Dissertation abstract: Contestability and the significance of the entrant’s home market

Abstract

The traditional description of Contestability theory considers the importance of potential entry threats in disciplining the incumbent firm in a natural monopoly market. Such a description however overlooks an important element in strategic interaction, that of an entrant firm having its own home market. Adding a home market to the model can critically alter conclusions and equilibrium predictions of market entry in a contestable market monopoly. In this thesis the role of entry threats in a contestable market is analyzed and evaluated in a game theoretic framework where the incumbent and the entrant firm each has its own home market and is a potential entrant in the other market. Equilibrium predictions point out that in such a multi-market context where each firm has its own monopoly market, the disciplining effect of potential entry is weak. In contrast, entrants from competitive markets have its predicted disciplining effect on the monopolist incumbent. I design a multi-market laboratory environment with contestable markets. Experimental results show that the threat of entry is the strongest when an entrant firm has a home market with very low or competitive returns. However, entrants and incumbents in symmetric monopoly home markets learn to cooperate tacitly to enjoy monopoly prices. I extend my analysis to an imperfectly contestable market with sunk entry cost and find similar results. My main conclusion is as follows: the behavioral implication for hit-and-run entry in a contestable monopoly market is strong and robust provided the entrant is from a market earning normal returns or competitive returns. Even in the presence of a modest level of sunk entry cost, entrants from competitive markets enter for transient profit opportunities. This in turn generates the threat of entry and disciplines the incumbent in the natural monopoly market. However, when each firm has its own home market monopoly we observe mutual forbearance leading to high prices in both the perfectly contestable and imperfectly contestable monopoly markets.