The ease at which a firm can enter and exit a market will leave it vulnerable to ‘Hit and Run’ competition. If there is abnormal profit in an industry then newcomers will enter the market, take their share of the excess profit and exit the industry when all the profits disappear.
In the long run firms that are in a contestable market will operate at the very bottom of their average cost curve. If a firm didn’t operate at this level then a new entrant would be able to establish itself, producing at the bottom of its average cost curve. Hence, firms in the long run in a contestable must be productively efficient.
Contestable markets are different from perfectly competitive markets. It is possible for one incumbent firm to dominate the industry, i.e. a monopoly. Each existing firm in the market can does produce a differentiated product. Therefore there are three conditions for contestability: -
- Perfect information and the ability/right to use the best available technology.
- Freedom to market/ advertise and enter a market
- The absence of sunk costs.
To what extent is the airline industry an example of a Contestable market?
The airline industry is very competitive and dynamic; the performance of the industry depends on how well the European economy is performing.
The rise in major airliners over the last decade suggests that more firms have entered the market and made it more contestable.
If you look in the past national flagships such as British Airways and Air France dominated the airline industry. These were state owned and owned by the government. These airliners accounted for 70% of the civilian passengers. This monopoly has recently been eroded when the airline industry was left to the free market forces. This means there is more pressure for airliners to produce at the lowest cost and be the most efficient.
The airline industry was made more contestable by a partial deregulation in 1987, which was completed only in 1997. As the population of Europe has more disposable income the demand for short haul flight from city to city has increased. This provides an opportunity for low cost airlines to enter the industry and compete with the major airliners.
As there is price sensitivity in the airliner market, it is naturally suited to low cost airlines, as customers will choose them instead of another.
An act called “freedom of the air” means that an airline holding a valid Air Operations Certificate in the EU can’t be prevented from operating on any route within the European Union, including flights wholly within another country. Granting these freedom rights makes the market more contestable, because any airline with a valid license can fly passengers.
Airlines enjoy substantial tax exemptions, particularly from all taxes on kerosene. This exemption for kerosene applies to international and intra-EU flights alike. This tax exemption for fuel provides no incentive for airlines to use the most efficient aircraft and to contribute to reducing CO2 emissions (of which air transport accounts for 13%). It also creates situations where the competition between air transport and other modes is unfair. This exemption makes the market more contestable as airliners have no pressure to keep pollution low, so if more airliners enter the market complaints of more pollution can be ignored.
All the above liberation of the air market means that there are fewer barriers to entry. As barriers to entry are removed the market becomes easier to enter and it makes it more contestable.
The airline market is only contestable to an extent, as there are other barriers to entry, which could prevent new firms joining. Examples of these are that availability of take-off and landing slots in airports restricts the amount of airlines that can exist in an industry. This is because a runway can only have a certain amount of capacity and a certain amount of airliners using it. This could prevent an airliner entering the industry.
Another example is that there are high costs in leasing new fleets of aircraft. These high start up costs means it could deter new firms entering into the market. Although any airline can apply for an Operator’s license the necessity of having one and the procedure of applying directly to the EU for one means that this could as a barrier to entry. Existing firms may already have a high brand image so a new firm entering will find it hard to attract customers. One major barrier to entry is the Economies of scale that large firms can command. As the existing firms have an increase in output their costs will go down. Low costs can be used to increase profit margins or set their tickets at a lower price. New firms who are wishing to enter the market will naturally have high start up costs and if they try to match the prices of the existing firms they will be operating at a loss.
There have been many mergers and takeovers between low cost airliners in recent years. As a firm takes over or joins another it becomes larger thus the market will become less contestable. These firms will have a strong brand image and customer loyalty. As these firms get larger they will be able to set lower prices.
When low cost airlines first entered the market it became more contestable as more affordable flights were available from more airports. A series of mergers and takeovers has left the low cost airline industry less contestable as there are only two remaining low cost airlines left in the UK.
To look at whether low cost airlines is operating in a contestable market or not we need to analyse recent trends in the industry. The above is an analysis using theory, but by using real life data in the next section will make it easier if it is a contestable market or not.
Recent Trends in the Industry
One reason why Ryanair can be seen as less contestable is because of their budget prototype. This is where they look to produce at the lowest cost. If they are producing at the lowest cost then competitors will be under pressure to operate at the same level. Another reason why it may be less contestable is that they have received many customer complaints for quality of service. In a less contestable market firms are under less pressure to produce a service of the highest quality. Recent mergers involving Easyjet and Ryanair have meant that the industry is being dominated by two big firms. This is an example of a Contestable market, because there is less competition and these larger firms will benefit from economies of scale such as brand loyalty and these firms will have more slots for taking off or landing, which reduces the amount of competitors that can enter.
The reason why it may be contestable is that in the industry there are lots of profits to be made. An increase in Ryanair profits would attract “hit and run” competition. Another reason is that Ryanair was able to purchase a Boeing 747 at a significant discount. This means that there will be low sunk costs as these planes could be sold off if you decide to exit the industry.
To conclude it can be said that the low cost airline industry is seen as contestable, because of the east to set up, excess profits, but recent news show that it is more becoming less and less contestable with mergers and few firms producing at low cost and really dominating the industry.
