The Theory of Contestable Markets and its Impact on Industrial Policy - Literature review Example

The theory of contestable markets and its impact on industrial policy By of [Department] [Date] Table of Contents Overview 1 Contestable Markets Theory 1 Properties of Contestable markets 5 a)In terms of welfare 5 b)In terms of industrial structure 6 Differences between fixed costs and sunk costs 6 The Contestable markets ensure competition 7 A model to study the contestable markets 9 Contestable Markets Theory and Deregulation 11 Reference List 16 The theory of contestable markets and its impact on industrial policy Overview The “theory of contestable markets” supports the idea of pure and perfect competition, in which there are no barriers to entry or exit. With regard to entry, once assumed costs that match critical mass, all companies entering that market perform the same rate of profit. The exit barriers mean that there are no irreversible costs in these markets (Brooks & Button, 2006, p. 100). In a contestable market, there is no profit-extra and all companies operating in the market have the same cost structure. Thus, oligopolistic or monopolistic markets may have the same characteristics as the pure and perfect competitive markets with regard to social welfare; that from the moment that the chances of free entry and exit in the industry are checked (Bikker, Spierdijk, & Finnie, 2007, p. 55). Contestable Markets Theory The theory of Contestable markets or contestability theory was developed in the early eighties by William Baumol. According to this author, a perfectly contestable market is a generalization of the concept of perfectly competitive market. It is characterized by optimal behaviour and can be applied to all structures of the industry, including the oligopoly and monopoly (Bikker, Spierdijk, & Finnie, 2007, p. 55). The concept of contestable markets perfectly serves as a benchmark of industrial organization. One of its strengths is that it is much more flexible and has more utility than perfectly competitive market (Brooks & Button, 2006, p. 100). A contestable market is defined as one in which admission is free and the output does not imply costs. Baumol uses the freedom of entry in the sense that coined Stigler, i.e., does not mean that the entry has no effect on costs or easy, but incoming has no disadvantage compared to the dominant operator in terms of techniques production or quality. Therefore, a market in which there are no barriers to entry (Yildirim & Philippatos, 2007, p. 195). Figure No: 01 Baumol also believes that absolute freedom out is a way of ensuring freedom of entry. It is a requirement for a contestable market to non-discriminate in costs for entrants. In other words, when a company leaves the market, it can recover all the costs incurred to enter. If a company can leave the market without costs this means it has not incurred sunk or sunk costs (Coccorese, 2005, p. 1083). Perfectly contestable markets are characterized additionally because they are very vulnerable to hit-and-run competition. Any opportunity to benefit will be taken into consideration by a potential entrant, since it can enter the market and make a profit before the price change and eventually leave no cost before the market competition is tougher (Coccorese, 2005, p. 1083). It is considered a market as questionable when no barriers to entry or the exit costs (sunk costs) for firms that eventually who wish to join. The companies operating in it are not protected any entries of hit and run type outside firms, attracted by extra-economic benefits of this market to join and make a profit, this will occur before the established firms have time to go out of business or even change their prices (De Langen & Pallis, 2006, p. 69). For a given market is contestable, is required to be greater homogenization of products and free access to production methods for all producers, who should have access to the same technology and have the same market demand (De Langen & Pallis, 2006, p. 69). As with the critique of Demsetz, even in oligopolistic and monopolistic structures, including natural monopolies, with the occurrence of significant economies of scale, can occurs contestability. In such situations, says TMC, a company in a monopoly position could not earn monopoly profits, because if company did, it would be subjecting itself to the danger of an attack of hit and run kind from other companies. This is called potential competition. Thus, there would be no need to regulate these industries, even though they were natural monopolies (Claessens, 2009, p. 83). The very natural monopoly was redefined by the TMC scholars came to the conclusion that a company, producing various goods or services, could hold a natural monopoly, even without economies of scale in the process. This would happen if such company incurs lower costs compared to other, producing goods or services separately (Corvoisier & Gropp, 2009). This was called subaditividade costs. A