Economies of scale can lead to a single firm dominating a particular market. Does this necessarily mean that the dominant supplier is immune from competitive pressure? Clearly, much will depend on the conditions of entry into the industry. If the supplier fears that positive profits will immediately induce a competitor to enter the market, the force of potential competition will constrain the monopolist to set a price which just allows costs to be covered but does not encourage entry. This seems a most unlikely circumstance in the cases mentioned earlier where an entrant wishing to serve the market would have to invest in large amounts of plant and equipment of a highly specific character. However, in principle we must recognize that the restraint on entry derives not from the ‘overhead’ or ‘fixed’ nature of the capital requirements, but from the fact that these costs are sunk. If the capital involved could always costlessly be retrieved from the business and used for some other purpose, the possibility of competitive entry to ‘steal’ the market, even for just a short time, could not be ruled out. In the extreme case with no sunk costs, and with the incumbent firm able to lower its price in response to a threat of entry only after a time-lag long enough for the entrant to set up at the appropriate scale, a market is said to be perfectly contestable.
Civil Aviation and Contestability
On a particular route, a single carrier may be able to operate at lower costs than could a number of competing airlines. In terms of the sub-additivity condition, air transport between two points may therefore be a natural monopoly. The capital involved is not specific to any particular route, however, and passenger aircraft can at relatively low cost be switched from one route to another. This has led to the idea that the conditions may approximate those of a contestable market, and that public regulation of fares is unnecessary.
Contestability theory has emphasized the importance of potential competition in providing constraints on the behaviour of natural monopolists. There are circumstances in which restrictions on entry have been recommended, however, even when an industry is contestable. In Figure 3.2, for example, the industry is a natural monopoly at output level q*, but in conditions of contestability there is no price which will enable the natural monopolist to cover costs without enabling a competitor to enter the market and make profits by supplying a lower output at a slightly lower price. Production of q’ at price p’, for example, would be profitable for a ‘hit and run’ entrant. A natural monopoly is said to be ‘sustainable’ if a pricing structure exists which will prevent new entry. Where large sunk costs are involved, ‘sustainability’ is obviously not usually considered a problem, although we have noted that restrictions have been imposed by governments in the past even in these conditions. In contestable conditions, however, the possibility arises of a natural monopoly being unsustainable, in which case new entry becomes disruptive and destabilizing.
In spite of the theoretical possibility that new entry could result in higher costs compared with those incurred by a single supplier, governments in many countries have in recent years moved in the direction of attempting to reduce barriers to new entry, thus making markets more contestable. From the point of view of administering and enforcing anti-monopoly policy, these developments have some useful attributes. For example:
By concentrating the efforts of administrators on facilitating new entry, their interests are less likely to become associated with those of the established firms. It has been suggested that regulation often serves the interests of those being regulated rather than consumers. The regulator is ‘captured’ by the industry being regulated. This danger may therefore be reduced when attention is focused on encouraging entry rather than discussing the details of pricing or investment policy.
The information requirements of a policy of monitoring and reducing entry barriers are different from those associated with price regulation or rate of return regulation. In Section 3.5 it will be shown that the latter requires detailed knowledge of matters over which incumbent firms have close control.
By encouraging new competition, aspiring entrants are induced to monitor the opportunities available and thus to supplement the policing efforts of regulators. If entry is forbidden or highly restricted, outsiders will have a smaller incentive to become informed about developments in an industry.
Express Bus Services in the UK
Before 1980 there were severe restrictions on the ability of new competitors to enter the market in express coach services. Each route was effectively assumed to be a natural monopoly and the market was dominated by a single company, National Express, a subsidiary of the publicly owned National Bus Company. The 1980 Transport Act removed all restrictions on entry except those relating to safety. The case has similarities of principle with that of airline deregulation in the US.
Electricity Generation and Distribution
The 1909 Electric Lighting Act confined the distribution of electricity to the Electricity Boards, and the 1911 Electricity (Supply) Act restricted the ability of new generators of electricity to enter the industry. In complete contrast, the Electricity Act 1989 and the subsequent privatisation of the industry were designed to encourage new entry in both generation and supply. The terms of access to transmission and distribution systems are overseen by the industry's regulator. All customers are now free to choose their own supplier. Privatisation of the industry will be discussed in Module 9.
Similar efforts to encourage new suppliers of gas have been made. As with electricity the main problem is in fixing the terms of access to the common carrier's network (in this case the gas pipelines). In these circumstances, potential competition is not a substitute for regulation but is rather dependent upon it. In 1997, for example, the transportation and storage activities of British Gas (Transco) were separated from the gas trading activities (Centrica). BG Transco Holdings, the transportation side of the business is now (since October 2000) held by the Lattice Group plc and is ‘ring-fenced’ for regulatory purposes. Thus the industry has been ‘disintegrated’ and domestic consumers are now free to choose between competing gas suppliers.
Terminal Equipment in Telecommunications
The 1981 British Telecommunications Act removed the monopoly in the supply of terminal equipment which had been operated by the Post Office until that date. This has resulted in greater variety and choice of equipment. Success has resulted from separating a market which has no natural monopoly characteristics (terminal equipment) from the distribution system to which it had been tied. New entry into telecommunications transmission has been more difficult to contrive. Mercury's gradual development of an alternative network is as far away from ‘hit and run’ entry as it is possible to get. Module 9 contains further discussion of these issues.
The trend towards deregulation and liberalization during the last two decades, which we shall discuss in Module 9, reveals that the encouragement of potential competition has become an important component of monopoly policy. Where sunk costs are large and the chances of significant new entry correspondingly small, however, governments have continued to impose more detailed regulatory constraints, and it is to these we turn in the next section.
