We can easily see that a perfectly contestable market is pareto efficient since it has to be x-efficient, produce at MES, set P=MC and earn only normal profits: prices cannot be above MC because hit and run entry would occur while in this model it makes no sense to set prices below MC, i.e. conduct a price war since after eliminating an incumbent or enforcing a cartel, new entry would occur again. These also imply that no cross subsidisation can occur. This is not true only for natural monopolies which cannot charge P=MC because they would make losses, so price will be equated to AC. Even in this case, though, the allocative inefficiency is reduced and the natural monopoly does not have super normal profits. Strictly speaking, pareto efficiency will also not be achieved in cases where the number of firms producing at MES is a fraction but this complication can be avoided if one accepts that we usually have saucer shaped cost curves. Moreover, the standard assumptions for the lack of externalities are obviously still valid.
The implications for this are that all market structures can behave as if they were perfectly competitive so that the power and reach of the invisible hand are considerably increased. It should be noted, however, that although it is frequently argued that contestable markets are a generalisation of perfectly competitive ones, this is not strictly speaking true since the latter make the additional assumption that the incumbents are slower to adjust their prices than entrants; the significance of this assumption will be discussed later on. This theory also Œfrees1 oligopolies from dependence on conjectural variations of incumbents and argues that market structure defined as the number of firms in an industry is unimportant. The policy prescriptions of this approach are that regulations can often have perverse effects as they may obstruct the freedom of exit and that policies to reduce entry barriers should be preferred to such measures as splitting up companies to artificially enforce competition.
The CM approach has been criticised on a number of grounds. Weitzman pointed out that contestable markets imply that no diminishing AC can exist at any output level so the only industry for which is applicable is the perfectly competitive one. This is so because any producer can simply rent, or buy and sell, the machinery necessary to produce at the MES for a sufficiently small period of time so as to meet his demand (since there are no sunk costs). This means that contestable markets apply only in the case of perfect competition. Baumol et al, have counterargued that while this is true, it is not applicable in cases where there is a minimum time necessary to produce any amount or where the good is not storable at all (e.g. services). This discussion, however, sounds somewhat irrelevant given the patently unrealistic assumptions on which contestable markets theory is based, as we will see now.
First, it is unrealistic that incumbents cannot change their prices before the entrant enters, makes a profit and exits. One possible way for this to occur is when the entrant signs contracts with customers before he enters which is particularly likely when purchasers are concentrated. On the other hand, of course, he has no reputation (this is a problem of sunk costs which we will examine later) while it is possible for the incumbent to insert a clause "meeting the competition". However, regulations or long term contracts may indeed make incumbents response long enough to allow the entrant to enter and subsequently exit with his fixed costs not being sunk costs. Moreover, there must be no entry lag so that the incumbents are continually afraid that entry will occur if they raise their prices. On the other hand, even in the textbook analysis of perfect competition it was accepted that adjustment lags may lead to abnormal profits in the short run, so perhaps this assumption is probably not absolutely necessary, though the short-run super normal profits earned by a monopolist who knows that there can be no entry for some time are much greater than those of a perfectly competitive industry in the same situation.
Perhaps the most crucial assumptions of the contestable markets approach are that there is no disadvantage in terms of the production technique and that there are no sunk costs. In practice, however, high fixed costs translate invariably to high sunk costs as well while many incumbents manage to secure cost advantages against possible entrants. In fact, this is exactly what the barriers to entry literature is about and indeed according to Bain, barriers to entry are those advantages of established firms over potential entrants which allow incumbents to have prices above their competitive levels. Such advantages can be distinguished in absolute cost advantages, product differentiation and economies of scale.