natural monopoly would take place, in this case, when a company possessing the subaditiva cost function during the most important region of its production (Corvoisier & Gropp, 2009). The sunk costs, as has been said, occur when there are costs that must be covered, although there is no production. The firms that have such costs require a very large amount of capital, which is little mobility and due to these characteristics, checks for sunk costs cannot be objectionable for those markets (Gutiérrez & Pombo, 2009, p. 112). Firms incur sunk costs, or those that require large sums of capital can, however, suffer other type of intermodal competition. For example, channelled carrier oil may undergo competitive product intermodal transportation of oil by trucks. The same form of road transport also competes with the rail not only in cargo transportation but also as the passenger (Gutiérrez & Pombo, 2009, p. 112). Services in which the existence of sunk costs is possibly low, and that the entry and exit of firms in the market do not demand very high costs, are typical cases in which the TMC function. For them, the theory calls for deregulation. Practical examples are the collection of urban waste, air transport or the phone system over long distances, reasonably appropriate to the recommended conditions (Claessens, 2009, p. 83). Baumol, Panzar and Willig state that for the standard case of average cost curves U-shaped (U-shaped average cost curves), although rare, there are examples of sustainability in certain industries, i.e. in certain market price the firm is able to cover its costs and still avoid any profitable entry of another firm. The most common situations, however, are those in which sustainability is not possible (ZHAO & ZHU, 2006, p. 14). Among the contributions provided by TMC include, among others, the creation of new and fundamental concepts, the affirmation of the importance of sunk costs and the importance that potential competition may have on improving the performance of industries. The TMC has two basic limitations noted by critics: the hypothesis of the absence of sunk costs (most critical) and the possibility of a company enters the market before the holder of the monopoly can change their prices (ZHAO & ZHU, 2006, p. 14). Properties of Contestable markets a) In terms of welfare First, the benefits in contestable market should be zero or negative, even if it is an oligopoly or monopoly. The reason for this is that any positive benefit means that an entrant can establish itself in the market, replicate the output produced by the dominant carrier at the same cost, sell it at a slightly lower price and make a profit. In short, a well contestable market means a benefit directly benefits an opportunity for entrants, who may be interesting to resort to hit-and-run strategy (Xingyu, 2009, p.11). Second, a perfectly contestable market is characterized by the absence of any inefficiency in production industry balance. Unnecessary cost and any abnormal benefit is an invitation to enter the market. Third, long-term equilibrium in a perfectly contestable market means that no product can be sold at a price below marginal cost. If so, an incoming company could sell the product at a price below marginal cost and profit (Chang, 2007, p. 403). b) In terms of industrial structure This property is closely related to the other property, in terms of welfare. That is, its incompatibility with an inefficiency of any kind. Therefore, the contestable markets are incompatible with industry inefficient organization. When the vector of output of an industry is small compared with the vectors of output that a firm can produce at a relatively low cost, then the efficient industry structure is characterized by the existence of few companies. The opposite situation is also possible where the vector of output of an industry is much larger than that of the company (Chang, 2007, p. 403). Differences between fixed costs and sunk costs An essential feature to determine whether a market is contestable is the presence of sunk or sunk costs. For this reason, it is important to distinguish between fixed and sunk costs. Fixed costs are those costs which have independent production scale and sunk by a short period of time, because they are committed (Chang, 2007, p. 403). Instead, those costs have sunk investment costs that produce a stream of benefits to a distant horizon but may never recover. Therefore, the distinction between “fixed costs” and “stranded costs” is of degree, not of kind, because fixed costs are only recoverable in the short term (Xingyu, 2009, p.11). It should be noted that the concepts of sunk and fixed costs account to make major abstractions. Firstly, there are different alternatives between these two extreme cases of short-term commitment and endless commitment. And secondly, because both concepts assume that the investment cost cannot be recovered in any way during the commitment period. In reality, however, a machine always