to invest in
research and development.
 X-efficiency. This is possible as the firm does face competitive pressures
to cut cost and provide better products.
Examples of monopolistic competition
  Restaurants – restaurants compete on quality of food as much as price.
Product differentiation is a key element of the business. There are
relatively low barriers to entry in setting up a new restaurant.
 Hairdressers. A service which will give firms a reputation for the quality of
their hair-cutting.
 Clothing. Designer label clothes are about the brand and product
differentiation
 TV programmes – globalisation has increased the diversity of tv
programmes from networks around the world. Consumers can choose
between domestic channels but also imports from other countries and new
services, such as Netflix.
Limitations of the model of monopolistic competition

 Some firms will be better at brand differentiation and therefore, in the real
world, they will be able to make supernormal profit.
 New firms will not be seen as a close substitute.
 There is considerable overlap with oligopoly – except the model of
monopolistic competition assumes no barriers to entry. In the real world,
there are likely to be at least some barriers to entry
 If a firm has strong brand loyalty and product differentiation – this itself
becomes a barrier to entry. A new firm can’t easily capture the brand
loyalty.
 Many industries, we may describe as monopolistically competitive are very
profitable, so the assumption of normal profits is too simplistic.
Key difference with monopoly
In monopolistic competition there are no barriers to entry. Therefore in long run,
the market will be competitive, with firms making normal profit.

Key difference with perfect competition

In Monopolistic competition, firms do produce differentiated products, therefore,
they are not price takers (perfectly elastic demand). They have inelastic demand.

New trade theory and monopolistic competition

New trade theory places importance on the model of monopolistic competition for

explaining trends in trade patterns. New trade theory suggests that a key element
of product development is the drive for product differentiation – creating strong
brands and new features for products. Therefore, specialisation doesn’t need to
be based on traditional theories of comparative advantage, but we can have
countries both importing and exporting the same good. For example, we import
Italian fashion labels and export British fashion labels. To consumers, the
importance is the choice of goods.
Readers Question: if all firms in a monopolistic competitive industry were to
merge would that firm produce as many different brands or just one brand?
Interesting question. I think it is an open-ended question with many different
possibilities. One approach is to think how firms in different industries may
behave if they did merge. Bearing in mind the model of monopolistic competition
doesn’t always stand up to scrutiny too well in the real world.

If the firms merged together, there is no certainty how they would behave.

In some industries, it makes sense to have many differentiated brands creating

an illusion of competition and providing a barrier to entry.

How many soap powders are there? About 35. But, most of these brands are
owned by two companies, Unilever and Proctor and Gamble. Having brand
proliferation means it is harder for a new firm to enter the market. This is because
a new firm would have to compete against 30 established brands as opposed to
2. There is less chance of getting a good market share with so many brands.
Therefore the new firm would have an incentive to keep different brands to deter
competitors.

However, if you have merge different brands there may be economies of scale.
You can devote more resources and investment to improving that particular
product and maximising its efficiency. This might be appropriate for an industry
like computer software or computers. There used to be many different brands of
computers until the pc came to dominate.

Are the different brands catering to different sectors of the market. If you take the
restaurant business, there is a big difference between Chinese and Indian. If 2
restaurants merge, they would be better off retaining distinct business. It would
make no sense to have a restaurant which offered a mixture of Chinese/Indian –
consumers would trust it less.

If you fear the arrival of a powerful company, it might be good to consolidate your
brands. For example, there are many small search engines, but they would be
better off combining forces to compete against the mighty Google.