In the absolute cost advantages category, patents and the access to superior knowledge may act as a significant barrier for entry. Nevertheless, patents serve a purpose in allowing a company to reap the benefits of its own research and indeed their very purpose is to limit the contestability of innovating firms so that it would be "unfair" to criticise the contestable markets theory for not being applicable in such a situation. The control of a factor of production by an incumbent firm can also be a barrier to entry, provided that this firm restricts the use of this factor more than an independent firm owing that factor would. Similar is the case with an incumbent firm owning the retail outlets. The extent, however, that such methods can be successful in preventing competition has been debatable and indeed vertical integration has been Œout of fashion1 for some time now.
A rather important advantage that incumbent firm may have is access to lower cost funds due to higher risk associated with a new entrant (problems of asymmetric information and imperfect capital markets are also important here). This problem, however, will be less severe to a diversifying entrant.
Economies of scale are also important since in the absence of complete and fully efficient capital goods markets, much of the specialised equipment needed will have to be subsequently sold at a considerable loss. Given that we are interested in concentrated industries, the possible buyers for these equipment will be few and possibly reluctant as they will be the incumbents who want to discourage entry. Thus, the greater the economies of scale and the more specialised the necessary equipment, the higher the sunk costs and the entry barriers.
Product differentiation can also act as a barrier to entry since it involves many elements of sunk cost. In the case of quality differentiation, coupled with uncertainty for that quality, consumers are prepared to pay a premium for the incumbent firm. On the other hand, a large product range may reduce entry barriers since the entrant is easier to find a niche. Indeed Dixit found that if no firm has a clear quality advantage, lower cross-elasticity of D i.e. greater product differentiation, lowers entry barriers. We can understand that in the extreme case of zero cross elasticity of demand, in which case the entrant simply ignores the incumbents. On the other hand, of course, the incumbent can also then ignore the entrant and raise his prices so there must be a trade off. [?] A large product range also has implications for the economies of scale: on the one hand, it may mean that the production of each particular product will be small so the economies of scale won1t be large but on the other a firm may need to enter with many products simultaneously, partly to obtain technical economies and partly to obtain consumer good will which gets us to the issue of advertising.
Advertising is often thought to be a genuine sunk cost given how intangible it is, although it could be argued that a very visible company in one sector can use this reputation in other sectors as well. Furthermore, it is likely that there exist asymmetries in advertising, i.e. advertising having to be above a certain level for it to be effective in which case economies of scale are once more important.
Quite clearly, the conditions for perfect contestability are not more plausible than those for perfect competition but the question is how robust the theory is to small deviations in its conditions. As far as the assumptions of no entry lags and of no sunk costs are concerned, the theory is relatively robust, i.e. its power gradually diminishes as the lag gets longer and sunk costs increase.
The big problem occurs when the assumption of delayed response of incumbents is relaxed since in such a case there is no reason for the incumbents to lower their prices at all and only x -inefficiency is still ruled out. Though Baumol has argued that the decrease in the power of his theory decreases gradually as the response gets faster, the problem is that there are very little conceivable cases when the response of incumbents is so much slower than that of entrants. In fact, when the lack of delayed response is coupled with the existence of some sunk costs we end up in strategic deterrence theories, i.e. exactly what contestable markets theory was supposed to eliminate. An extreme situation is that of the Sylos postulate when the entrant sees current output by the incumbent as a signal for his future output, i.e. output remains unchanged (the incumbent acts as a Stackelberg leader).
We can now have strategic barriers to entry such as predatory pricing and the issues of credible threats become of concern. If the cost of becoming credible is less than the costs of entry, the incumbents may build excess capacity and choose more capital intensive methods so that profitability depends on high capacity utilisation in order to prevent entry from occuring. Sunk costs are once again crucial since for the incumbents1 threats to be credible, they should not be easily reversible since there would be no commitment then. Advertising can also be used to generate Œconsumer goodwill1 while even crude threat may be effective, especially when the incumbent is being threatened in many markets and wants to set a precedent.