has some residual value that can be recovered in a second hand market. Thus, it may be useful to consider that the commitment period is one in which the cost of disinvestment is too high to make it profitable (De Langen, 2007, p. 14). Baumol and Willig in 1981 concluded that the stranded costs, unlike fixed costs constitute a barrier to market entry. Therefore, sunk costs can raise monopoly profits and can generate an inefficient allocation of resources and other inefficiencies (Corvoisier & Gropp, 2009). In contrast, fixed costs do not mean barriers to entry and therefore do not generate subsequent allocation problems. However, it is true that the fixed costs of a given magnitude in an industry have natural monopoly characteristics. But when the costs are fixed and not sunken, the market will be contestable. Consequently, the benefits tend towards zero and improve efficiency. In short, potential entry restricts any inefficient behaviour (De Langen & Pallis, 2006, p. 69). The Contestable markets ensure competition The possibility of market entry ensures that the monopolist will set discounted prices to prevent the entry of other companies. The threat of entry is more than enough to ensure that the industry operates competitively or at least close to optimal. Therefore, contestable markets ensure the socially efficient output, avoid duplication of fixed costs and achieve technological efficiency (Bikker, Spierdijk, & Finnie, 2007, p. 55). From different researches it is illustrated that the threat of competition effect the behaviour of the firms which is presented in the figure below: Figure No. 02 Source: (Brooks & Button, 2006, p. 100) In the above given diagram might a pure form of monopoly price is at P1, which is the profit maximising profit. On the other hand, if the market is considered as contestable then we observe a downward pressure on the price, due to the existence of signals of supernormal profits for new organizations in order to enter the market and if the present monopolist is producing at very highest price and also has permitted their total average cost to flow at greater peace, then the new entrants can weaken the power of monopolist and on the other hand, some of the unusual form of profit will be competed away. When average revenue equals to the total average cost then the normal form of profit equilibrium will occur at the output Q2 and price P2. Higher form of output and lower price are the source of increase consumer surplus. The conclusions of the theory of contestability are very important. It has long been considered an industry with significant increasing returns cannot behave competitively, so it should be nationalized or regulated thoroughly. However, if an industry behaves as a perfectly contestable market, the market outcome will approach both to the optimum as permitted by restricting non-negative profits of the company. Therefore, in the absence of real competition potential competition may be sufficient to discipline incumbents (Brooks & Button, 2006, p. 100). However, the theory of contestable markets has been criticized for its lack of application in real situations, since the existence of markets where there are no sunk costs and barriers to entry and exit is very small. A model to study the contestable markets To analyze the performance of a contestable market, consider the existence of an industry that sells a single product and has a technology with increasing returns. We assume that the company has a fixed cost, f, and a constant unit cost, c (De Langen & Pallis, 2006, p. 69). Figure No: 3 Source: (Corvoisier & Gropp, 2009) Thus, the total cost of producing q units of product are: If we call p the price of the product, we can write the monopoly gross profit (excluding fixed costs) that maximizes the monopoly as follows: Therefore, the monopoly is feasible if your gross benefits are greater than its fixed costs, in this context, the only viable organization of industry is that offers an output at a price equal to the average cost of production. The price-quantity challengeable combination is obtained from the intersection between average cost and the demand curve: In this example, the contestability theory predicts the following results: There is only one company operating in the industry. Therefore, there is technological efficiency, as the company takes full advantage of economies of scale. This company makes a profit equal to zero. If the company had a greater benefit then it would encourage market entry. The market price is the average cost of production. Furthermore, the allocation achieved with this price is efficient, since the social planner does not use subsidies to reduce prices. Economic theory suggests that the optimal price must be equal to marginal cost. However, with this price the company would not be willing to operate. In this situation, a social planner prefers the lowest price that will allow the company to earn non-negative profits:. We see, therefore, as the threat