Baumol's Contested Market Model
1. INTRODUCTION:
The literature on contestable markets emerged from a research program
that claimed two principal achievements in advancing economic knowledge, and two
important policy contributions. The theory of contestable markets was advanced
as a generalization of the theory of perfectly competitive markets, and a generalization
that (in contrast with the previous literature) endogenizes the determination
of industry structure.
This theory was first developed by the American economist W.J.Baumol in
the early 1980s. The theory argues that what really matters in determining an
industry's price and output is not, in reality, whether the industry is
perfectly competitive or a monopoly, but the potential of new firms to enter or
leave the market. The theory is based on the idea that a firm may enjoy a
monopoly position within a market, but if there existed the real threat of
competition from other firms, this would force the firm to behave as if it
actually faced competition; that is, the firm would not pursue a policy of
charging exorbitant prices to make excessive profits.
2. THE THEORY:
A.
What
is a contestable market ?
The
term 'contestability' has nothing to do with the number of firms currently in
the industry, but refers instead to the ease with which firms are able to enter
or leave a market; a perfectly contestable market is one in which there are no
barriers or costs to entry or exit: the greater these are, the less contestable
is the market, and thus the greater is the monopoly power of existing firms; so
for a market to be contestable, a barrier to entry, such as a patent protecting
technical knowledge, must be absent.
B. Important
conditions for contestable markets to prevail are:
The
first condition is that the new firms can enter the market with the same cost
conditions as the existing firm or firms. If the existing firm enjoys some
cost advantage as compared to the potential entrants in the market, then the
new firms that enter the market cannot succeed in competing with the existing
one which can afford to lower the price and inflict losses on the new entrants.
The second condition for the
contestable markets is that firms should be able to leave or exit the market
(i.e. industry) without incurring any capital loss. If the production in an
industry involves much capital investment which is specific to that industry
and therefore of no use elsewhere, leaving the industry will entail losses
equal to the sunk costs. Sunk costs act as an important barrier to the entry of
new firms and are therefore deterrent to the existence of contestable markets.
The third condition for
contestable markets to exist is that the potential entrants must be at no
disadvantage as compared to the existing firms with regard to the production
technology or product quality as perceived by the consumers. Any lack of
access to the same production technology as used by the existing firms prevents
the new entrants from competing the existing firms on the basis of cost or
product quality. This would work to reduce the threat by potential entrants and
enable the existing firms to charge higher than competitive price and earn
supernormal profits.
The last condition for the
contestable markets to exist is that the new entrants must be able to engage in
‘hit and run’ tactics. That is, entry should be free and costless so that
the new entrants enter the market or industry and make profits and exit the
industry before the existing firms adjust their prices downward.
C. Evaluation:
The theory of contestable markets is often
seen as an alternative to the traditional, Neo-classical, theory of the firm.
Perfectly contestable markets can deliver the theoretical benefits of perfect
competition, but without the need for a large number of firms. However a
perfectly contestable market is not possible in real life. Instead, we talk
about the degree of contestability of a market. The more contestable a market
the closer it will be to a perfectly contestable market.
This theory argue that
determining price and output is not actually dependent on the type of market
structure, in other words whether it is a monopoly or perfectly competitive
market, but rather the threat of competition. Hence, for example a monopoly
protected by high barriers to entry (e.g. it owns all the strategic resources)
will make supernormal or abnormal profits with no fear of competition. However,
in this same case if it did not own the strategic resources for production then
other firms could easily enter the market, leading to higher competition and
thus lower prices, thus making the market more contestable.
Price setting in a contestable
market is illustrated in the following figure .Suppose there are two firms
in an industry, that is, there is duopoly in the product market. DD is the
demand curve for the industry’s product. The average and marginal cost curves
of each firm are shown.
The threat of entry of new firms
leads each duopolist to charge a price OP (which is equal to their minimum
average cost) and produces output equal to Oq. The total output OQ will be
equal to two times Oq. (That is OQ = 2Oq). Each firm earns zero economic
profits.
