When Firms Contest in Markets: An Experiment

Abstract

Regulating a natural monopoly market has always remained a source of concern. The problem arises because of the decreasing average cost structure in the market. Ideally, only one firm serving the whole market demand is the efficient solution to avoid any cost duplication. However, when there is a single unregulated firm serving a market it brings up the standard monopoly price-gouging problem. Many utility services share the characteristics of a natural monopoly. As a result, almost all countries in their deregulation phases are concerned with the efficient running of such markets. Restraining monopoly behavior effectively in a natural monopoly market remains a much-debated issue. The idea of creating a “contestable”¹ environment has influenced USA, UK and many other countries during their deregulation phase. In a perfectly contestable market² the threat of hit-and-run entry by new entrants in the monopoly market can provide the right disciplining stick for the monopolist incumbent to charge a price equal to the average cost of production (the Ramsey optimal price). This outcome is described as a contestable (market) outcome³.

I thank James C. Cox, Martin Dufwenberg, Stanley Reynolds the participants at the ESA 2004, EES 2004 conferences and the editorial board for useful and critical sugestions. I also extend my gratitude to Professor Hidetoshi Yamaji and the organizers of the EES 2004 conference for giving me an opportunity to present my work. A special thanks to Todd Sorenson for his insight in programming the software. Financial Support from the Experiment Science Laboratory at the University of Arizona is gratefully acknowledged.

William Baumol in his 1981 address as outgoing president of the American Economic Association put forward the idea of a contestable market.

A perfectly contestable market is devoid of any sunk entry costs. So an entrant can enter a market whenever there are profit opportunities without worrying about sunk costs.

Baumol Panzar and Willig [1]