09 Dec 2024 Articles

Does Improved Market Contestability Imply Higher Consumer Surplus?

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In this article written as part of Concurrences’ 20th Anniversary book: ‘Why Competition?', Jorge Padilla and Salvatore Piccolo examine how market contestability impacts consumer surplus, challenging the assumption that more competition always benefits consumers, and highlighting the role of market power and entry barriers.

The views expressed in this paper are the sole responsibility of the authors and cannot be attributed to Compass Lexecon or any other parties.

Introduction

Consumer surplus is a fundamental economic concept. It represents the monetary gain people receive when purchasing a good or service at a price lower than the maximum amount they are willing to pay. Any price increase, be it driven by an anticompetitive conduct or increased market power, causes consumer surplus to decrease, either because every buyer who still purchases the product after the price increase pays a higher amount, or because fewer consumers can purchase the product due to the higher prices.

Another key economic concept is that of market contestability, which refers to the degree of competitiveness and ease with which new firms can enter or exit a market.[1]

This brief chapter discusses the relationship between the two notions, which is less obvious than is often assumed, especially by non-economists.

It is well known that consumer surplus is maximized in a perfectly competitive market with many buyers and sellers and homogeneous products. In such an ideal setting, prices are driven down to marginal cost, and consumers capture the entire benefit of competition through lower prices. This result has led many to conclude that consumer welfare is maximized in the absence of market power and, therefore, that it is highest in markets where there are no barriers to entry and/or exit.

And yet, as is also well known, perfect competition is an idealized scenario. In the real world, economic factors—such as, economies of scale, product differentiation, and asymmetric information—and non-economic factors—such as legal and regulatory barriers to entry and exit—result in oligopolistic or monopolistic market structures characterized by the presence of market power, where consumer surplus is below its perfect-competition level.

The relevant and difficult question is whether in markets subject to economies of scale, product differentiation or asymmetric information, the elimination of barriers to entry and exit—i.e., the adoption of policies aimed at ensuring the contestability of markets—is necessarily aligned with the promotion of consumer welfare. Is it correct to think that maximizing market contestability necessarily leads to lower prices, greater output and, hence, higher consumer surplus.

Building on recent academic work, we explain why this presumption fails when there is cost heterogeneity within the industry and firms have private information about these cost differences. In these instances, an increase in market contestability may result in higher prices, lower quantity, and reduced consumer surplus. We then argue that settings with these features are not just theoretical curiosities, but are relevant from a practical point of view.

Assuming that consumer surplus maximization is equivalent to improved market contestability under these conditions might ultimately damage consumers. This is particularly the case when relatively inefficient firms enter a market with low barriers to entry but face high exit costs when adverse market conditions are realized. When firms are privately informed about their marginal production costs, the presence in the market of inefficient firms excessively reduces the production of their more efficient rivals, thereby inducing an inefficient allocation of market shares in the industry at the expense of consumers.

The rest of this chapter in organized as follows. In Section II, we explain the notion of market contestability and discuss its role in antitrust. Section III reviews traditional economic models showing that market contestability is not always good for “total welfare”—i.e., the sum of consumer welfare and industry profits. In Section IV, we explain the economic mechanism behind a recent academic article showing that increased market contestability may lower quantity, increase prices, and harm consumer surplus. Section V concludes.

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References

  1. Joe Staten Bain, Barriers to new competition, their character and consequences in manufacturing industries (Harvard Univ. Press 1956). Elizabeth Bailey & William Baumol, Deregulation and the Theory of Contestable Markets, 1 Yale J. Regul. 111 (1984). William J. Baumol et al., Contestable Markets: An Uprising in the Theory of Industry Structure: Reply, 73 Am. Econ. Rev. 491-496 (1983). William A. Brock, Contestable Markets and the Theory of Industry Structure: A Review Article, 91 J. Pol. Econ. 1055-1066 (1983). Marius Schwartz & Robert J. Reynolds, Contestable Markets: An Uprising in the Theory of Industry Structure: Comment, 73 Am. Econ. Rev. 488-490 (1983).

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