Deniability

Deniability (English contestability ) is in the micro-economics , the ease of entry by a potential competitors .

If the new competitor does not have sunk costs when entering the market and directly has the same production costs as the established provider, then there is perfect deniability . The higher the sunk costs and the differences in production costs between the established and the potential competitor, the less contestable a market is.

The contestability of a market is effective in order to limit the market power of the incumbent supplier in markets with a high degree of subadditivity . However, the theory of contestable markets is also applicable to markets without subadditivity. The more contestable a market, the more likely the natural monopolist will set the price in such a way that it just covers all of the costs incurred. In the case of perfect contestability, first-best is achieved, or second-best in the case of subadditivity. The message of the contestable markets theory is that not only actual but also potential competition influences the behavior of the supplier.

Conditions of contestability

For a market to be considered contestable, two essential prerequisites must be met: the market entry must be “completely free” and the market exit must be “free”. “Completely free” market entry does not mean that the company does not have to pay any costs to enter a market. “Completely free” means that the new company has to pay the same costs when entering the market as the current provider, i. H. the potential provider has no cost disadvantages compared to the provider established on the market. Accordingly, there must be equal access to sales and procurement markets, technology and / or manufacturing experience ( learning-by-doing ) for the current and potential provider .

A "free" market exit means that every company can leave the market and recoup all costs that were incurred when entering the market by selling or dissolving the assets . It is therefore assumed that a company can sell the same assets that it purchased for market entry at the purchase price (less depreciation) when it leaves the market. Ie all costs would have to be reversible. The higher the share of irreversible costs (sunk costs), the lower the market's contestability.

Theory of contestable markets (with perfect contestability)

The theory of contestable (vulnerable) markets goes back essentially to the economists William J. Baumol , John C. Panzar and Robert D. Willig.

In the case of the theory of contestable markets, there must always be contestability. In addition, the following assumptions are made:

There are no subsidies .
The products must be homogeneous in each market and the consumers must not have any preferences for a specific company
The established provider only reacts very slowly to the new provider's entry into the market by lowering prices and expanding its supply volume accordingly.
Complete information or market transparency is available.

If these assumptions or conditions are fully met, then a monopolist is forced to produce technically efficiently and to set the price in such a way that its own economic viability is just guaranteed or zero profit arises. Assuming the monopolist makes a profit, a new company could enter the market, charge slightly lower prices and thus tap the monopolist's entire demand. The new provider would then have a profit (but less than the old monopoly) and would drive the old monopoly out of the market. If, however, the old monopolist reduces its price below the level of the new provider as a reaction to the market entry, the new provider can simply exit the market, recover all costs incurred by selling the assets and take the profits tapped up to this point. In both cases the price is reduced.

The same scheme applies if the established monopolist generates zero profit, but produces technically inefficiently: Either the established monopolist would lose its market to a new provider or it would correct the technical inefficiency and thus be able to offer the same price as the new provider, which one can then exit the market again free of charge. In both cases, the inefficiency is eliminated.

Accordingly, it can be said that in a perfectly contestable market it is not possible for a monopolist to make a profit or to produce at higher than the minimum cost - not even for a short period of time. The market entry of a new provider would follow immediately, which can then skim off profit at a lower price over a certain period of time until the old monopolist makes adjustments. As soon as a price competition begins, the new provider can exit the market at no cost. William J. Baumol describes this strategy as a " hit-and-run " market entry. Since the established monopolist is aware of this problem, he will not offer potential new providers any incentive to enter the market and thus produce directly technically efficient and set prices in such a way that there is zero profit - this is how the threat of potential ones works alone Disciplining market entries on the market owner.

The first-best optimum is not achieved in the case of a natural monopoly on contestable markets, because a price that corresponds to the marginal costs would lead to losses. However, with a natural one-product monopoly with perfect deniability, the second-best optimum is achieved. With a natural multi-product monopoly, Ramsey prices do not necessarily have to be achieved (as described later), so that second-best is not necessarily fulfilled here .

Numerical example

A monopolist produces a homogeneous good. He is faced with the demand ( = price). Its fixed costs are ( ) . For the sake of simplicity, the monopolist has no variable costs. The monopolist wants his profit ( maximize) . There is a maximum when the first derivative of the profit is zero and the second is less than zero. ${\ displaystyle D (p) = 1-p}$ ${\ displaystyle p}$ ${\ displaystyle F}$ ${\ displaystyle {\ tfrac {1} {7}}}$ ${\ displaystyle \ Pi}$ ${\ displaystyle \ max {\ Pi} = \ max {(1-p) pF}}$

{\ displaystyle {\ begin {aligned} {\ frac {\ partial \ Pi} {\ partial p}} & = 1-pp = 0 {\ text {and}} {\ frac {\ partial ^ {2} \ Pi } {\ partial p ^ {2}}} = - 2 \\\ Rightarrow p & = {\ frac {1} {2}} \\\ Rightarrow \ Pi & = {\ frac {1} {4}} - F \ end {aligned}}}

The market is vulnerable because it is worthwhile for another company to enter the market, undercut the monopoly and generate positive profits. So that the market does not become vulnerable, the monopolist sets the price at which he makes zero profits.

