The Contestability of Transport Markets

Maura O'Connell (Senior Sophister)

Successful management of the transport sector has become one of the most difficult challenges for governments world-wide. Maura O'Connell portrays the inefficiencies of the Irish government's regulation programme and argues the case for a more deregulated, procontestable market.


A contestable market is one in which the positions of incumbent firms are easily contested by entrants. Entry is completely free and not impeded by fear of retaliatory price alterations, and exit is costless. New and existing firms compete on perfectly symmetric terms. In this essay, I propose to outline the necessary conditions for a contestable market. The benefits of a regulated and openly competitive market are then discussed. In light of this, I will conclude by explaining the post-deregulation barriers to contestability which may continue to affirm the supremacy of existing firms over new entrants.

Features of a Contestable Market

The condition of free entry will be satisfied if entry does not require any sunk costs. This implies that there may be no cost discrimination against entrants in favour of incumbents.Baumol (1982) indicated that a perfectly competitive market is necessarily perfectly contestable, but not vice-versa. The reason behind this stipulation is that perfect competition is applicable as a guide only where scale economies are absent, so that a large number of rival firms can survive and prosper. Contestable markets, however, contain only a few large firms, and, since there is no regulation, cost differences arise only from distinctions in price or quality. Indeed, perfect contestablility has been hailed as a 'model of socially desirable firm behaviour.'

Such a market can be shown in equilibrium to enjoy all the welfare benefits usually associated with perfect competition. Perfect contestability precludes the earning of supernormal profits, which would expose the industry to 'hit and run' entry. Even a very transient profit opportunity need not be neglected by a potential entrant, who can go in, collect his gains, and leave the market without cost, should the climate turn hostile. It is this threat of competition which forces monopolists and oligopolists to offer consumers the benefits which competition would otherwise bring.

Perfect contestability also rule out productive inefficiency, either through sheer waste, a misallocation of resources, or poor organisation of the industry. Furthermore, the price of each product cannot exceed the marginal cost under conditions of pareto optimality.; hence cross-subsidisation in multi-product firms is unfeasible. The logic that leads to these conclusions can be illustrated in the case of an existing firm earning excess profits. In this circumstance a new entrant (Ryanair, for example) can punish the over-compensated and pareto inefficient incumbent (Aer Lingus) by offering lower airfares. Cross-subsidisation is prevented since a firm earning only normal profits will go bankrupt if it sells any of its products (fares in this instance) at prices that do not cover its costs. Predatory pricing is therefore abolished as a weapon of unfair competition.

The Rationale behind Uncontestable and Contestable Markets

The nature of government intervention is a contentious issue. Thomson and Hunter (1973) put forward a series of arguments for nationalisation of the transport sector. They suggest that technical economies could be gained only by integration and central control of the public utility industries and that competition has lead to a wasteful under-utilisation of capital equipment. Rivalry in the haulage sector, for example may lead to the bidding down fo average loads and hence the raising of unit costs to an unnecessarily high level. In the bus or airline industries, this wasteful competition argument refers to the duplication of an existing service with adequate capacity. They also stress the benefits of a nationalised transport utility to those who has not previously benefited from basic public services and question whether finance would be forthcoming if the private capital market was the only source.

Nash (1982) emphasises the need for regulation in order to ensure safety in transport markets (granting licences only if drivers and vehicles are deemed safe, for example). He also draws attention to the dangerous nature of direct competition between vehicles on the same route at the same time. The historical market failure postulated in this case is one of imperfect information. The user, it is argued, is incapable of correctly perceiving the risks involved and is therefore incapable of signalling his willingness to pay more for the operator who adopts safer equipment and work practices. Glaister (1982) cautiously proposes that the monitoring of service quality may be necessary because individuals need to be protected by weights and measures from unscrupulous procedures

However there is a tendency to see things from the eye of an established operator who has something to lose from a new competitor, to the neglect of the user who might have been offered a better quality service at low cost. In fact, there arguments are invalidated by the available evidence.

