Saturday, March 29, 2008

Critique of Contestable Market Theory

From 1979 to 1981 there was a lot of "hit and run entry" into the airline industry. This partly influenced George Baumol in 1982 to write his restatement of the potential competition doctrine in its new form, contestable market theory. He and his colleagues believed the airline industry was one of the best examples of a "perfectly" contestable market.

In 1982 it seemed all a potential entrant into the airline carrier industry needed to do was a hire a few staff, some pilots, and lease an old plane. It did not seem very difficult. The basic assumptions of the theory were as follows:

  1. Entry into the market was free. This means there were no barriers to entry, no cost advantages for incumbents, no patents, and no product differentiation advantages.
  2. Entry was absolute. When the entrant lowers prices it undermines the incumbents revenues completely.
  3. No sunk costs were associated with entry. When there are no sunk costs, costs that cannot be recovered, then there are no barriers to exit, which again implies there are no barriers to entry.
Any move away from these assumptions would change the results dramatically. If sunk costs were greater than zero, for example, then hit and run entry would be impossible and incumbents could earner excess profits without attracting entry. If the airline carrier industry was perfectly contestable, then prices would equal average cost. This was said to be the only sustainable price since any higher prices would attracts entry. Essentially, Baumol said the industry was setting limit prices.

But, of course, entry is not free, not absolute, and there are sunk costs associated with entry.
  1. Free entry. There are more costs associated with entry than the variable costs associated with hiring labor and leasing aircraft. If incumbent firms are pricing below the entrants average costs, this is a barrier. Assuming capital markets are perfect, this would still imply greater costs. Firms with cash reserves and easy access to capital markets through networks and reputation have an absolute cost advantage. Restrictive practices at airports make it difficult to obtain landing slots. The scarcity of gate slots and bidding over them can also become barriers to entry.
  2. Absolute displacement. This assumption is highly questionable in any market. In the airline industry incumbents always have sufficient advanced notice of any impending entry to permit them to respond with price reductions. The cost advantages of incumbents become barriers to displacing their prices.
  3. Sunk costs. If some sunk costs are necessary to penetrate the market, then assumption three is false. Advertising has been identified as one of the most significant sunk costs in a market. Advertising costs cannot be recovered if the carrier is not successful. The trademarks and rights associated with this all become sunk costs, and thus barriers to exit, and ultimately, barriers to entry.
Historically, many major incumbents did not role over when the newer airlines entered the market after deregulation. Many carriers which entered the market during the early eighties have either merged or vanished. For example, Big Sky, Braniff, Gulf Air, People's Express, etc. Vanished incumbents like Pan Am and Eastern was due to direct competition with other incumbents after deregulation and cost inefficiencies in general.

The Chicago School of Economics, which Baumol was educated in, says in general that there are no barriers to entry in any market. There are only "natural barriers". Without government regulation, many entry barriers disappear. This is true. But there still significant barriers and costs (especially sunk costs) associated with almost every market entry.

Although the airline industry is not perfectly contestable, as Chicago said, the theory had a large impact on the industry. Antitrust authorities were loathe to intervene in the industry due to the popularity of the theory of contestable markets, and I think this is a good thing for the industry. Perhaps all an industry really needs is to be contestable enough to attract not potential entrants per se, but rather, substantial criticism of antitrust intervention.


Anonymous said...

I am a bit confused. Pan Am, Braniff, and Eastern were not new entrants in the 1980's. These were old, established U.S. airlines. People's Express is a correct example however. Also, "Branith" is actually Braniff.



Acumensch said...

Thanks for reading closely. I was talking about entrants in the 80s but listed some carriers that had vanished since deregulation in the 80s. It's two sides of the worry that there would be a lot of competition after deregulation and then it would settle and become anti-competitive. Both incumbents and entrants had vanished.