Last Sunday the sun was out and the children's playground was full of kids and their families. As usual the ice cream van was nearby with a steady stream of willing customers. Then something unexpected happening - another ice cream van turned into the car park. What would happen? Well, the driver saw he was not alone, turned around and left. So, we missed out on any particular excitement. Even so, this brief encounter is a nice illustration of the concept of contestable markets.
The standard textbook typically associates the extent of competition with the number of firms in the market. A monopoly has one firm and perfect competition has a large number of firms. Simple enough. But, also misleading, bordering on plain wrong. It is more accurate to measure competition, not by the number of firms, but by the restrictions on entry to the market and the standardization of goods in the market.
To illustrate the issues consider our ice cream van. Suppose the local council has a system for allocating a permit to operate near the playground. And they issue only one permit. Then the firm that gets the permit has monopoly power. That power comes from the fact that only they are allowed to operate - there are barriers to entry. In this scenario the ice cream van would be able to charge monopoly prices. For instance, suppose the marginal cost of selling an ice cream is £1.50. There is nothing to stop the monopolist charging say £2.00. Less people will buy for £2.00 than £1.50 but the net effect on profits may well be positive.
Now consider the scenario where anyone can come and set up an ice cream van near the playground. Moreover, suppose that there are no costs at all to doing this. Does the single ice cream seller still have monopoly power? No because if it charges more than £1.50 another ice cream van will soon come along and undercut. And, given the product is standardized nobody is going to buy an ice cream at, say, £2.00 if they can buy it next door for £1.75. The threat of competition, therefore, keeps prices at marginal cost. This is the basic notion of contestable markets.
Contestable markets mean that the number of sellers can be misleading. In particular, you could have only one seller but still have perfect competition. The one seller clearly satisfies the legal definition of monopoly because she has 100% market share. But the threat of entry means that she does not have market power to influence price. Hence, she does not meet the economic criteria for monopoly.
Clearly the idea of free entry to a market is unrealistic. For instance, it costs money and time to drive an ice cream van to the playground to check what is going on. That is a barrier to entry. Generally speaking, however, the lower the cost of entry the less power firms have to influence price. This is what really drives competition in the long run.
So, why do the textbooks focus on the number of firms? The number of firms may be a proxy for the ease of entry into the market. It is, however, not a perfect correlation. One can think of many contexts where a firm might have a large market share but if it were to push up prices too high someone else would come in and undercut. Moreover, a large number of firms in a market may be a sign of capacity constraints rather than lack of market power. Consider, for example, hotels and restaurants on a busy holiday weekend. There are lots of them but they can still hike up prices.
There is, though, particularly in the short run, a big difference between one firm in the market and two or more. That second firm makes a difference because it provides direct rather than threatened competition. Once you have two firms then a third has much less of an impact. Which is why it was somewhat disappointing the second ice cream van didn't set up shop and give some entertainment.