A student asked me a good question a couple of days ago, the question was, roughly:
‘How can you tell if a firm is keeping prices low because it is a contestable market or because it is actually already facing competition.’
I asked her to explain and she pointed to an example where she lives. On her road there is only one 7/11. ( a corner shop), and, therefore, that shop has some degree of monopoly power. It could put its prices up and most people would still shop there because we wouldn’t bother walking to the next road just to buy milk.
But the shop doesn’t increase its prices, they seem to be the same as anywhere else in Bangkok.
(OK, some of this consistency in pricing might be that it is simply not worth 7/11 adjusting prices on a case-by-case basis. This would make sense if 7/11 is trying to make the most of its economies of scale.)
So the question is this: Does the shop keep the prices low becuase the market is contestable or becuase their is some competition?
To answer this we first need to think does this example satisfy the criteria for contestability?
Remember, a contestable market is one where firms faces a credible threat of competition. There must also be no barrier to new firms entering the market.
Does this example fit with this?
Largely yes. It wouldn’t take much for a new firm to enter and if it did the shop would lose out.
If it put prices up, it would make greater profits. We would have good information about this as we see the price go up and complain about it. An entrepreneurial character might then think it worthwhile opening up a rival shop on the same road and the 7/11 would lose market share. This sounds fairly realistic and would sit well with what we know about contestable markets.
Therefore this is the main reason the prices stay low.
However, my student argued it was because the shop did face competition that it kept its prices low and the fact that the market maybe contestable as well is irrelevent.
She pointed out that she and her family do some shopping at 7/11 and some shopping at Tesco. If you notice prices going up at 7/11 you would shop less at 7/11 and more at Tesco. The 7/11 does have some degree of monopoly power on the street, but it is not the threat of competition that keep prices low, it is that it is actually already competing against other firms.
I am not sure she is right. If we have net inelastic demand for the service that 7/11 provides it would still make sense for them to put prices up even if they lost some custom. Therefore the reason the prices stay low is the threat of competition.
We argued this around a bit.
I am not sure you can clearly distinguish in this case. Either way it was good discourse and raises some interesting question about what if any difference lies between contestability and competition.
It was also a good example of contextual evaluation of economic theory which would allow the student to get really good marks in an examination.
I hope I will be putting up some notes on Contestability later today.