of entry affects the behaviour of the incumbent, as it establishes a monopoly less than the price (Corvoisier & Gropp, 2009). Contestable Markets Theory and Deregulation In principle, as has been mentioned, if the deregulation process undertaken in a market has led to increased competition would expect an improvement in efficiency in the allocation. But total competition is not essential to achieve the desired efficiency, sufficient for there the threat of potential competition. This assumption characterizes the theory of contestable markets or sustainable (Gutiérrez & Pombo, 2009, p. 112). According to Baumol, his article entitled contestable Markets: An Uprising in the Theory of Industry Structure 1982, a perfectly contestable market is a generalization of the concept of perfectly competitive market, characterized by an excellent performance and that applies to any level of industrial structure including monopoly and oligopoly (Coccorese, 2005, p. 1083). Baumol defines a contestable market as one in which admission is absolutely free and absolutely output costs. The “contestability” of markets requires the fulfilment of two conditions: Freedom of market entry, in the sense that the potential competitor does not have disadvantages compared to companies already established in the market, all companies have access to the same technology, presenting identical cost functions and the same quality product. In addition, these companies may enter the market at any level of production, including that corresponding to natural monopoly sectors. Freedom of departure, in the sense that any competitor can leave unhindered market, being able to recover any investment or cost incurred at the time of entry except, of course, the depreciation. In other words, there should be sunk costs (sunk costs), which are those costs that cannot be recovered once the market is exited (Brooks & Button, 2006, p. 100). Under these conditions, companies that integrate perfectly contestable market can obtain optimal results in Pareto without being small or large or independent in their decisions or produce homogeneous products, requirements attributable to perfect competition. This implies that the perfectly competitive market is necessarily a contestable market but not vice versa, so, it follows (as well shown) that one company can be a perfectly contestable market obtaining optimal results in Pareto (Chang, 2007, p. 403). Therefore, the fundamental property of a contestable market is that the equilibrium does not depend on the number of companies, but the absence of barriers to entry and exit of competitors (Xingyu, 2009, p.11). As a result of the two requirements starting perfectly contestable markets are very vulnerable to entry for potential competitors. Any small chance of benefit, albeit transient, will be exploited by a potential entrant, since it can enter the market without costs, mark lower the company already installed price, take profits and exit the market also at no charge. This practice is the Anglo-Saxon name “hit and run” (Gutiérrez & Pombo, 2009, p. 112). To prevent the possibility of a lightning input or “hit and run” incumbent firms must produce as efficiently as possible and set a price to annul any possible extraordinary profit, implying that: 1. A contestable market never offers more than a normal rate of profit, taking economic benefits equal to zero, even in the case of monopoly or oligopoly. 2. Absence of any kind of allocative inefficiency or organizational industry, since otherwise potential entrants would be attracted by the possibility of producing efficiently and get higher than the company already installed benefits. 3. Long-run equilibrium of the contestable market shows us that we cannot sell at a different price to marginal cost. If the price is lower, will be encouraging the entry of a potential competitor who sees the possibility of selling a smaller quantity at the same price or lower, and profit. The same approach is followed in the event that the price marked by incumbents is greater than the marginal cost, to enter a company producing a little more and getting positive benefits (Bikker, Spierdijk, & Finnie, 2007, p. 55). Thus, Baumol shows that a perfectly contestable market shares the same effects on welfare than a perfectly competitive market. But the highlight of this theory is that conditions similar to those that lead to a competitive market equilibrium can be maintained even if the market operates under a single efficient company under a natural monopoly. In fact, Baumol, Panzar and Willing show that the accessibility (contestability) are given in a natural monopoly where the pricing structure makes the market is sustainable, i.e. its price, while being second best not induce the entry of potential competitors (Yildirim & Philippatos, 2007, p. 195). However, the theory of contestable markets has not been without criticism. The Baumol itself presents some cases where contestability is not possible. Other criticisms