Contestable Markets

How does the threat of competition affect a firm’s behaviour?

Topic 3.3.10


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.

• Contestable markets are constantly changing!• Can be seen at a local, regional, national and

international level• In a contestable market, the number of firms & the size

distribution of firms is not considered to be important• More focus given to credible threat of entry from rivals• Almost all markets are contestable to some degree• Technology is changing contestability

– E.g. Barriers to entry have lowered because of digital advances– Many start-ups use the web as a platform to enter markets

• Contestable markets often show high dynamic efficiency – challenger brands attacking established operators

Contestable Markets

Some Contestable Markets In Action

Peer to Peer Lending

Fast Food Industry

Hotel / Room Sharing Sector

City Transport Services

Private Education

Bookselling

Netflix and Global Expansion

Netflix Annual Revenue ($ million)

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 20150

1000

2000

3000

4000

5000

6000

7000

8000

Reve

nue

in m

illio

n U.

S. d

olla

rs

Netflix and Global ExpansionAmount of content available on Netflix in selected countries as of January 2016, by content type

All videos Movies SeriesArgentina 3,511 2,847 664Australia 2,081 1,623 458Brazil 3,538 2,956 582Canada 3,517 2,870 647Chile 3,505 2,847 658Cuba 3,040 2,425 615France 1,906 1,510 396Germany 1,816 1,451 365India 774 563 211Indonesia 715 529 186Ireland 2,966 2,411 555Japan 1,786 1,376 410Mexico 3,525 2,869 656New Zealand 2,034 1,581 453Nigeria 702 493 209Russia 753 542 211South Korea 691 525 166Spain 1,305 1,061 244Switzerland 2,180 1,736 444United Arab Emirates 643 465 178United Kingdom 2,973 2,414 559United States 5,680 4,566 114

Peer to Peer Lending (Funding Circle)

Peer to Peer Lending (Funding Circle)

2010 2011 2012 2013 2014 20150

50000000

100000000

150000000

200000000

250000000

300000000

350000000

400000000

450000000

Amou

nt o

f mon

ey le

nt in

£s

1-2 2-3 3-4 4-5 5-6 6-7 7-8 8-9 9-10

10+0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

0.1%0.3%2%

9%

27% 27%

19%

9%

4%3%

Investor return after fees and bad debts

Shar

e of

inve

stor

s

Airbnb

Airbnb

2014 2015*0

5

10

15

20

25

30

10

25.5

0.82.3

Company valuation Total equity funding

Valu

e in

bill

ion

U.S.

dol

lars

Hotel rooms & Airbnb listings in New York

2012 2013 2014*0

20000

40000

60000

80000

100000

120000

94,235 97,400 99,250

6,58510,963 12,446

Hotel rooms Airbnb listings

Num

ber o

f ava

ilabl

e ro

oms

Absence of sunk costs

Access to all available

technology

Low rate of existing

consumer loyalty Low barriers to entry

1. A pool of new entrants who are willing and ready to enter the market – e.g. app developers

2. No significant entry or exit costs – lowers the risk of market entry

3. Equal access to available industry platform technologies

4. High rates of customer churn (switching)

Key Conditions for a Contestable Market

Examples of Disruptive BusinessesDisruptive Businesses,Top Innovators, Disruptive Business ModelsA: Air BNB, Aldi, Alibaba, AvantB: Bitcoin, Bloom Energy, Buzz Feed, BookIndyC: CrowdCube, Coursera, Cahoot, Car Trawler, CoinJarD: Dropbox, Dollar Shave, DeliverooE: EventbriteF: First Utility, Funding CircleG Google, GetAroundH: HuaweiI: InstagramJ: Jawbone, Just EatK: Kickstarter, King of ShavesL: Lyft, LidlM: Mozilla, Metro BankN: Netflix, Nest

Examples of Disruptive Businesses

O: Osper, OppoP: Pinterest, PeriscopeQ: QuirkyR: Rent the Runway, RyanAir, RinseS: Shazam, Samsung, Snapchat, Space XT: Tesla, Twitter, Trip Advisor, TataU: UberV: Vine, ViberW: What’s App, WikpediaX: XiaomiY: Yo Sushi, Yelp, YPlan, Yik YakZ: Zipcar, Zoopla, Zynga

Contestable Markets in Action!• Jan 2016: Netflix announces their streaming service is now

available in 130 countries.• Nov 2015: Apple 'to launch peer-to-peer payment app' in

competition with PayPal• Nov 2015: Gym Group, one of the UK's low-cost fitness chains

goes for listing on stock market to fund future expansion• Nov 2015: Uber taxi app set to launch in Edinburgh• Nov 2015: Amazon announces the opening of their first

physical “bricks and mortar” bookstore• Oct 2015: Metro Bank Takes Step Towards £1bn Listing• Oct 2015: Sainsbury's tests out 'micro-stores' for busy

shoppers

Contestability and Dynamic Efficiency

• Dec 2015: Porsche to make electric sports car in €700m project - aimed at challenging Tesla's dominance of the battery-powered sports car market

• Dec 2015: Ford says it will invest $4.5bn (£3bn) to expand its fleet of plug-in and hybrid electric vehicles, and will start selling 13 new electric models by 2020.

