When you hear that some company or industry is abusing the public with high prices or unconscionable profits, ask yourself the following: Is this a contestable market? If the answer is yes, the assertions probably are not true.
New York University’s William Baumol, the greatest microeconomist not yet awarded a Nobel Prize, developed the idea of contestable markets. Historically, economists examined industry structure to evaluate monopoly power. A large company in an industry with only one or two competitors had more pricing power than another with five or eight.
They also considered conduct. If General Motors announced prices for new models on Monday and Ford and Chrysler followed on Wednesday and Friday with remarkably similar numbers, there probably was implicit collusion.
Baumol argued one had to go beyond the number and size of firms. Even an industry with few firms might be competitive if it were easy for new startups to begin producing and “contest the market.”
On the other hand, a sector with several firms might be uncompetitive if some barrier to entry kept out any further competitors.
Consider a simple example. I had a student whose family grew half of all the horseradish processed in Canada. Considering structure, they should have had considerable pricing power. But raising horseradish does not require a Ph.D. If they demanded much higher prices, the processor would find alternative growers. It was a contestable market.
Some people are outraged by reports that refinery operators are cutting back previously announced expansions in light of government plans to cut gas usage and foster biofuels. Are such cutbacks just a ploy to perpetuate high prices? Many apparently think so. Indeed, refiners are the most criticized sector of the oil industry right now.
If refining is so profitable, why don’t others jump into the business? Yes, the capital costs are high, but even private-equity firms don’t bat an eye at $10 billion deals nowadays. Yes, getting permits for a new refinery is extremely difficult. But why don’t outsiders buy existing facilities and expand them? Expansion rather than new construction has been the industry rule for 30 years.
But when we look back over the last four decades, rather than the last four years, we see that refining has not been a high-margin business. It won’t be in the future. And as major oil companies lose market share to the government-owned ones of oil-producing nations, their potential for a monopoly is weakened.
Those who see conspiracy and evil in every business decision will respond that existing refiners have the power to freeze out new entrants by depriving them of crude oil or access to key information. Evidence that others can enter an industry if they want won’t sway anyone whose mind already is made up. But for those who really want to understand contemporary issues, a closer look at an apparently highly profitable business can be illuminating.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.