How does the threat of competition
affect a firm’s behaviour?
Topic 3.3.10
How does the threat of competition
affect a firm’s behaviour?
Topic 3.3.10
Students should be able to:
•
•
Define contestability and understand how the threat of new
entry may influence behaviour and market performance of
existing firms.
Understand the relationship between sunk costs and the
degree of contestability — examples may include banking,
airline industry and petrol retailing.
Key Concepts – Contestable Markets
Contestable Market
Hit and run entry
Sunk costs
Where an entrant has access to all
production techniques available to
incumbents and entry decisions can be
reversed without cost
When a business enters an industry to
take advantage of temporarily high
(supernormal) market profits.
Sunk costs cannot be recovered if a
business decides to leave an industry.
The existence of sunk costs makes a
market less contestable.
Contestable Markets
• Contestable markets are constantly changing
• Contestable markets can be seen at a local, regional,
national and international level
• In a contestable market, the number of size distribution
of businesses in the industry is less important
• More focus is given to the threat of entry from rivals
• Almost all markets are contestable to some degree
• Technology has the potential to change contestability
• E.g. the barriers to entry in many markets are widely
thought to have lowered because of digital advances
• Contestable markets often show high dynamic efficiency
Conditions for a Contestable Market
• Pool of new
entrants willing and
ready to enter the
market
Absence of sunk costs
Access to technology
Low consumer loyalty
Low legal barriers
• No significant entry
or exit costs
• Access to the
available technology
• High rates of
customer churn
Contestable Markets in Action!
• Nov 2015: Apple 'to launch peer-to-peer payment app'
in competition with PayPal
• Nov 2015: The Gym Group, one of the UK's low-cost
fitness chains and it is now listing on the stock market
to fund future expansion
• Nov 2015: Uber taxi app to launch in Edinburgh
• Nov 2015: Amazon begins a new chapter with opening
of first physical bookstore
• Oct 2015: Metro Bank Takes Step Towards £1bn Listing
• Oct 2015: Argos launches Same Day Delivery
• Oct 2015: Sainsbury's tests out 'micro-stores' for busy
shoppers
Generic Drugs and Contestability
Leading global generic drug manufacturers by market share 2013
Top 10 generic drug manufacturers - worldwide market share in 2013
Market share
0.0%
5.0%
10.0%
15.0%
Teva Pharmacetical
13.4%
Novartis
11.9%
Actavis
9.1%
Mylan
8.6%
Aspen Pharmacare
4%
Sun Pharmaceutical
3.9%
Hospira
3.5%
Daiichi Sankyo
3.2%
Sanofi
3.1%
Note: Worldwide
Lupin
2.5%
Each medicine has an approved
name called the generic name. For
example, paracetamol is a generic
name. There are several companies
that make this with brand names
such as Panadol®, Calpol®
A Contestable Oligopoly?
Market share of mobile handset manufacturers in the UK in June 2014
35.0%
5 firm
concentration ratio
= 84.4%
31.8%
30.0%
Market share
25.0%
22.9%
20.0%
16.9%
15.0%
10.0%
6.7%
7.4%
6.1%
5.0%
3.7%
2.4%
2.1%
Motorola
LG
0.0%
Samsung
Apple
Nokia
Sony
HTC
RIM
Other
Hotel rooms & Airbnb listings in New York
Hotel rooms
Airbnb listings
120000
Number of available rooms
100000
99,250
97,400
94,235
80000
60000
40000
20000
6,585
10,963
12,446
0
2012
2013
2014*
Sunk Costs
• Sunk costs cannot be recovered if a business decides to
leave an industry. Examples include:
– Capital inputs that are specific to an industry and which have
little or no resale value.
– Money spent on advertising, marketing and research and
development projects that cannot be carried forward into
another market or industry.
– Money spent in building expensive and complex IT systems
that are subsequently ditched because they are unworkable
• When sunk costs are high, a market becomes less
contestable. High sunk costs act as a barrier to entry of
new firms because they risk making huge losses if they
decide to leave a market.
• In markets such as fast-food restaurants, sandwich bars,
hairdressing salons and local antiques markets there are
low sunk costs so the barriers to exit are low.