There are several ways to test for the significance of entry barriers and hence for the applicability of the contestable markets hypothesis: A first possibility is the structural analysis pursued among others by Bain (1956). He found that profit rates were 50% higher in industries judged to have very high barriers to entry, particularly due to product differentiation. Economies of scale, are found by engineering studies done by Bain and others to be very significant in the UK where almost all industries had a MES larger than 10% of the market, while in the USA this percentage is much lower. On the other hand, international trade means that the size of the internal market may not be the correct measure to look at. Furthermore, the AC curves appear quite flat so that the penalty for being small is not as great. Other ex post studies of economies of scale, based on which plant size is expanding relative to the others or on the firms who have more than one plant, find much smaller MES estimates. It is likely that the barriers on mobility and the degree of product differentiation within the broad industries considered in those studies may explain the large number of small firms operating in them.
What is often apparent is that in different industries, different barriers are important. Patents and in particular creative patenting is shown to be important by many case studies, an example being Du Pont which invented nylon and systematically patented a series of variations of it to avoid being imitated. Licensing and legal restrictions are also important in selected industries such as brewing.
Sunk costs independent of economies of scale may also be important. One would expect that in industries where equipment is versatile between product lines or even other industries, sunk costs and hence prices and profits would be lower. Indeed the classic example of the contestable market is that of the airlines which can switch their fleet between routes with little sunk costs. Even within the airline industry Bailey and Panzar (1981) found that the long haul routes in the US since deregulation in the late 701s, supply, were prices competitively even when specific routes were a natural monopoly because trunk airlines have large many haul aircraft which can be switched to alternative routes while for the more specialised short-haul traffic, prices were well above their competitive level.
Product differentiation seems to be important and even more importantly seems to be largely strategically created so that consumers develop brand loyalty even with products which are largely homogeneous such as cigarettes and detergents. Schmalensee (1978) notes how marketing analysis in the US cereal industry led to the market being dominated by 6 firms, sharing 80 brands and earning a 20% return on capital. Similarly advertising has been found to be important but only for selected industries such as certain food, confectionery, drinks and domestic appliances, outside which it is quantitatively unimportant. In retailing, however, advertising seems to increase contestability as the available information available to consumers increases, as Benham1s (1972) study of eyeglasses showed.
Such analysis, however, is difficult and subjective so that most analysts have prefered to run regressions of profits with concentration. The evidence for this is far from clear cut with some tentative support for the view that concentration is related to profits. But such a finding may be influenced by a number of other factors such as the riskyness and maturity of the concentrated industries. A more direct test involves regressions of profitability and price-cost margins on entry bariers such as the MES, advertising over sales and patents over sales to measure R&D. Such equations suffer from severe data problems and poor proxies for such variables as the capital stock, the MES and product differentiation. In general, studies have found advertising, the minimum capital requirement for entry (usually measured by MES times the industry capital intensity) and MES to be significant for a large number of countries.
Other studies have looked to the relation between profits, entry barriers and entry rates. Orr1s pioneering study for Canada found capital requirements, advertising intensity and high concentration to be significant barriers to entry. Gorecki extended this study to examine for foreign firms and found that foreign subsidiaries were not affected by entry barriers and were more affected by industry growth, indicating the importance of diversificating entry.
It is also generally found that while there is a lot of entry and exit taking place, it is predominantly in the form of small firms, probably in order to minimise risks and permit learning by doing. Furthermore, entry does not seem to be very responsive to changes in expected profits, though other factors such as risk may be at work here. Furthermore new small entrants find it difficult to grow large although deliberate hit run entry is very rare. Given that the impact of small firms is generally limited, evidence that competition between incumbents more important in keeping prices down.
Concluding, as Baumol admitted, contestable markets are not particularly more realistic or more common than perfectly competitive ones but they are simply a welfare ideal used to evaluate industries and guide govt policy. Thus, it can be seen as complementary to the strategic deterrence and barriers to entry approach, focusing attention on the importance of sunk rather than fixed costs and in the importance of freedom of exit. In a way, these approaches highlight violations of the CM ideal which the govt has to rectify.
