1. Contestability recap

2. Lesson objectives Recap how markets can become more contestable
Differentiate the level of contestability between markets and what determines it using industry examples
Explain using a diagram the implications of contestable market theory on firms in the industry
Introduce the economic underpinnings of “competition policy”

3. Contestable Markets Recap – New entrants
‘Hit and Run’ tactics – enter the industry, take the profit and get out quickly (possible because of the freedom of entry and exit)
Cream-skimming – identifying parts of the market that are high in value added and exploiting those markets

4. Contestable Markets Recap
Note that the threat of new entrants may encourage positive OR negative behaviour by incumbents
Key characteristics:
No (low) barriers to entry or exit
No (low) sunk costs
Firms’ behaviour influenced by the threat of new entrants to the industry
Firms may deliberately limit profits made to discourage new entrants entry - limit pricing
Firms may attempt to erect artificial barriers to entry – e.g…

5. Contestable Markets
Over capacity – provides the opportunity to flood the market and drive down price in the event of a threat of entry
Aggressive marketing and branding strategies to ‘tighten’ up the market
Potential for predatory or destroyer pricing
Find ways of reducing costs and increasing efficiency to gain competitive advantage

6. Barriers to Contestability
No market is perfectly contestable – there are always some barriers!
Existing firms can engage in predatory behaviour to make entry more costly to new rivals
Raising rivals’ costs
Vertical integration means that some firms act as component suppliers to other firms in their industry – they have control over the supply-chain (also known as vertical restraint)
The use of import tariffs to increase the relative prices of overseas output
Reducing rival’s revenues – “bundling”
A monopoly can use profits in one market to boost market power in another (cross-subsidisation)

7. Bundling – Anti-Competitive Behaviour?
Product bundling is a marketing ploy of giving away a relatively cheap product with a relatively expensive one to attract customers
Bundling can have the effect of tying the consumer to both products
This is particularly prevalent in computer manufacturing where the product comes with specific items of software already pre-loaded

8. Banking Where are the opportunities to skim or hit and run?
Use your checklist
sheet
Banking
Where are the opportunities to skim or hit and run?
Barriers to entry?
Barriers to exit?

9. Banking Where are the opportunities to skim or hit and run?
Barriers to entry?
Brand loyalty
Marketing
Legal
Financial
Barriers to exit?
Opportunities to skim?
- Improve Customer service? Move into most profitable sector: high net worth individuals where they can charge fees, lots of money hanging around to earn interest
Opportunities to hit and run?
- difficult as you can’t sell someone a bank account and then move on to a different industry
- barriers to exit
Barriers to entry
Capital
Trust
Branch network
Brand
Legal
Barriers to exit
Customers expect the bank to continue

10. Evaluating Contestable Markets
There are no perfectly contestable markets
What matters is the degree of competition / contestability
The idea is that what matters is not so much competition within a market, but rather competition for a market.
What also matters is the threat of entry of new suppliers – but this may not be enough to affect the behaviour of existing firms
The absence of competition in a market over a long period of time does not necessarily suggest a lack of contestability
Structural changes in costs in different industries can change the degree of contestability
Contestability may force existing firms away from profit-maximising behaviour (e.g. towards sales-revenue maximisation)

11. Over to you… Draw Monopolist’s profit maximising equilibrium
How might the monopolist react to the threat of hit and run entry by removing the new entrants’ incentive?
Revenue
Output (Q)

12. Normal Profit Contrasted with Profit Maximisation
Got this far in this lesson
Price
If the monopolist charges the profit-maximising price, then - if the market is contestable – the firm will be vulnerable to hit and run entry
The only way the monopolist can avoid this happening is to set the price equal to average cost, so that there are no supernormal profits to act as an incentive for entry MC
ATC P1 P2
No one in the industry has any advantage over anyone else AR MR Q1 Q2
Output (Q)

13. Implications of contestable market theory
The number of firms in an industry is irrelevant in terms of economic efficiency
Abnormal profits attract new entrants driving down prices and ensuring economic efficiency
All markets (excluding natural monopoly) can be efficient so long as they are contestable
Shifts the emphasis of government competition policy away from number of firms towards reducing barriers to entry in an industry
Potential competition may be more important for economic efficiency than actual competition

14. Contestable Markets
Examples of markets exhibiting contestability characteristics:
Financial services
Airlines – especially flights on domestic routes
Computer industry – ISPs, software, web development
Energy supplies
The postal service?

15. N.B. Exam board likes the topic of contestability
Remember the threat of competition can be as effective as actual competition
Key is the relationship between sunk costs and the degree of contestability

16. Contestability 10 minute essay
“To what extent is the UK banking market a contestable market”
Agree a structure as a group
Divide up the work amongst yourselves
Write the bullet points of an essay

17. Government intervention to maintain competition in markets

18. Why does the GovernmentOR
Why does the Government seek to make markets more contestable?
Why does the Government
intervene to
maintain competition?

19. Competition Policy Efficiency Competition Consumers
Toughened since 1997
Competition Policy
Promote
Competition
Protect
Consumers
Enhance
Efficiency
Assumption is that competition eliminates x-inefficiency
Better resource allocation
vs.
Economies of scale

20. Competition Policy
At the heart of competition policy is the comparison between Perfect Competition and Monopoly
Draw the two LR equilibrium diagrams

21. PC and “Multi-plant” Monopoly compared
Big Assumption!
No cost difference between the two market structures
Government Remedy =
Increase Competition!
PC and “Multi-plant” Monopoly compared
Part of consumer surplus transferred to Monopoly as profits
The Monopolist at constant returns to scale can continue to supply with no change in MC
Price PC
Consumer Surplus
Deadweight loss = cost on society B Pm
Thank You! E
LRS (=LMCm)
Ppc
PC firms prepared to supply any quantity at this price C
D=AR MR O Qm
Quantity
Qpc
Monopolist supplies Qm at price Pm
PC firms supply Qpc at price Ppc

22. Homework Read and make notes on Anderton Ch 58 P380-382
Be prepared to hand in your notes at next lesson

23. Define the term “Competition Policy” and explain why it exists
Plenary
Define the term “Competition Policy”
and explain why it exists