Markets can become more contestable through deregulation, tougher competition laws, and new technologies lowering entry costs. Contestable market theory holds that the threat of entry, not just current competitors, keeps prices low and forces firms to act efficiently. For example, the open skies agreement allowed more airlines to compete on transatlantic routes, threatening British Airways' profits from high-fare passengers. While no market is perfectly contestable, the degree of competition/threat of entry is what matters most according to this theory.

1. How can markets become more
contestable?

2. By the end this lesson you will be able to…
• Explain how markets can become more contestable?
• Differentiate the level of contestability between markets
and what determines it using industry examples
• Explain using a diagram the implications of contestable
market theory on firms in the industry
• Evaluate contestable markets

3. Making Markets More Contestable
• Main approaches
– De-regulation - i.e. reducing statutory barriers to entry to
liberalise a market
– Tougher competition laws acting against predatory
behaviour by existing firms / tough rules against cartels
– The changing nature of technology – which has brought
down entry costs in some markets (an increase in capital
mobility)

4. Back to the airline industry…
•
To what extent is entry and exit in the market 'costless'?
•
How would you describe the market structure of the low cost airlines industry?
•
Looking at the pricing strategies of each company in this market, is there
evidence that fierce competition is succeeding in driving prices down as we
might expect in a perfectly competitive market structure?
•
What response are the traditional airlines making to the impact of the low-cost
carriers? (The quote and link below may be of help in pointing you in the right
direction).
•

5. Competitive response
•
•
•
•
Today, major airline carriers are judged according to their "low-cost" label. As a result, the
biggest impact of Low Cost Carriers (LCCs) on business travel might soon lie in the
reactions of traditional airlines. To fight back against the cheap fares advertised by LCCs,
major carriers have adopted two parallel strategies:
First, they have focused on the quality of their service (their line is, in short: we do
not skimp on service).
Second, they have launched low fares of their own to meet the LCCs in the price
war.
This has been understood more quickly in the UK than anywhere else in Europe. For
companies, the issue of "low-cost carriers" is "out of date". The focus is now about
leveraging traditional airlines low fares. Large German and Dutch companies are also
heading in this direction. Potential cost cutting is likely to grow in the months ahead.
Major savings opportunities await companies, providing they are able to take full
advantage of them."
Source: Quote taken from What benefits do low-cost carriers really bring to
business travel in Europe?, a 'White Paper' report from Carlson Wagonlit Travel
[PDF, 260 KB]

6. •
•
Normal Profit Contrasted with Profit
Maximisation
Revenue
If the monopolist
charges the profitmaximising price,
then - if the market is
contestable – the firm
will be vulnerable to hit
and run entry
MC
ATC
P1
The only way the
monopolist can avoid
P2
this happening is to set
the price equal to
average cost, so that
there are no
supernormal profits to
act as an incentive for
entry
No one in the industry
has any advantage over
anyone else
AR
MR
Q1
Q2
Output (Q)

7. The Low Cost Airline Model (low cost carriers)
• (1) Use of the Internet to reduce distribution costs
• (2) Maximise the utilisation of the aircraft assets
• (3) Direct sell only via the net
• (4) Ticketless travel
• (5) No free airline food
• (6) Use smaller airports - cheaper to fly from
• (7) One kind of aircraft: Commonality maximises efficiency in the
recruitment and training of staff

8. Barriers to entry in the aviation industry
• (1) Availability of take-off and landing 'slots'
• (2) Necessity of entering a new route on a large enough scale to
achieve acceptable cost levels
• (3) The costs of leasing new fleets of aircraft
• (4) Securing an air operator’s licence from the EU
• (5) Contracts with ground-handling companies
• (6) Retaliatory behaviour by rivals (e.g. an expansion in flight
frequency, cuts in fares)
• (7) Overcoming existing customer loyalty achieved by companies
who have exploited first-mover advantage on specific routes

9. Open Skies…! March 2008
• The Open Skies agreement was
reached between the European
Union and the United States.
• Previously, only British Airways,
Virgin Atlantic, United and
American Airlines were legally
allowed to offer direct flights from
Heathrow Airport to the US.
• But after the deregulations of
transatlantic air travel, the market
was opened to competition from
challengers.

10. Article (March 2008): British Airways faces £250m
threat to profits as open skies era takes off
•
•
•
The sweeping away of restrictive rules that
govern transatlantic air travel could cost
British Airways £250 million a year in lost
profits.
From tomorrow, BA, which is reeling under
a torrent of criticism for the chaos that has
surrounded the opening of Terminal 5, its
new base at Heathrow, will face increased
competition on its most lucrative routes as
the “open skies” era begins.
The agreement allows any European carrier
to fly to any American city, effectively
smashing the Heathrow cartel. To this end,
on Sunday Continental, Delta US Airways
and even Air France will muscle in on
transatlantic services from Britain's largest
airport. This is expected to drive down air
fares, particularly in business class.
•
•
The arrival of new carriers at Heathrow is a
particular threat to BA, which controls 48
per cent of the airport's slots and is the
largest transatlantic carrier.
Airlines make almost no money on
transatlantic economy fares but reap large
profits from business and first-class
passengers. BA is thought to make as
much as 60 per cent of its profits from its
Heathrow-to-New York operations alone.

11. Evaluating Contestable Markets
• There are no perfectly contestable markets
• What matters is the degree of competition / contestability
• The idea is that what matters is not so much competition within a market, but
rather competition for a market.
• What also matters is the threat of entry of new suppliers – but this may not
be enough to affect the behaviour of existing firms
• The absence of competition in a market over a long period of time does not
necessarily suggest a lack of contestability
• Structural changes in costs in different industries can change the degree of
contestability
• Contestability may force existing firms away from profit-maximising
behaviour (e.g. towards sales-revenue maximisation)

12. Implications of contestable market theory
• The number of firms in an industry is irrelevant in terms of economic
efficiency
• Abnormal profits attract new entrants driving down prices and ensuring
economic efficiency
• All markets (excluding natural monopoly) can be efficient so long as they are
contestable
• Shifts the emphasis of government competition policy away from number of
firms towards reducing barriers to entry in an industry
• Potential competition may be more important for economic efficiency than
actual competition