The Theory of Contestable Markets: Applications to Regulatory and Antitrust Problems in the Rail Industry

By William B. Tye | Go to book overview

equilibrium. Chapter 4 shows that firms charging such Ramsey prices are vulnerable to profitable hit-and-run entry when the handicap of the assumed lagged price responses of incumbents is explicitly taken into account. The extreme difficulties encountered in establishing the multimarket conditions necessary for Ramsey prices that are sustainable against profitable entry raise major questions as to how the theory would serve as a "surrogate for competition" by regulators.

The perception of major viability and sustainability problems in markets approaching perfect contestability is not simply a theoretical curiosity. This perception, in turn, leads applications of contestability theory to conclude that one must impose (1) specific restrictions on consumer choice (demand substitution between the offerings of the potential entrant and incumbent) to prevent intramodal price competition from driving prices to marginal cost and thereby precluding firm viability and (2) specific restrictions on supply (substitution between the markets served by the potential entrant and the incumbent) to prevent profitable hit-and-run entry. Examples of the first restriction come in the form of competition-reducing mergers, and examples of the second may be found in restrictions on competitive access (approvals of vertical foreclosures). In short, welfare-maximizing Ramsey prices are viewed as incompatible with enhanced contestability, and degradation of contestability to permit Ramsey prices in excess of marginal cost is viewed as welfare enhancing in the last three applications.

If movements toward perfect contestability via enhanced competition during the transition to deregulation lead to a "market meltdown" in the theory, what is the alternative? Chapter 5 discusses the alternative proposed by Meyer and Tye ( 1988), the "contractual equilibrium." It closes with a discussion of the achievements of contestability analysis in addressing the issues raised by a transition to deregulation.


NOTES
1.
"The crucial feature of a contestable market is its vulnerability to hit-and- run entry." See Baumol ( 1982) and Baumol, Panzar, and Willig ( 1982).
2.
See Baumol and Willig ( 1983a, 1983b) and Interstate Commerce Commission ( 1983). The ICC's views were based on the contestable market theories and were supported by 14 other prominent economists, including George Stigler, Almarin Phillips, Kenneth Arrow, Elizabeth E. Bailey, and Ann F. Friedlaender. See Comments of Five Railroads ( 1983) and AAR ( 1985).
3.
The necessity to impose a lag in the pricing response of the incumbent in the postentry world was only implicit in the contestability model as initially specified in Baumol, Panzar, and Willig ( 1982, 5, 9, 11, and 361). Its crucial role appears to have been first observed by Dixit ( 1982), who noted that a lag is necessary to preclude the old incumbent from deterring entry by threatening to slash prices faster than the new incumbent can exit the market. The idea of permitting the entrant to achieve this lag via contracts with customers prior to entry apparently

-24-

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The Theory of Contestable Markets: Applications to Regulatory and Antitrust Problems in the Rail Industry
Table of contents

Table of contents

  • Recent Titles in Contributions in Economics and Economic History ii
  • Title Page iii
  • Contents vii
  • Preface ix
  • 1 - Lntroduction 1
  • Notes 24
  • 2 - Vertical Mergers into Contestable Markets 29
  • Notes 45
  • 3 - Sunk Costs, Transactions Costs, and Vertical Foreclosures in the Rail Industry 51
  • Notes 82
  • 4 - Determination of Market Dominance and Maximum Reasonable Rates in the Transition to Deregulation 93
  • Conclusion 115
  • Notes 116
  • 5 - Conclusions on Recent Applications of Contestability Theory 119
  • Note 128
  • References 129
  • Index 139
  • About the Author 145
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