Contesting contestability

Economics, like fashion, has its hot ideas. Among the hottest ideas of 1982 was the theory of contestable monopoly, described as an ‘uprising’ by its leading proponent William Baumol. To quote the summary in Wikipedia

Its fundamental features are low barriers to entry and exit; in theory, a perfectly contestable market would have no barriers to entry or exit (“frictionless reversible entry” in economist William Brock’s terms).[1] Contestable markets are characterized by “hit and run” competition; if a firm in a contestable market raises its prices much beyond the average price level of the market, and thus begins to earn excess profits, potential rivals will enter the market, hoping to exploit the price level for easy profit. When the original incumbent firm(s) respond by returning prices to levels consistent with normal profits, the new firms will exit. Because of that, even a single-firm market can show highly competitive behavior

Contestable monopoly theory didn’t stay at the top of the hit parade for long. In theoretical terms, it was hard to formulate the hit-and-run analysis in the language of game theory, which was beginning its rise to dominance around the same time. More importantly, at least from my viewpoint, the predictions turned out wrong, most notably in relation to US airline deregulation, which was the primary motivation for the theory. Routes served by only one or two airlines were characterized by higher fares than more competitive routes, and “raids” of the type described by the theory were rarely if ever observed. Looking at Google Scholar, I found hardly any recent papers making use of contestable monopoly theory (feel free to point some out!)

Yet an examination of the policy statements of Australian governments would make it appear that contestability is a central idea in economic theory. Google reveals the term applied to electricity and water consumers, vocational education (a spectacular disaster), the Department of Finance, and even Tasmania.

It seems that contestability, having died as an economic theory in its native country, has been resurrected as a piece of policy jargon in Australia. Presumably, it is supposed to carry with it the positive connotations of the theoretical term. In practice, however, it’s one of the long list of euphemisms for “privatisation”, a word that is almost never used nowadays, except by its opponents.

9 thoughts on “Contesting contestability

  1. JQ, I am glad you raise this topic and I fully concur with your conclusion. The contestable market argument is theoretically unconvincing and in its application it is used to promote privatisation. More than 10 years ago I made a submission to an authority concerned with pricing, the name of which I have forgotten, on the topic of water supply privatisation. During public consultations in Sydney I noticed the private sector advisers relied on the contestable market hypothesis and they seemed to follow a script of some sort.

  2. I always thought contestabilty as a framework for any industry that was remotely capital-intensive was daft. You could always see how an industry with very low capital requirements could have rapid entry and exit – but in that case the industry would be competitive anyway so “contestable monopoly” would be unlikely. And of course such industries are nothing like utilities or airlines, which typically need karge upfront capital investment.

    What people like Finance mean by “contestability” is markets for policy advice or service delivery. But such industries are in fact capital-intensive too; in this case human capital. This daft notion that generic expertise can be bought like a kilo of sausages at the supermarket ignores, inter alia, the fact that expertise is specific and can only be measured by a measurer with the same expertise (in which case there is little point in buying it). In these markets asymmetric info rules.

  3. I adhere to Veblen’s idea that there is “business” and there is “industry”. Industry makes stuff. Business “manages” industry. Business is the managing of industry in the interests of business and the extraction of profits from industry in the interests of business. Business is autocratic, parasitical and contributes nothing to the national effort. Indeed, business sabotages industry and the nation to keep private profits high.

    Certainly, contestability has sabotaged our public infrastructure and utilities. The quality and amenity of life declined for most citizens, or else failed to rise to where it could have been otherwise. Special business interests got richer. The rest of us essentially got poorer. For example, with communications and power still in public hands, our internet would have been much better and our power system much further on its progression to renewables. Business has deliberately made a mess of these things. It’s deliberate sabotage of the nation. If the rich men are made a billion richer but the country overall ten billion poorer, they don’t care because that’s just “good business”.

  4. I’m with DD.

    Surely high capital requirements means high barriers to entry as in the Electricity industry.

  5. I do not make and have not made personal attacks John. How this could be even seen in that light is very strange

  6. icono?

    what about the advertising “industry”?

    and the public relations “industry”?

    i know it’s outside the current definition but it’s still real and ignored.

  7. @nottrampis Since you can’t see what you’re doing, I’ll make the rules clearer. Make no comments referring personally to anyone, specifically including me and other commenters here.

  8. I apologise for the sloppiness of my earlier post. My submission was to IPART regarding its Review of Water and Wastewater Industry Structure and Pricing in Greater Sydney Metropolitan Area
    (ref: 04/587), 31 May 2005.
    My submission was a critique of the methodology, supported by empirical evidence.

    “The economic conceptual framework in the IPART Issues Paper, May 2005, is known to me as the theory of contestable markets (eg Baumol, W., R.D. Willig, and J.C. Panzar, Contestable Markets and the Theory of Industry Structure, 1982, 1987). The theory of contestable markets addresses one (1 only) specific type of ‘market imperfection’, namely potentially sub-optimal resource allocation (‘allocative inefficiency’) due to ‘lack of competition’. Lack of competition is ascribed to ‘barriers to entry’ due to a ‘natural monopoly’ or actual or assumed ‘competitive advantages’ arising from public sector ownership (restrictions on foreign investment is another example).”

    “It is possible to think of examples where the contestable markets framework is suitable. But the problem at hand is not one of them.”

    “The economic problem of ecologically sustainable development is categorically different from that addressed in the theory of contestable markets. In the first instance, it is not ‘lack of competition in markets’ which is the problem but rather it is the total absence of relevant markets (competitive or otherwise).”

    “The empirical relevance of my statement that there are missing markets is acknowledged publicly in the form of environmental performance measures which are expressed in non-market (non-price) quantities (Sydney Water, Annual Reports).”

    “I submit that the micro-economic reform practised during the past decade may be viewed as a social experiment. It provides relevant data to reject the economic theory on which the reform has been based. However, the data is consistent with the theoretical proposition that ecologically sustainable development cannot be separated from economics and the appropriate economic theoretical framework to start off with (at least for democracies) are theoretical models of non-dictatorial resource allocation systems of ‘competitive private ownership economies with incomplete markets’.”

    I noted this inappropriate method had been used for at least 10 years (aviation, health, insurance) and the results on education aren’t in yet.

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