{\ displaystyle {\ begin {array} {l} \ Pi = (1-p) p - {\ frac {1} {7}} = 0 \ quad \ Leftrightarrow \ quad 7p ^ {2} -7p + 1 = 0 \ quad \ Leftrightarrow \\ p = {\ frac {7 \ pm {\ sqrt {21}}} {14}} {\ text {also}} p = {\ frac {7 - {\ sqrt {21}} } {14}} \ end {array}}}

.

Theory of contestable markets with limited contestability

If a new provider has to reckon with a quick reaction from the established and with high sunk costs when entering the market, the market entry could lead to ruinous competition , i. H. to competition with non-cost-covering prices. In order to understand this fact, it is necessary to consider the lower limit for the price of the established monopolist: He will reduce the price to his reversible average cost in order to force the new provider out of the market. The new provider will also set the opportunity costs for the irreversible cost components (= sunk costs upon exit from the market) at zero and thus only determine its price on the basis of the reversible cost components. Both neglect the irreversible costs . Since the irreversible costs are also part of the total costs , the reversible marginal and average costs are always lower than the total costs. If the providers lower their prices to the reversible costs, the competition is ruinous or no longer covers costs.

Such behavior is particularly understandable when the assets that cause / represent irreversible costs have amortized (i.e. no more depreciations need to be earned) and can still be used for a while, which is usually the case with established providers. However, if these assets are financed to a significant extent by outside capital , which is usually the case with the new provider, then interest and principal payments still have to be made, which makes it hardly possible to neglect the irreversible costs . The high sunk costs when leaving the market and the likelihood of ruinous pricing behavior by the established provider will probably deter a competitor from entering the market. Especially in view of the fact that all expenses for the (potential) competitor are reversible costs before entering the market. Before entering the market, he must therefore base his price calculation on the total average costs incurred (reversible + irreversible costs ). If he anticipates the price reduction of the established at reversible costs, he will not enter the market, since after entering the market he will no longer be able to generate the irreversible costs due to the price reduction.

Criticism of the theory of contestable markets

As the economists Marius Schwartz and Robert Reynolds describe, the strength of hit-and-run entries (more precisely: the fear of such entries) is based on the assumption that a new provider can enter a market and generate profits before the established one has his May decrease prices. In most cases, however, it would be much quicker and easier for the incumbent to reduce its prices than for a new company to buy the necessary equipment and production facilities, hire employees and alert consumers to the new products on offer. Given these circumstances, the incumbent monopoly could keep the price above the zero profit level indefinitely. If the established company observes that a new company wants to enter its market, it can simply lower its prices before the new competitor even offers its products. Since the potential new provider knows that the monopolist would act in this way, he will not even enter the market, even if the established monopolist makes profits and / or produces technically inefficiently .

There are two ways that arguable markets theory can defy this argument:

The new provider can conclude long-term contracts with customers before entering the market. These contracts would oblige customers to no longer buy from the established monopoly, but only from the new provider (at least until the contracts expire). If the new provider charges a lower price than the established one, the customers will sign the contract, even if they know that the established one will lower their prices in response to entering the market. As soon as the contracts expire, the incumbent monopoly would raise its prices again. The potential new provider first collects signed customer contracts before entering the market - only when he is certain from the signed contracts that entering the market will be profitable will he start his business. In other words, customers know that the new provider will only appear on the market by signing the contracts and that competition will depress the price of the established monopolist. The customers' only hope for lower prices in the long term is therefore to sign the contract with the new provider. If the established person perceives that a new provider is concluding contracts with customers, he could try to conclude contracts with the customers as well - at the same price as the potential new provider or even cheaper. Should this defensive measure successfully prevent the new entry, the price will still be lower in the long term until the contracts of the established company with the low prices expire.
The regulator can require the incumbent monopoly not to lower its prices in response to a market entry. If the established person knows that every price level must be maintained (even with a new entry), he will choose low prices, which make entry unattractive. This means that it would generate zero profit and offer it technically efficiently.