come from Schwartz and Reynolds, for whom the theory presented lack of “robustness”, considering that any reduction in cases of departure causes loss of its validity (Claessens, 2009, p. 83). Specifically, Schwartz and Reynolds point out that the main criticism of the perfect contestability comes from vulnerability to lightning input or “hit and run”. Exposed how perfectly contestable market requires two conditions difficult to verify, first, that in response to high prices, a potential competitor to enter immediately on any scale without a delay in the entry occurs; and second, that an entrant may cut prices to compete with existing businesses and leave without loss of fixed costs before the company already established can adjust their prices (Corvoisier & Gropp, 2009). Schwartz and Reynolds believe it is more realistic to happen in reverse, i.e. that the company already installed later least change its price required to enter next, produce, sell and exit the market. Another criticism of the theory comes from Weitzman (1983) stating that sunk costs are always present with increasing returns to scale and that if the model is representing the potential competitor can always walk into any production level efficiently, this implies constant returns to scale (Gutiérrez & Pombo, 2009, p. 112). In short, the theory of contestable markets tells us that under a series of more or less plausible to reality conditions, decisions on production and pricing will be efficient and, therefore, public regulation inappropriate. The regulation creates barriers to efficient behaviour by restricting competition by imposing administered prices and barriers to entry. However, following Becker should not assume that the contestability of markets and efficient results are inspired by the philosophy of “laissez faire” in the sense that it does not abolish government intervention in the economy, but purport to address these interventions to create conditions in the market to bring you as much as possible to the structure characterized as contestable (Yildirim & Philippatos, 2007, p. 195). This means that we must act more about the market and less on industries, causing them to reduce, for example, sunk costs (formerly called “sunk costs”) or barriers to entry or preventing anti-competitive behaviour of firms and installed. The barriers to contestability not derived only from the existence of technical or regulatory barriers, but also come from anti-competitive behaviour of market participants. When a monopolistic sector is deregulated, an established company can retain a dominant position to prevent the entry of competitors adopting, for example, certain strategic pricing policies. Therefore, public intervention through regulation should prevent any possible abuse of dominant position which tends to reduce the effects of contestability (Claessens, 2009, p. 83). In short, the theory of contestable markets helps in establishing criteria to be linked deregulatory barriers to market entry and exit of several factors such as regulatory legislation, structural market characteristics or behaviour of market players. Reference List Bikker, J. A., Spierdijk, L., & Finnie, P. (2007). The impact of market structure, contestability and institutional environment on banking competition. De Nederlandsche Bank. Brooks, M. R., & Button, K. J. (2006). Market structures and shipping security.Maritime Economics & Logistics, 8(1), 100-120. Chang, Y. (2007). The New Electricity Market of Singapore: Regulatory framework, market power and competition. Energy policy, 35(1), 403-412. Claessens, S. (2009). Competition in the financial sector: overview of competition policies. The World Bank Research Observer, 24(1), 83-118. Coccorese, P. (2005). Competition in markets with dominant firms: A note on the evidence from the Italian banking industry. Journal of Banking & Finance,29(5), 1083-1093. Corvoisier, S., & Gropp, R. (2009). Contestability, technology and banking. De Langen, P. W. (2007). Port competition and selection in contestable hinterlands; the case of Austria. European Journal of Transport and Infrastructure Research, 7(1), 1-14. De Langen, P. W., & Pallis, A. A. (2006). Analysis of the benefits intra-port competition. International Journal of Transport Economics, 33(1), 69. Gutiérrez, L. H., & Pombo, C. (2009). Corporate ownership and control contestability in emerging markets: The case of Colombia. Journal of Economics and Business, 61(2), 112-139. Xingyu, Y. A. N. (2009). Review on the Theory of Perfectly Contestable Market.Industrial Economics Research, 1, 011. Yildirim, H. S., & Philippatos, G. C. (2007). Competition and contestability in Central and Eastern European banking markets. Managerial Finance, 33(3), 195-209. ZHAO, Y. L., & ZHU, X. H. (2006). Analysis of the Compacts of Market Structures on Enterprises Technological Innovation-Based on the Contestable Markets Theory [J]. Journal of Wuhan University of Technology (Social Sciences Edition), 4, 014.   Read More