How does the threat of competition affect a firm’s behaviour? Topic 3.3.10

How does the threat of competition affect a firm’s behaviour? Topic 3.3.10 Students should be able to: Define contestability and understand how the threat of new entry may influence behaviour and market performance of existing firms. Understand the relationship between sunk costs and the degree of contestability — examples may include banking, airline industry and petrol retailing.

Key Concepts – Contestable Markets Where an entrant has access to all production techniques available to incumbents and entry decisions can be reversed without cost Hit and run entry When a business enters an industry to take advantage of temporarily high (supernormal) market profits. Sunk costs Sunk costs cannot be recovered if a business decides to leave an industry. The existence of sunk costs makes a market less contestable.

Contestable Markets Contestable markets are constantly changing Contestable markets can be seen at a local, regional, national and international level In a contestable market, the number of size distribution of businesses in the industry is less important More focus is given to the threat of entry from rivals Almost all markets are contestable to some degree Technology has the potential to change contestability E.g. the barriers to entry in many markets are widely thought to have lowered because of digital advances Contestable markets often show high dynamic efficiency

Conditions for a Contestable Market Absence of sunk costs Access to technology Low consumer loyalty Low legal barriers Pool of new entrants willing and ready to enter the market No significant entry or exit costs Access to the available technology High rates of customer churn

Contestable Markets in Action! Nov 2015: Apple 'to launch peer-to-peer payment app' in competition with PayPal Nov 2015: The Gym Group, one of the UK's low-cost fitness chains and it is now listing on the stock market to fund future expansion Nov 2015: Uber taxi app to launch in Edinburgh Nov 2015: Amazon begins a new chapter with opening of first physical bookstore Oct 2015: Metro Bank Takes Step Towards £1bn Listing Oct 2015: Argos launches Same Day Delivery Oct 2015: Sainsbury's tests out 'micro-stores' for busy shoppers

Generic Drugs and Contestability Leading global generic drug manufacturers by market share 2013 Top 10 generic drug manufacturers - worldwide market share in 2013 Each medicine has an approved name called the generic name. For example, paracetamol is a generic name. There are several companies that make this with brand names such as Panadol®, Calpol® Note: Worldwide

A Contestable Oligopoly? Market share of mobile handset manufacturers in the UK in June 2014 5 firm concentration ratio = 84.4% Note: United Kingdom; June 2014*

Hotel rooms & Airbnb listings in New York Note: United Kingdom; June 2014*

Sunk Costs Sunk costs cannot be recovered if a business decides to leave an industry. Examples include: Capital inputs that are specific to an industry and which have little or no resale value. Money spent on advertising, marketing and research and development projects that cannot be carried forward into another market or industry. Money spent in building expensive and complex IT systems that are subsequently ditched because they are unworkable When sunk costs are high, a market becomes less contestable. High sunk costs act as a barrier to entry of new firms because they risk making huge losses if they decide to leave a market. In markets such as fast-food restaurants, sandwich bars, hairdressing salons and local antiques markets there are low sunk costs so the barriers to exit are low.

Core Examples of Sunk Costs Asset-write-offs – e.g. the expense associated with writing-off the value of plant and machinery, stocks and the goodwill of a consumer brand Closure or project cancellation costs including redundancy costs, contract contingencies with suppliers and the penalty costs from ending leasing arrangements for property The loss of business reputation and goodwill - a decision to leave a market can seriously affect goodwill among previous customers, not least those who have bought a product which is then withdrawn and for which replacement parts become difficult or impossible to obtain. A market downturn may be perceived as temporary and could be overcome if and when the economic or business cycle turns and conditions become more favourable

Examples of Sunk Costs Nov 2015: Redcar owner loses £530m on steel plant liquidation

Retail Contestability – Rise of Aldi & Lidl Lidl is following a strategy of rapid organic growth Aldi - world’s leading limited assortment grocery, with total sales of €61bn in 2013, followed by Lidl at €59bn Together, the two German discounters have more than 20,000 stores across Europe, the US and Australia. Lidl is present in 26 European markets Majority of their products are own-label, rather than brands - gives them purchasing power with suppliers. The range suppliers are asked to provide is narrower – perhaps four to six products compared with 30-40 at a large grocer – driving efficiencies and big volumes

Contestable Markets – Price and Profit The more contestable a market is, the more likely that an allocatively efficient outcome is achieved The threat of entry affects the behaviour of firms Often smaller disruptive businesses challenge the monopoly power of existing businesses The threat of entry is as important as actual competition

Highly Contestable Market – Profit Maximising Output Pricing – Options in Contestable Markets Cost & Price Highly Contestable Market – Profit Maximising Output Price > Average Cost Supernormal profits High profits send signals to other suppliers In the left hand diagram draw in the profit maximising output and price (label it Q1 and P1.) MC P1 AC AR C1 MR Q1 Output (Q)

Highly Contestable Market – Profit Maximising Output Pricing – Possible Long Run Equilibrium? Cost & Price Highly Contestable Market – Profit Maximising Output In the long run if the market is highly contestable which level of price and output is probable? (Label this Q2 and P2). MC P1 When AC = AR, normal profits made, a return sufficient to keep factor inputs in their present use AC P2 AR C1 MR Output (Q) Q1 Q2

Highly Contestable Market – Pricing to Maximise Revenue Pricing – Maximising Revenue In the right hand diagram show the price and output for a firm that seeks to maximise total revenue Cost & Price Highly Contestable Market – Pricing to Maximise Revenue MC AC AR MR Output (Q)

Highly Contestable Market – Pricing to Maximise Revenue Pricing – Revenue Maximisation In the right hand diagram show the price and output for a firm that seeks to maximise total revenue Cost & Price Highly Contestable Market – Pricing to Maximise Revenue Revenue maximised when marginal revenue = zero MC AC P1 AR MR Output (Q)

Highly Contestable Market – Pricing to Maximise Revenue Pricing – Revenue Max – Lower Profits In the right hand diagram show the price and output for a firm that seeks to maximise total revenue Cost & Price Highly Contestable Market – Pricing to Maximise Revenue Revenue maximised when marginal revenue = zero Still some super normal profits made MC Revenue max means a lower profit margin is made – usually good for consumer welfare – but profit has value too! AC P1 AR C1 Lower price and higher output than MC=MR MR Output (Q)

Key Barriers to Contestability Economies of scale Vertical integration Brand loyalty Control of important technologies Expertise and reputation

Exit Costs – Barriers to Exit Asset write-offs Lost consumer goodwill Redundancy costs

Policies to Increase Contestability Deregulation of an industry Open up networks of monopolies Tough rules on predatory pricing Policies on international trade

Contestable Markets – Evaluation Points The threat of competition may be a powerful an influence on the behaviour of existing firms If a market is contestable, industry structure and firm behaviour is determined by the threat of competition - 'hit-and-run' entry A highly contestable market will resemble perfect competition, regardless of the number of firms, since incumbents behave as if there were intense competition.

How does the threat of competition affect a firm’s behaviour? Topic 3.3.10