Evaluate the effectiveness of policies to increase contestability as a means of reducing abuse of monopoly power. [25] 30 MINUTE TIMED

Contestability is the measure of competition within the market, looking at a range of factors such as number of firms in the market, product differentiation, concentration ratio of top firms and barriers to entry. Monopoly power occurs where a firm has high to pure market power, and characteristics include being a price maker, high barriers to entry, few firms in industry and supernormal profit. Policies to reduce monopoly power through increased contestability include deregulation and privatisation, however this could lead to greater inefficiencies and potential unintended consequences.

Monopolies lead to a misallocation of resources due to the price mechanism; they are an example of market failure. This is because their high entry barriers lead to lack of substitutability which allows the monopoly to produce at profit maximising output (MC=MR), making supernormal profit of Pmabc. This is at a lower output than the allocatively efficient point at and at a higher price than , reducing consumer surplus from at socially efficient equilibrium . Therefore a policy such as deregulation such as reducing equipment for market licenses which would reduce entry barriers would enable more firms to enter into the market that previously could not afford to. Due to supernormal profit of prior firm with monopoly power, this incentivises hit and run firms to enter the market, if the market becomes contestable enough. This eventually will lead to production increasing to Qc and price B or Pc, leading to firms making normal profit. This has reduced monopoly power, as firms can more easily enter market and exit, there are greater firms within market and supernormal profit is not being made. The firms are now price takers. Furthermore, the incumbent firms are incentivised to improve non-price factors and increase differentiation in order to gain demand able to raise price and make supernormal profit again, showing abuse of monopoly power reducing. However this policy, may not be effective because the market license is unlikely to be erase the most significant barriers to entry; for example in the taxi industry, getting a driver’s license and taxi license is at a far fewer cost than owning a vehicle to drive. Moreover, with certain industries a greater barrier to entry may be consumer loyalty leading to low levels of consumer churn. Given that this companies are reliant on trust, despite new firms being cheaper due to deregulation, the reputation of incumbent firms may still be too significant of a barrier to entry to increasing contestability to reduce abuse of monopoly power. Therefore the effectiveness depends on how important reputation and loyalty is within each industry.

Another example of a policy to increase contestability as a means of reducing abuse of monopoly power would be privatisation. This involves selling national industry to private sector, and breaking it up into smaller firms to compete against one another. The argument is that the smaller privatised firms are more profit orientated and therefore more likely to operate more productively as they are not funded by the state, so will look to reduce average costs to make profits. This allows market to operate contestably which reduces ability of firms to be able to abuse monopoly power. However some state monopolies such as the water industry, electric and railway services have such high sunk costs that they operate best as natural monopolies, run by the state. By privatisation, this means that firms are still able to charge higher prices as they cannot gain cost advantages from economies of scale at profit maximising point Qm. Furthermore natural monopolies such as the water industry are likely to see very inelastic PED, therefore private firms through more mergers may collude to raise prices for consumers, operating as if they were a monopoly. This was seen in the train van industry in early 21st century. Given that water companies saw record dividends given of £1.6 bn, it can be inferred that this policy was not effective in reducing abuse of monopoly power, and that state ownership of the industry, natural monopoly, at Pa Qa, would not lead to abuse of monopoly power due to alternative interests of state (welfare orientated not profit maximisation). Therefore this depends on the type of monopoly in regards to policy effectiveness. Though it could be argued that this depends upon the aims and objectives of the state, and the level of corruption such as in formalities.

Another policy to increase contestability as a means of reducing abuse of monopoly power is allowing free trade areas. These will lead to increased trading across border and can lead to increased competition for smaller countries where state monopolies are more common. This allows firms to face competition from firms with larger economies that have experienced cost advantages from economies of scale to compete with smaller countries’ monopolies giving consumers more choice and increasing substitutability. As a result, this leads to a reduction in the trade barriers to entry which reduces ability for monopolies to abuse monopoly power. However, countries may be subject to regulatory capture as large monopolies have great political influence. Therefore the policy to may be ineffective in that if monopoly cannot abuse monopoly power by entering FTA, firm may succeed in persuading country to not join. This therefore depends upon the connection between politics and monopoly (incumbent firm).

In conclusion I believe that policies such as deregulation in theory should reduce abuse of monopoly power, but in actuality there are greater barriers to entry such as bias and reputation. Therefore the most effective policy would include behavioural economic theory such as the auto renewal of car insurance to reduce default bias to increase contestability. Information asymmetry must be reduced in order for policy to be most effective.