• Nov 2015: Huawei reveals a new quick-charge battery• Nov 2015: The doctor will text you now: Will mobile

devices change healthcare? – new app allows doctors to process their patients electronically and remotely

Leading global generic drug manufacturers by market share 2013

Top 10 generic drug manufacturers - worldwide market share in 2013

Note: Worldwide

Teva Pharmacetical

Novartis

Actavis

Mylan

Aspen Pharmacare

Sun Pharmaceutical

Hospira

Daiichi Sankyo

Sanofi

Lupin

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%

13.4%

11.9%

9.1%

8.6%

4%

3.9%

3.5%

3.2%

3.1%

2.5%Market share

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®

Generic Drugs and Contestability

Market share of mobile handset manufacturers in the UK in June 2014

Samsung Apple Nokia Sony HTC RIM Motorola LG Other0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%31.8%

22.9%

16.9%

6.7% 6.1%

3.7%2.4% 2.1%

7.4%

Mar

ket s

hare

A Contestable Oligopoly?

The 5 firm concentration ratio = 84.4% - but this is a highly competitive market!

Sunk Costs

1. Sunk costs cannot be recovered if a firm leaves an industry

2. When sunk costs are high then a market becomes less contestable

3. High sunk costs act as a barrier to entry of new firms because they risk making significant losses if they decide to exit the sector

4. In markets such as fast-food restaurants, sandwich bars, hairdressing salons and local antiques markets there are low sunk costs so barriers to exit are low and contestability is high

Core Examples of Sunk Costs1. Asset-write-offs – e.g. writing-off the value of plant and

machinery, stocks and the goodwill of a consumer brand 2. Closure or project cancellation costs including redundancy

costs, bad debts, contracts with suppliers and the penalty costs from ending leases for property & equipment

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.

• 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

Asset write-offs Lost consumer goodwill

Redundancy costs

Exit Costs – Barriers to Exit

Internal economies of scale Vertical integration Strength of customer

brand loyalty

Control of important technologies

Expertise and reputation

Key Barriers to Market Contestability

Deregulation of an industry Open up networks of monopolies

Tough rules on predatory pricing Encouraging international trade

Policies to Increase Contestability

Key Concepts – Contestable Markets

Key concept Brief definition

Contestable MarketWhere an entrant has access to all production techniques available to incumbents and entry decisions can be reversed without cost

Hit and run entryWhen a business enters an industry to take advantage of temporarily high (supernormal) market profits.

Sunk costsSunk costs cannot be recovered if a business decides to leave an industry. The existence of sunk costs makes a market less contestable.

• 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

Retail Contestability – Rise of Aldi & Lidl

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

Cost & Price

Output (Q)

Highly Contestable Market – Profit Maximising Output

AC

AR

MR

MC

In the left hand diagram draw in the profit maximising output and price (label it Q1 and P1.)

Q1

P1

C1

Price > Average Cost

Supernormal profits

High profits send signals to other suppliers

Pricing – Options in Contestable Markets

Cost & Price

Output (Q)

Highly Contestable Market – Profit Maximising Output

AC

AR

MR

MC

In the long run if the market is highly contestable whichlevel of price and output is probable?

Q1

P1

C1

When AC = AR, normal profits made, a return sufficient to keep factor inputs in their present use

P2

Q2

Pricing – Possible Long Run Equilibrium?

Cost & Price

Output (Q)

Highly Contestable Market – Pricing to Maximise Revenue

AC

AR

MR

MC

In the right hand diagram show the price and output for a firm that seeks to maximisetotal revenue

Pricing – Maximising Revenue

Cost & Price

Output (Q)


AC

AR

MR

MC


P1

Revenue maximised when marginal revenue = zero

Pricing – Revenue Maximisation

Cost & Price

Output (Q)


AC

AR

MR

MC


P1

C1

Revenue maximised when marginal revenue = zero

Still some super normal profits made

Lower price and higher output than MC=MR

Revenue max means a lower profit margin is made – usually good for consumer welfare – but profit has value too!

Pricing – Revenue Max – Lower Profits

• The threat of new competition is often a powerful an influence on the behaviour of existing established firms

• A highly contestable market will resemble perfect competition, regardless of the number of firms, since incumbents behave as if there were intense competition!

• Competition policies that help to open up the market to new suppliers or persuade consumers to switch in greater numbers help to increase contestability

Contestable Markets – Evaluation Points


Topic 3.3.10

Contestable Markets

Economy & Finance