Core Examples of Sunk Costs
1. Asset-write-offs – e.g. the expense associated with writingoff the value of plant and machinery, stocks and the goodwill
of a consumer brand
2. Closure or project cancellation costs including redundancy
costs, contract contingencies with suppliers and the penalty
costs from ending leasing arrangements for property
3. The loss of business reputation and goodwill - a decision to
leave a market can seriously affect goodwill among previous
customers, not least those who have bought a product which
is then withdrawn and for which replacement parts become
difficult or impossible to obtain.
4. A market downturn may be perceived as temporary and
could be overcome if and when the economic or business
cycle turns and conditions become more favourable
Examples of Sunk Costs
• Nov 2015: Redcar owner loses £530m on steel plant
liquidation
Retail Contestability – Rise of Aldi & Lidl
• Lidl is following a strategy of rapid organic growth
• Aldi - world’s leading limited assortment grocery, with
total sales of €61bn in 2013, followed by Lidl at €59bn
• Together, the two German discounters have more than
20,000 stores across Europe, the US and Australia. Lidl
is present in 26 European markets
• Majority of their products are own-label, rather than
brands - gives them purchasing power with suppliers.
• The range suppliers are asked to provide is narrower –
perhaps four to six products compared with 30-40 at a
large grocer – driving efficiencies and big volumes
Contestable Markets – Price and Profit
• The more contestable a market is, the more likely
that an allocatively efficient outcome is achieved
• The threat of entry affects the behaviour of firms
• Often smaller disruptive businesses challenge the
monopoly power of existing businesses
• The threat of entry is as important as actual
competition
Pricing – Options in Contestable Markets
Cost & Price
In the left hand
diagram draw in
the profit
maximising output
and price (label it
Q1 and P1.)
Highly Contestable Market –
Profit Maximising Output
Price > Average Cost
Supernormal profits
High profits send
signals to other
suppliers
MC
P1
AC
AR
C1
MR
Q1
Output (Q)
Pricing – Possible Long Run Equilibrium?
Cost & Price
In the long run if
the market is highly
contestable which
level of price and
output is probable?
(Label this Q2 and
P2).
Highly Contestable Market –
Profit Maximising Output
MC
P1
AC
P2
AR
C1
MR
Output (Q)
Q1
Q2
When AC = AR,
normal profits made,
a return sufficient to
keep factor inputs in
their present use
Pricing – Maximising Revenue
In the right hand
diagram show the
price and output
for a firm that
seeks to maximise
total revenue
Cost & Price
Highly Contestable Market –
Pricing to Maximise Revenue
MC
AC
AR
MR Output (Q)
Pricing – Revenue Maximisation
In the right hand
diagram show the
price and output
for a firm that
seeks to maximise
total revenue
Cost & Price
Highly Contestable Market –
Pricing to Maximise Revenue
Revenue maximised
when marginal
revenue = zero
MC
P1
AC
AR
MR Output (Q)
Pricing – Revenue Max – Lower Profits
In the right hand
diagram show the
price and output
for a firm that
seeks to maximise
total revenue
Cost & Price
Highly Contestable Market –
Pricing to Maximise Revenue
Revenue maximised
when marginal
revenue = zero
Still some super
normal profits made
MC
Revenue max means
a lower profit margin
is made – usually
good for consumer
welfare – but profit
has value too!
P1
AC
AR
C1
Lower price and
higher output than
MC=MR
MR Output (Q)
Key Barriers to Contestability
Economies of scale
Vertical integration
Control of important
technologies
Expertise and
reputation
Brand loyalty
Exit Costs – Barriers to Exit
Asset write-offs
Lost consumer goodwill
Redundancy costs
Policies to Increase Contestability
Deregulation of an industry
Open up networks of monopolies
Tough rules on predatory pricing
Policies on international trade
Contestable Markets – Evaluation Points
• The threat of competition may be a powerful an
influence on the behaviour of existing firms
• If a market is contestable, industry structure and
firm behaviour is determined by the threat of
competition - 'hit-and-run' entry
• A highly contestable market will resemble perfect
competition, regardless of the number of firms,
since incumbents behave as if there were intense
competition.
How does the threat of competition
affect a firm’s behaviour?
Topic 3.3.10