Though the two firms can enter
into tacit collusion and push up the price and earn supernormal profits, they
do not do so because they think new entrants will enter industry quickly and
undercut price and in this way inflict losses on them. To prevent entry of new
firms and avoid competition with them each duopolist produces OQ output and
charges OP price.
By producing at the lowest
minimum average cost they are able to enjoy all the economies of scale. Thus,
in producing the level of output at the minimum average cost and charging a
price equal to it, the two firms behave like a perfectly competitive firm.
3. Implications of the theory:
The theory implies that, given
easy entry to and exit from an industry, monopoly or oligopoly firms will
behave as if they actually existed in perfect competition; that is they will:
1.
Equate MC with MR to maximise profits
2.Only earn normal profits (AR = ATC) in
the long run, because if supernormal profits were made, new firms would enter
the industry increasing supply and driving down price to a level where only
normal profits are made; and if losses are made, some firms will be forced to
leave the industry, causing supply to fall and price to rise back to a level
consistent with the making of normal profits.
3.Operate with productive efficiency on the
lowest point of the ATC curve where AC = MC; if this were not the case, new
firms could enter the industry, produce at the most efficient level, price
their goods more competitively and force existing firms out.
4. Operate with allocative efficiency where P = MC; this will occur
because the earning of long run normal profits requires that AR or price should
equal AC, and as AC = MC (see above point), the MC should equal the price.
4. Criticisms of the theory:
The theory of contestable markets
has been criticized, among others by Shepherd who points out that it is based
on extremely unrealistic assumptions regarding entry and exit of new firms.
According to him, in the real world entry is not free and exit is not costless.
The extent to which the theory of contestable markets may be applied in
practice is limited. Two pre-requisites may not be met:
Firstly, firms' sunk costs must be low so that
they can easily leave the market. However, in reality sunk costs may be
extremely high, even when capital is transferable.
Secondly, the specific technical knowledge
necessary to operate in the industry must be freely available. However, sole
possession of technical knowledge, often protected by patent, is a common and
powerful barrier to entry to monopolistic markets where production is of a
highly sophisticated nature, and is underpinned by extensive R&D - for
example, the case of the drugs industry.
5. RELEVANCE OF THE THEORY IN REALITY:
The
applicability of the theory to real-world situations may be questioned,
however, particularly as there are very few markets which are completely free
of sunk costs and entry and exit barriers. Low-cost airlines remain a commonly
referenced example of a contestable market; entrants have the possibility of
leasing aircraft and should be able to respond to high profits by quickly
entering and exiting. However, it is now generally admitted that Baumol's
judgment that the US airline industry was therefore best left deregulated was
incorrect, since the now duly deregulated industry is "well on its
way" to evolving into a concentrated oligopoly. More generally,
experimental evidence collected since the publication of Baumol's paper has
suggested that perfectly competitive markets would – if they existed – behave
in the way Baumol outlined, the performance of imperfectly contestable markets
(i.e. real-world markets) depends "on actual rather than potential
competition", perhaps in part due to the range of "strategic
responses" available to incumbents that were not considered by Baumol as
part of his theory.
The theory of contestable markets
has been used to argue for weaker application of antitrust laws, as simply
observing a monopoly market may not prove that a firm is exploiting its market
power to control the price level. Baumol himself argued based on the theory for
both deregulation in certain industries and for more regulation in others
6. CONCLUSION
To conclude, the threat of new
entrants can lead to the existing monopolists and oligopolists to behave like a
competitive firm in some situations but when there exist substantial sunk
investment costs, the existing firms have an edge over the new entrants and
charge higher than competitive price and make large supernormal profits. We
thus see that contestable market theory does not apply to all monopolistic and
oligopolistic market situations.
7.REFERENCES:
(i) Jhingan
M.L, Advanced Economic Theory,13th revised and enlarged edition
Published:vrinda
publication(p) limited,Delhi.
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