Profits as a signal for firms

When the possession of market power is profitable, it should attract new entrants into the industry. If entry is easy, then the existence of very few or even only one firm may not result in economic inefficiency. The threat of potential entry may be enough competition to keep the industry operating at or close to the competitive price and output. In this case the market is a contestable market.

However, if entry is not easy, but there are significant barriers to entry, the threat of competition is less. Barriers to entry exist when there are sunk costs, expenses which cannot be recovered once a firm has entered the industry. Where these costs are high, the industry probably operates as the theory of monopoly suggests it will.

One seller but still some competition

The theory of contestable markets suggests that even if there is only one seller, the seller may be forced to act as if there were many more. In contrast, there are times when great numbers of sellers are able to organize and act as a unified seller. Sellers have the incentive to act in this way because it will increase profits. The key to their success is their ability to restrict sales.

Costless entry and exit

A perfectly contestable market is one in which entry and exit are absolutely costless. In such a market, competitive pressures supplied by the perpetual threat of entry, as well as by the presence of actual current rivals, can prevent monopoly behaviour (higher prices and restricted output)

Markets that have become more contestable in recent years

Internet Service Providers (including the entry of "free" ISP's - over 200 of these in September 1999

• Online Communications (including video conferencing; virtual reality games; publishing; home shopping; travel services; information services; databases)

• Home Banking and Financial Services

• Electricity and Gas Supply

• Parcel delivery

• Opticians

• Low cost domestic airlines

• Road Haulage Companies

In a contestable market there are no structural barriers to the entry of firms in the long-run. If existing businesses are enjoying high economic profits, there is an incentive for new firms to enter the industry. This increases market competition and dilutes monopoly profits for the incumbent firms.

Market contestability requires there are few sunk costs. A sunk cost is committed by a producer when entering an industry but cannot be recovered if a firm decides to leave a market. Examples include marketing and advertising spending and outlays on industry specific items of capital.

RETAIL BANKING UNDERGOES A REVOLUTION

Retail commercial banking is undergoing a revolution with dramatic implications for the way we experience banking and related financial services. Consider a few of the many changes both in the market for retail savings and loans and mortgages in recent years.

• Many former building societies including Halifax plc have de-mutualised and become fully-fledged commercial banks.

• National food retailers such as Tesco and Sainsbury have launched hugely successful banking operations with millions of customers.

• Tesco's Clubcard Plus scheme provides a full range of financial services including mortgages and travel insurance.

• The market for mortgage finance and long-term savings in equities and deposit accounts has been affected by the entry of companies such as Virgin Direct, Egg and Standard Life Bank. Standard Life has built up a "mortgage book" in excess of £1.7 billion even though its operation started in January 1999. It has taken a 15% share of the market for new mortgage lending!

• European and North American mortgage lenders are entering the UK market in increasing numbers.

EGG AND THE BATTLE FOR HOUSEHOLD SAVINGS

Egg smashed its way into UK retail banking in October 1998. Owned and run by Prudential - one of the world's largest insurance companies, EGG offered high-interest savings accounts (initially a guaranteed interest rate of 6% on all deposits) plus low mortgage rates (priced at 5.99%). Prudential set a target of attracting £5 billion worth of deposits in the first five years. This was exceeded in little more than six months! The cost of market entry was put at £77m in the first year, rising to £200m over three years. Egg is now limiting new accounts to those customers with Internet accounts - whose banking costs are much lower than traditional customers.

CREAM-SKIMMING IN THE MARKET FOR SAVINGS AND LOANS

One feature of a contestable market is that new entrants may seek to "cream skim" the most profitable segments of an industry. The trick is to identify which sectors of a market offer the best returns and then successfully target existing customers.

The largest UK banks make profits of hundreds of millions of pound every year - but most of this money comes from user-services such as foreign exchange commission and high interest loans to a relatively small number of customers.

Many accounts in high street banks are loss-makers - particularly those held by people with tiny savings balances who rarely use other bank services.