In addition, the assumptions that there are no barriers to market entry, which is hardly the case in reality, and that the replacement of the market owner is complete, which requires unlimited capacities, must be viewed critically.

Allocative problems with free market entry and contestability

The contestable market theory suggests that the regulator should allow free market entry. It is not necessary for the regulator to have a precise overview of the costs, demand and prices of the established company. Rather, he would only have to ensure that the conditions of contestability are met in the best possible way, and so, if there is contestability, the optimal prices would be set automatically.

However, the granting of market entries may cause problems in some situations, particularly when the conditions for contestability are fully met. It could mean that an allocatively optimal equilibrium is never reached. To illustrate this problem, the concept of so-called "sustainable prices" must be explained. A price is considered "sustainable" if, under the conditions of contestability, a monopolist generates at least zero profit and no new company decides to enter the market. In other words, with the selected prices, the number of companies in a market remains unchanged over an extended period of time. The profit must be at least zero, since a negative profit would eliminate the monopoly and this would change the number of companies on the market.

If a monopolist has zero profits and produces technically efficiently , it does not mean that prices are automatically sustainable. The following example is intended to illustrate this phenomenon: Assume that there are economies of scale in the production of two goods, so that one company can produce both goods more cheaply than two companies. The demand for each good is fixed at 1,000 units (assuming a fixed demand is not essential, it just makes the example easier to understand). Let us also assume that the goods are manufactured by a monopoly who produces technically efficiently and sets prices so that his profit is zero. The monopoly has production costs of € 50,000 for the provision of both goods . If the goods are manufactured separately from one another in two companies, the production costs of one good would be € 30,000, so a total of € 60,000. The monopoly now sets the price for good A to 35 € and for good B to 15 €. As mentioned above, he makes zero profit, because the sales correspond exactly to the costs.

Given these circumstances, a new company could now enter the market, only produce good A and charge € 34 for it. The entire demand for good A, which up to now came from the established monopoly, would now be served by the new provider due to the lower price and he could achieve sales of € 34,000. As mentioned, the production costs of the new supplier are € 30,000, so that there is a profit of € 4,000. It can thus be seen that even if the established monopolist produces technically efficiently and achieves zero profit, there may be incentives for a new provider to enter the market.

The problem is that the monopolist's prices are unsustainable. If the monopoly set the prices in such a way that no more than € 30,000 turnover could be generated in any market (e.g. € 28 for good A and € 22 for good B), no new provider could offer just one of the goods at cost-covering prices - sustainability would exist and at the same time the profit would be zero.

The important question now arises as to whether it is possible for a natural monopolist to set sustainable prices in every situation. Research by Elizabeth E. Bailey , William J. Baumol , Robert D. Willig, and William W. Sharkey has shown that it is possible that a monopoly may not have sustainable prices, as described in the following two examples.

Figure 1: Natural monopoly with negative economies of scale

Example 1: Assuming a natural monopolist has economies of scale for 90% of market demand and then negative economies of scale occur for the remaining 10% demand , as shown in Figure 1. Despite the negative economies of scale for part of the demand, it is still more cost-effective for one company to serve all market demand than two or more companies. The only price that leads to zero profit for the incumbent monopolist is what is defined as the intersection between the average cost function and market demand. However, a new provider could enter the market, demand a lower price (a price between and ), tap 90% of the market demand and leave the remaining (more expensive) 10% to the incumbent monopoly. Since the average cost to manufacture is 90% of market demand , the new entrant would make a profit at any price between and . It can therefore be seen that the average costs are lower if only part of the market is supplied than if the entire market is supplied, and so the new provider can undercut the established monopoly. If the monopolist anticipates the possibility of being displaced by market entries, then he will reduce the output volume to the minimum of the average costs and thus only cover part of the total demand, i.e. H. there would be an undersupply on the market. As the economist Edward Zajac shows, the same problem can arise in a multi-product situation. Assume three services are offered, each of which has a fixed additional charge of 1,000 units. Each service could be provided by a single company for € 30,000. With three providers the total costs would be 90,000 €. Assuming there are network effects , so that if any two of the three services are provided in one company, costs of 48,000 € arise. The total costs in this case would be € 78,000 (two services are provided in one company = € 48,000 and one service in a second company = € 30,000; € 48,000 + € 30,000 = € 78,000). If all three services are provided in one company, the total costs are € 75,000. There is therefore a natural monopoly , since it is cheaper to offer all three services in one company than with several. Yet there are no sustainable prices that a monopoly could charge. Assume the monopolist sets the price for each of the three services to € 25 and thus receives a total of € 75,000 in sales (= zero profit). A new provider could now enter the market and offer two services (service A & service B) for € 24.5. Since this price is cheaper, customers would purchase services A and B from the new provider and bring the company a turnover of € 49,000. After deducting the manufacturing costs of € 48,000, the new provider would have a profit of € 1,000. The only thing left to do with the original monopoly was to offer Service C. The monopolist could now offer services A and B for € 24, so it would not be worthwhile for the new provider to enter the market, because if he undercuts the € 24 per service, he would no longer be able to cover his costs of € 48,000. However, if the monopolist offered A and B for € 24, he would have to charge € 27 for service C to cover his total cost of € 75,000. At this price combination, however, a new provider could now offer service A for € 23.5 and service C for € 26.5 and generate sales of € 50,000 (i.e. € 23,500 for service A and € 26,500 for service C). At a cost of € 48,000, the profit would be € 2,000. Regardless of which price combination the monopolist sets, the same problem would always arise: A new provider would be able to offer two of the three services at lower prices and thus make a profit. Example 1 shows that in very special one-product and multi-product situations it is possible that no sustainable prices exist for a natural monopoly, with production being technically efficient and zero profit being generated. This realization has important implications, because the regulator cannot be sure, without knowledge of the costs and demand of a monopolist, whether market entries by new providers are a sign that the monopolist has charged too high prices. According to this, it is possible that market entries or the fear of market entry do not lead to an optimum with a company that would be desirable from a cost perspective. ${\ displaystyle P_ {m}}$ ${\ displaystyle P_ {m}}$ ${\ displaystyle P_ {e}}$ ${\ displaystyle P_ {e}}$ ${\ displaystyle P_ {m}}$ ${\ displaystyle P_ {e}}$

