Is the theory of Contestable Markets a successful synthesis of the static and dynamic views of competition?
Historically the views of competition have typically fallen into two camps, namely static and dynamic views. This assignment will first look into the background of the two prevailing schools of thought, before proceeding into explaining the theory of Contestable Market and how it fits in with the aforementioned approaches.
Static View of Competition
The static view of competition is primarily based on the notion that the primal influence on the level and manner of competition within a market is the structure of the market itself. This approach excludes (or minimizes the influence of) non-price competition, such as quality and product differentiation. Competition is most accurately summised as occuring on a spectrum of market structures, with perfect competition on one end whereby there is a plethora of firms that drive abnormal profits to zero. On the other end of the spectrum is monopoly whereby one firm controls the resources to the markets and is the only producer. In between these two extremes are monopolistic competition (which allows a degree of product differentiation in markets of many firms) and oligopoly (where a small number of firms compete). Oligopolistic competition has been extensively studied in economic academia, initially via Cournot (1838) who argued that firms compete in a static set-up by choosing quantities to supply of a homogenous good. This was challenged by Bertrand (1883) who produced a model driven by firms competing on price, not quantity.This view of competition has been criticised for ignoring the more dynamic methodology of competition. Judd (1989) argues ‘It is well known that the Cournot and Bertrand models are substantial simplifications of firms’ strategies…yielding no clear predictions about important questions since the answers generally depend on the choice of strategic instrument’.
Under the static view, strategic interaction between firms is possible and meaningful, and every firm must take into account other firms’ actions as per the methodology of game theory. The static view eliminates the distinction between the short run and the long run due to the existence of barriers to entry / exit which protect the oligopolistic structure (Coursera). Models that have been developed utilising the static view within industrial organisation, include Cournot & Bertrand (referenced above) but also, a two stage model (Stackelberg) whereby one firm acts as leader and makes a business decision (such as on price) before the other participants react to that decision.
The policy implications which are derived from the static view of competition is that due to the fundamental importance of market concentration, markets should be made more accessible and in essence move closer towards perfect competition, with the associated benefits of eliminating a deadweight loss to consumers while providing the greatest degree of choice (Schwartz 1986). The cornerstone to this approach is that the market structure is the starting point, the constant factor in the equation on which competition is built upon. It is the market structure that sets the framework for understanding the competitive interactions between all current and future market participants. The economic forces behind competitive progressions in industry relate to efficiency gains and associated price reductions, rather than through the innovation and concentration fluctuation.
Dynamic View of Competition
The dynamic view of competition in contrast places emphasis on firms utilising human capital of the owner / entrepreneur in conjunction with utilising technological advances and innovation to separate themselves from their rivals. In reference to economic theory, initially this view was espoused by Classical economists such as Smith and Mills, who viewed competition “as the mechanism that coordinates the conflicting self-interests of independently acting individuals and directs them to the attainment of equilibrium in a dynamic sense of the term, that is, a never-ending process of elimination of any excess profits or losses and the tendential establishment of natural prices as the centres of gravitation of market prices. This is the reason why Smith notes that despite the fact that each individual is pursuing the satisfaction of his own self-interest, nevertheless “is led by an invisible hand to promote an end which was no part of his intention” (Smith, Wealth, p. 456). The neo-Austrian school of thought, in particular, Schumpeter, and those economists influenced by it have been redefining the concept along classical lines, although with a much greater emphasis on the entrepreneurial role, the role of discovery, and rivalrous competition. Performance in industries is argued to be characterized by dynamic competition, expressed through innovation and variation rather than through efficiency and price reductions, which is the case in the static approach.
This view portrays competition as a process of change and evolution rather than a static state in which equilibrium will be reached. Hayek, a main architect of this approach, defines competition as a dynamic behavioural activity. Central to this activity is knowledge, how it is acquired and communicated through the economy. He criticises the neoclassical assumption of perfect knowledge, with the view that costs are not a given, and so not exogenous. Competition is a process of interaction with the environment, in which innovation, such as new methods of production and new products, are a response to the unique situation of the economy.
It results in the optimal use of resources. (Auerbach 1988) Alchian believes that there is a natural selection process which results in a competitive outcome. Such competition depends not only on the physical possibilities but also the abilities and attitudes of participants, the entrepreneurs and consumers. It therefore argues for property rights, as to increase the level of competition, forcing companies to undergo research and development and to innovate, in order to survive.
