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Contestable Markets - Activity

This activity looks at an example of an industry that is said to be contestable: the low cost airlines industry. In reality, there is unlikely to be such a thing as a perfectly contestable market but some industries may exhibit many of the key characteristics of such an industry.

Remember the basic principle: even in cases where a market structure is oligopolistic or where monopoly power exists, behaviour may be highly competitive if the market has the key characteristics of contestability.

In attempting to identify whether the low cost airline industry exhibits these characteristics, we need to think about the relevance of the characteristics you have identified to the industry in question. As is often the case with many industries that you come across in economics, you may not know a great deal of detail about them. A detailed knowledge of the industry is not necessary but you can think about what the basic business activities of firms within such industries are. Think about the following questions:

Task 2:

Image: Is British Airways still one of the top five UK airlines? Copyright: Anders Presterud, airpics.com

• Identify what you would consider to be the 5 main airline firms based in the UK.
• Identify the main UK airports from which they fly.
• What are the main destinations to which they fly? (A general outline will be sufficient - you do not need to go into great detail here!)

The following links help to provide some context:

• The evolution of low-cost carriers' market share - from Eurocontrol [PDF, 354 KB] (http://www.eurocontrol.int/statfor/gallery/content/public/analysis/93%20Low-cost%20study%20v10.pdf)
• Report into Low Cost Airlines - from Cranfield University (http://www.cranfield.ac.uk/university/press/092003/1.htm)

Image: BMI Baby. Copyright: Joe Curry, airpics.com

Now it is time to think about what these airlines actually do. They obviously fly from one destination to another but the key point is to think about the industry in more detail. The whole market might be classed as the 'market for airline travel', but within that area there may be lots of what could be called 'micro-markets', each of which is subject to competition. For example, the London to Dublin route could be seen as being one market whilst the Birmingham to Malaga route another. In this case, therefore, there might be many markets making up the 'whole market', each of which could contribute to the firm's overall profits and which can be subject to entry and exit relatively easily.

What may make things even trickier is that larger airline carriers could also be competing on these routes; British Airways, for example, may well see opportunities to increase its scope for developing its business by using some of its spare capacity to fill profitable routes it does not yet fly.

Let's now return to the key characteristics of contestable markets and ask whether the behaviour of firms in this industry seems to match with the predictions of the theory.

Having now got a bit more background, we need to think about how far the market for low cost airlines reflects the principles of a contestable market. Write a short response to the following questions.

Task 5:

Image: Virgin Express - launched in 1996. Copyright: Petter Aspelund, airpics.com

• To what extent is entry and exit in the market 'costless'? As Baumol comments, no market entry or exit is completely costless but the key principle is the how far an entrant would suffer damage as a result of entering and subsequently leaving the market. This is where the work you did on 'micro-markets' above will be relevant.
• 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?
• Using the information you have looked at and any other relevant sources you can find, to what extent is there evidence that costs are being driven down - again, as would be expected in perfectly competitive markets?
• 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).

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] (http://www.carlsonwagonlit.com/export/sites/cwt/en/global/our_insight/white_papers/white_papers/lowcosts.pdf)

• Read the story of Laker Airways - the 'first' 'low-cost' carrier back in the 1970s. (http://news.bbc.co.uk/onthisday/hi/dates/stories/february/5/newsid_2535000/2535297.stm)
• In the course of your research, is there evidence that the 'established' low cost carriers are seeking to erect artificial barriers to entry to prevent new entrants from taking advantage of the profits in the market?
• To what extent is there evidence of 'hit and run' tactics as predicted by the theory of contestable markets

Image: Sir Freddie Laker waving a flag at the launch of the 'Skytrain' no frills, low fare operation. Title: Flag Flying. Copyright: Getty Images, available from Education Image Gallery

Having looked at all these areas, it is time to draw some conclusions. If you have followed the process through, you should now be in a position to make a judgement as to whether the low cost airline industry does exhibit the main characteristics of a contestable market. You do not have to agree that it is, and may have very good reasons for suggesting it more closely resembles another market structure. Remember that the theory as laid down by Baumol represents the 'pure' form. Economists are realists in that they recognise that such models do not exist in reality but they are used to help analyse the real world and to consider the consequences and implications as a result of the model.

Image: Ryanair have come in for some expensive criticism of the way it has carried out its business by the EU Competition Commission. Copyright: Anders Presterud, airpics.com

If you conclude that the industry does indeed exhibit some characteristics, it may have implications for competition policy in the UK and EU. Ryanair, for example, has already come in for some expensive criticism from the EU Competition Commission for the way it has carried out its business. If the market is characteristic of a contestable market, such regulation might be deemed as being unnecessary, given the conclusions drawn by Baumol of this type of market and which have been highlighted at the beginning of this article.