Example 2: In example 1 it was shown that it is possible for a natural multi-product monopolist that no sustainable prices exist. In Example 2, it will be shown that in a natural multi-product monopolist sustainable prices exist can , but does not the second-best Ramsey prices must be. Gerald R. Faulhaber and William W. Sharkey demonstrate this fact using an example. Assume there are two goods, A and B. The demand for good A is fixed at 1,000, the demand for good B is price-elastic and is described by the following function: Q = 1280 - 10P. If only good A is produced by one company alone, the company incurs fixed costs of € 20,000 and constant marginal costs of € 2. Good B incurs fixed costs of € 30,000 and marginal costs of € 3 if it is produced individually . If both goods are manufactured in one company, there are economies of scale and the fixed costs are reduced to € 40,000, which means a saving of € 10,000 compared to the total fixed costs of producing both goods separately of € 50,000 (€ 20,000 for goods A and 30,000 € for good B). The marginal costs of joint production are the same as for separate production: € 2 for good A and € 3 for good B. Should the monopolist charge € 17 for good A and € 28 for good B, he would have a turnover of € 17,000 for good A and € 28,000 for good B and thus achieve a total turnover of € 45,000. The company's fixed costs are € 40,000, plus the variable costs of € 2,000 for good A and € 3,000 for good B result in total costs of € 45,000. So the monopolist's profit is zero. Since the sales of each product are lower than the fixed costs if they were produced separately, no new supplier can offer the goods at a lower price and make a profit - the prices are therefore sustainable. However, these awards are not second-best Ramsey awards . Since the demand for good A is completely inelastic (fixed at 1,000 units) and the demand for good B is rather elastic , the Ramsey rule would stipulate that good B is offered at marginal costs and that the price for good A is set sufficiently high, to achieve profitability. Ie the total fixed costs for both goods are passed on to good A. The Ramsey prices would therefore be € 42 for good A and € 3 for good B. With these prices, a new provider would be able to enter the market and only offer good A at, for example, € 40. The new provider would generate sales of € 40,000 and the costs would be € 22,000 (fixed costs = € 20,000 + variable costs = € 2,000), resulting in a profit of € 18,000. It can thus be seen that although sustainable prices exist in this situation, the Ramsey prices are not. In this situation, free market entry would prevent Ramsey pricing that is optimal for welfare. In order to achieve Ramsey prices here, the regulator would have to prohibit free market entry. Ramsey prices don't have to be sustainable - but they can be sustainable in certain situations. Whether or not Ramsey prices are sustainable depends on a company's cost and demand. Even if the welfare-optimal Ramsey prices are sustainable, it is uncertain whether the monopoly will set the Ramsey prices in order to prevent potential new suppliers from entering the market. In addition to Ramsey prices, other price combinations can also be sustainable and possibly (in contrast to Ramsey prices) enable the monopolist to make a profit.