For competition to be improved and sustained there needs to be a genuine desire on behalf of entrepreneurs to engage in competitive behaviour, to innovate and to invent to drive markets forward and create what Schumpeter famously called the “gales of creative destruction”. (Vickers, 1995, pp15). In the classic dynamic view, it argues that there is a tendency for rates of return to equalise, due to profit seeking behaviour, and the movement of capital from low profit areas to that of higher profit areas. However equilibrium may never be reached.
Before the tendency for equalisation, the economy may have changed, such as the structure of demand, or the available technology, and products may have evolved. The general criticism of the dynamic view of competition is that is lacks the simplicity and decisiveness than the static view of competition. The policy implications of the dynamic view of competition is less concerned with regulation of markets, instead encouraging property rights in order to allow firms to benefit from their own research and development, allowing for technological advancement, and the ensuing competition.
Contestable Market Theory
The theory of contestable markets is based in the concept of potential, or hyperthetical competition, as opposed to realised or actual competition. Firms that participate in a market are making decisions based on a mixture of short-term and long-term incentives, which revolve around sales, revenue, costs and profitability quantitatives. Thus, for longer term considerations, a firm must take into account the detrimental effects of competition (and the likelihood of competition intensifying, and under which circumstances this would be pervasive) and act accordingly to protect the interests of the firm in the short-run. The theory came to prominence in the 1980s, predominantly via the work done by Baumol who proposed this alternative to the neo-classical theory of industrial organisation.
The work initially used the airline industry as suitable for the theory, due to the degree of “hit and run entry” into the industry from 1979-1981. The theory builds upon three core assumptions:
(i) Entry into the market was free no barriers to entry
(ii) Entry was absolute
(iii) No sunk costs were associated with entry akin to no barriers to exit (Utopia or:Bust)
To expand on the above with a consideration of policy implications, contestable markets theory implies that competition policy should provide an equal weighting of importance to the levels of barriers to entry and exit in a market as to the existing levels of competition within the market. In academic discussions, it would be accurate to highlight that there is much debate and a lack of coalescience of agreement around a uniform set of outputs as to whether contestable market theory is a synthesis of the static and dynamic views of competition. Baumol equated his work to an ‘uprising’ (his paper was published in the wake of the Richard Nixon resignation which he used as context) from the traditional theories (Baumol, 1982), although other commentators viewed the theory in a considerably more mundane fasion as a mere extension of the traditional theories of competition.
The theory of contestable markets incorporates important concepts from the static view of competition. The relationship between market structure and competition is a major factor in contestable market theory as it is in the static view, however in the former, as stated earlier, the causation is reversed. So the relationship is still key, albeit with market structure being dependent upon its firm’s behaviour. Furthermore, barriers to entry and exit, which are important in the static view in terms of its negative effects in allowing incumbents to earn economic rent, are of prime importance in the new theory. In a perfectly contestable market, there would be no barriers to entry and exit, thereby allowing firms to enter and leave instantly as a reaction to the changing market environment. This is an equivalent way of stating that in this extreme scenario, there would be an absence of sunk costs.
Although the new theory turns it on its head and focuses on the positive effects of removing barriers, and the resultant competition that comes with it. Barriers are thus significant market determinants. Thus for some contestable market theory provides a static equilibrium theory of industry structure which is generally more applicable than before. The theory also points towards some dynamic interpretation of markets. Firms are able to enter on an ongoing basis, constraining market behaviour of incumbents.
The degree of contestability of a market can change over time with technology, regulatory breakdown, or changes in other barriers altering the entry and exit conditions. An incumbent pricing optimally can protect them self against new entrants using the same technology, but can’t protect against innovation or technological advancements. Furthermore, the threat of competition should lead to a faster rate of technological diffusion, as firms have to be particularly responsive to the changing needs of consumers. Thus dynamic aspects of competition are also important in the new theory.
Baumol et al have argued the contestable theory as a new general system to replace the original static and dynamic views of competition. However their analysis should only be treated as a specialised, extreme set of conditions, which are unlikely to be found in reality, due to rigid assumptions of contestability theory. Some have even argued that little has been added to the pre-existing entry and exit analysis. (Shepherd, 1984). In fact Baumol himself concedes ‘perfectly contestable markets do not populate the world of reality any more than perfectly competitive markets do’.