William Baumol and his various co-authors (e.g., 1982) reach their central insight by integrating potential competition into their analysis. If some potential entrant can credibly threaten to enter a market in a “hit-and-run” manner, this will lead to the erosion of all monopoly profit by the incumbent. “Hit-and-run” means that a new competitor can enter into a market but will be able to leave it before the incumbent has a chance to react, e.g., by retaliation. Since this is a very important development of competition policy, we want to have a closer look at the underlying model.
Baumol et al. (1982) illustrate the relevance of potential competition by drawing on the case of natural monopoly. Economists talk of natural monopolies if fixed costs are so important that the entire relevant demand of a certain good can be supplied cost efficiently by a single supplier. Markets in which fixed costs play an important role are markets in which a net, e.g. a telephone or a railway net, is necessary before a single unit of goods can be supplied. Once a supplier has at its disposal a net, the average cost of every additional unit decreases over the entire relevant demand range. To transport only one container on a newly erected railway net will be very expensive indeed, every additional container transported will reduce average costs because the fixed costs are spread over a larger number of units.
Natural monopolies pose a problem for politics: on the one hand, monopolies are generally considered to be undesirable, on the other, a higher number of nets would lead to an increase of average costs since the fixed costs would have to be borne more than once.9 The answer to this predicament has traditionally been to introduce regulation and have some agency control the behaviour of the natural monopolist. In natural monopolies, application of the price-setting rule “price should equal marginal costs” would lead to losses of the supplier since he would not be able to recoup his fixed costs. Therefore, a host of other price-setting rules have been discussed, “price should equal average cost” being one of them. What is more interesting is that numerous agencies are run on the basis of this theory (in the U.S., e.g., the Federal Aviation Administration and the Federal Communication Commission).
The achievement of Baumol et al. (1982) now lies in challenging conventional wisdom concerning the necessity to regulate natural monopolies. Suppose an incumbent has hitherto set price equal to average costs and now tries to increase his price above that level. According to Baumol et al. (1982), this would induce somebody else to enter into this market with a lower price who could still make profits. Just for completeness: the incumbent cannot make itself better off by setting a price below average costs because that will not allow him to recoup his fixed costs. We can thus conclude that
– there will only be one firm on that market;
– the firm does not make any profits;
– price equals average costs (see also Tirole 1988/99, 678-80).
Notice that this result was achieved without widespread regulation. It is secured simply by the threat of a potential entrant entering the market.
The approach has often been criticised by pointing at the entry conditions that have to be present for contestability in order to achieve its beneficial results. Baumol and Willig (1986) have stressed the following fact: “Contestability does not imply the ability to start and stop production without cost– only the ability to sell without vulnerability to incumbent’s responses for a time long enough to render all costs economically reversible.” It is thus not the absence of sunk costs as such but the ability of the incumbent to react to the entry before a potential entrant has earned the costs that had to be sunk. An incumbent might be able to change prices rather quickly. In certain instances this is, however, not sufficient to make customers lost to the entrant come back immediately, e.g., if the entrant has agreed on contracts long enough to enable him to cover all the sunk costs incurred in order to enter into the market. A case that is often named in order to prove the real-world relevance of contestability theory is the airline industry. If entrants can lease aircraft on rather short terms, their sunk costs might be sufficiently low to make entry worthwhile.
The conditions under which hit and run entry can pay off are the following:
(1) there is a pool of potential entrants; (2) entrants do not have a cost disadvantage;
(3) sunk costs are low; and (4) contracts are long or incumbents are slow to react.
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