How can markets become more contestable?

By the end this lesson you will be able to…

• Explain 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

• Evaluate contestable markets

Making Markets More Contestable

• Main approaches

– De-regulation - i.e. reducing statutory barriers to entry to liberalise a market

– Tougher competition laws acting against predatory behaviour by existing firms / tough rules against cartels

– The changing nature of technology – which has brought down entry costs in some markets (an increase in capital mobility)

Back to the airline industry…• To what extent is entry and exit in the market 'costless'?

• How would you describe the market structure of the low cost airlines industry?

• Looking at the pricing strategies of each company in this market, is there evidence that fierce competition is succeeding in driving prices down as we might expect in a perfectly competitive market structure?

• What response are the traditional airlines making to the impact of the low-cost carriers? (The quote and link below may be of help in pointing you in the right direction).

Competitive response• Today, major airline carriers are judged according to their "low-cost" label. As a result, the

biggest impact of Low Cost Carriers (LCCs) on business travel might soon lie in the reactions of traditional airlines. To fight back against the cheap fares advertised by LCCs, major carriers have adopted two parallel strategies:

• First, they have focused on the quality of their service (their line is, in short: we do not skimp on service).

• Second, they have launched low fares of their own to meet the LCCs in the price war.

• This has been understood more quickly in the UK than anywhere else in Europe. For companies, the issue of "low-cost carriers" is "out of date". The focus is now about leveraging traditional airlines low fares. Large German and Dutch companies are also heading in this direction. Potential cost cutting is likely to grow in the months ahead. Major savings opportunities await companies, providing they are able to take full advantage of them."

Source: Quote taken from What benefits do low-cost carriers really bring to business travel in Europe?, a 'White Paper' report from Carlson Wagonlit Travel [PDF, 260 KB]

Normal Profit Contrasted with Profit Maximisation

• 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

Output (Q)

Revenue

ARMR

MC

ATCP1

Q1

P2

Q2No one in the industry

has any advantage over anyone else

The Low Cost Airline Model (low cost carriers)• (1) Use of the Internet to reduce distribution costs

• (2) Maximise the utilisation of the aircraft assets

• (3) Direct sell only via the net

• (4) Ticketless travel

• (5) No free airline food

• (6) Use smaller airports - cheaper to fly from

• (7) One kind of aircraft: Commonality maximises efficiency in the recruitment and training of staff

Barriers to entry in the aviation industry• (1) Availability of take-off and landing 'slots'

• (2) Necessity of entering a new route on a large enough scale to achieve acceptable cost levels

• (3) The costs of leasing new fleets of aircraft

• (4) Securing an air operator’s licence from the EU

• (5) Contracts with ground-handling companies

• (6) Retaliatory behaviour by rivals (e.g. an expansion in flight frequency, cuts in fares)

• (7) Overcoming existing customer loyalty achieved by companies who have exploited first-mover advantage on specific routes

Open Skies…! March 2008• The Open Skies agreement was reached between the European Union

and the United States.

• Previously, only British Airways, Virgin Atlantic, United and American Airlines were legally allowed to offer direct flights from Heathrow Airport to the US.

• But after the deregulations of transatlantic air travel, the market was opened to competition from challengers.

Article (March 2008): British Airways faces £250m threat to profits as open skies era takes off

• The sweeping away of restrictive rules that govern transatlantic air travel could cost British Airways £250 million a year in lost profits.

• From tomorrow, BA, which is reeling under a torrent of criticism for the chaos that has surrounded the opening of Terminal 5, its new base at Heathrow, will face increased competition on its most lucrative routes as the “open skies” era begins.

• The agreement allows any European carrier to fly to any American city, effectively smashing the Heathrow cartel. To this end, on Sunday Continental, Delta US Airways and even Air France will muscle in on transatlantic services from Britain's largest airport. This is expected to drive down air fares, particularly in business class.

• The arrival of new carriers at Heathrow is a particular threat to BA, which controls 48 per cent of the airport's slots and is the largest transatlantic carrier.

• Airlines make almost no money on transatlantic economy fares but reap large profits from business and first-class passengers. BA is thought to make as much as 60 per cent of its profits from its Heathrow-to-New York operations alone.

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)

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