However, the situations listed, in which free market entry prevents an optimal balance, are extremely rare in practice. Market access restrictions represent severe interventions in the market mechanism , so they should only be used in the event of blatant market failure . By completely eliminating the pressure of competition, an essential force for disciplining the monopolist would be eliminated, which would result in leeway for exploitation as a result of this measure. In reality, it is often the case that market access restrictions are often accompanied by price regulations.

Artificial deniability with the help of the demetz competition

If there is insufficient contestability in a market so that the monopolist is not disciplined by potential competition, there is the possibility of demetzing competition. The idea is simple: the regulator grants the exclusive right to operate in the market and thereby protects the natural monopoly . However, this right will be auctioned. The supplier who can offer the product at the lowest cost is awarded the contract . If a sufficiently large number of participants take part in this auction , if vendors cannot coordinate and all vendors have the same technology, then the result will be that the vendors will compete on the average cost price. If a bidder bids a higher price, then he is in the same situation as a monopolist with perfect contestability - competitors can undercut him. Only those who set the prices at the level of the average costs can be sure that they will not be undercut.

Examples could be a municipality auctioning off the right to operate the garbage disposal. Or that the right to operate or use a state-provided network is auctioned. The rail network of the Bahn AG could remain in the possession of the state, while the passenger traffic is operated by private providers, to whom the rails are available for a fee.

However, the demetz auction has weak points. Assuming a winner has been determined during the auction. The regulator must now draw up a contract with the successful bidder in which the rights and obligations of the monopoly are specified. It must therefore be precisely determined which services, in what quality and at what price must be provided. After the contract is concluded, the monopolist has no way of changing the price. However, it could reduce the cost of service production by degrading the quality. It will be successful if the regulator cannot fully monitor it due to the existing information asymmetry . The regulator could therefore not judge whether a deterioration in quality is due to a lack of efforts on the part of the monopolist or to general environmental influences, i.e. H. all things that are outside the provider's sphere of influence and responsibility. Here there is a principal-agent problem between the regulator and the monopolist . Even the artificially initiated competition cannot always lead to satisfactory results.

Game theory consideration

Contestability can also be seen as a social dilemma : If you consider two companies that are each faced with the choice of whether to enter the market or not, entering the market alone can lead to high profits. A non-entry, on the other hand, does not result in any costs, but also in no profit. The situation is more problematic if both actors decide to enter the market. Then none of the companies can count on a monopoly profit, instead, on sunk costs .

Proponent of the contestable market theory

The contestable market theory served as a competition policy doctrine by British Prime Minister Margaret Thatcher . She postulates that free market access is sufficient for monopolists to sell at average costs instead of monopoly prices and that this would lead to an optimal allocation of resources. Therefore the contestability of the market is sufficient.

Individual evidence

↑ ^a ^b ^c ^d ^e ^f ^g ^h Michael Fritsch: Market failure and economic policy . 8th edition. Vahlen, Munich 2011, ISBN 978-3-8006-3807-9 , pp. 182, 183, 184, 190, 191, 192, 196 .
^ ^A ^b ^c ^d Joachim Weimann: Economic policy, allocation and collective decisions . 3. Edition. Springer, Magdeburg 2003, ISBN 3-540-01273-7 , pp. 334 .
↑ ^a ^b ^c ^d ^e ^f ^g ^h ⁱ ^j ^k ^l ^m ⁿ ^o ^p ^q ^r Kenneth E. Train: Optimal Regulation, The Economic Theory of Natural Monopoly . 1st edition. The MIT Press, London 1991, ISBN 0-262-20084-8 , pp. 303-315 .

literature

Baumol, William J. , John C. Panzar, and Robert D. Willig : Contestable Markets and the Theory of Industry Structure . Saunders College Publishing / Harcourt Brace, 1982, ISBN 0-15-513910-X .

[:0-1] ↑ ^a ^b ^c ^d ^e ^f ^g ^h Michael Fritsch: Market failure and economic policy . 8th edition. Vahlen, Munich 2011, ISBN 978-3-8006-3807-9 , pp. 182, 183, 184, 190, 191, 192, 196 .

[:2-2] A ^b ^c ^d Joachim Weimann: Economic policy, allocation and collective decisions . 3. Edition. Springer, Magdeburg 2003, ISBN 3-540-01273-7 , pp. 334 .

[:1-3] ↑ ^a ^b ^c ^d ^e ^f ^g ^h ⁱ ^j ^k ^l ^m ⁿ ^o ^p ^q ^r Kenneth E. Train: Optimal Regulation, The Economic Theory of Natural Monopoly . 1st edition. The MIT Press, London 1991, ISBN 0-262-20084-8 , pp. 303-315 .