Will the market, left to itself, seriously under-invest in transport? The historical evidence suggests otherwise. Kelsey revealed that in 1885 there were 467 transport companies listed on the London Stock Exchange, with a nominal value of IRL750 million (IRL250 billion at 1985 prices), 14 percent of the total of all companies quoted. By 1985, however, this figure stood at IRL2.8 billion and accounted for just 1.3 percent of the aggregate. Government policies of nationalisation, not market forces, wiped out investors interest in the transport sector. With the exception of the railways, this pattern has been repeated down the years in all sectors of the transport market. Posner, in response to the public interest theory of regulation, cites the theory of regulatory capture: 'Regulation is not about the public interest at all, but is a process, by which interest groups seek to promote their private interest.... Over time, regulatory agencies come to be dominated by the industries regulated.'

The case of CIE is a prime example of the inefficiency of government regulation. The Natural Prices Commission found that most of the thirty-seven licensed provincial bus companies operating in 1972 charged significantly lower fares than CIE. In 1982 the CIE Expressway provincial bus fare was 82 percent higher than Midland Bus (Athlone-Mullingar) and 69 percent higher than the average of Midland, Wharton, and Kavanagh. Public policy, despite deregulation, prevents the operation of a level playing field int the independent bus service in Ireland. CIE has an annual subsidy in excess of IRL100million and its borrowings are part of the Public Sector Borrowing Requirement. By contrast, many independent bus companies use hire purchase. CIE receives first option on the school transport contract, worth IRL26.2 million in 1989. Where competitors seek an extension to a route, or a new one altogether, proposals are sent to CIE rather than being independently assessed; there is no right to appeal against the decisions and CIE has the benefit of its competitors' market research. Despite these huge advantages, CIE remains an inequitable service.

The airline industry is perhaps the strongest case for contestability. The 1944 Chicago convention agreed that the right to operate air services should be governed by bilateral deals between governments. In the spirit of the times, politicians wished to maintain control of their airspace. Fifty years on, this $220 billion industry is one of the biggest blots on free trade. The deregulation of air transport between Ireland and the United Kingdom in recent years has become a classic illustration of improved efficiency following the termination of a cartel. The Anglo-Irish air cartel under-supplied the market as passenger numbers dropped from 1.95 million in 1978 to 1.85 million in 1985. The cartel had restricted the supply of discounted fares by use of the computer yield management programme. The market was then opened to competition in May 1986. Passenger numbers increased from 2.7 million in 1987 to a phenomenal 4.2 million in 1989, while prices on the London to Dublin route have decrease by as much as two-thirds. The passenger is evidently much better-off under deregulation.

There can be no salvation for those who cannot compete, no matter whose flag they carry. Baumol 1982 argues that '...we must reject as perverse the propensity of regulators to resist the closing down of unprofitable lines of activity.' Jan Carlzon. president of the SAS group, prophesies that '...those in the airline business who persist in harbouring protectionist leanings will clearly expire'.

Barriers to Contestability

The gains from deregulation on both sides of the Atlantic have been immense, yet incumbents still hold a number of structural advantages over potential entrants. The continuation of 'grandfather rights', whereby the allocation of slots is decided by incumbents through scheduling committees, severely prohibits the fulfilment of the condition of free entry. This barrier to contestability must be replaced with a market for slots, either by lottery or by auction. Ground-handling monopolies, the preserve of established operators discriminate against new entrants by not allowing them to carry out their own check-ins and baggage handling. Furthermore, the computer reservation systems of incumbents must be used by fledgling firms due to economies of scale. These systems may be used to sway travel agents' displays against smaller airlines.

In addition, larger airlines can practice predatory pricing on competitive routes by cross-subsidising it with gains from uncontested routes, an action intended to bankrupt the smaller airlines. They also cut out competition by taking over minor operators (Air France with respect to Air Inter, UTA for example. Finally, subsidies to principal national airlines have given them an unfair advantage over potential entrants, enabling carriers to sell below cost. American Chapter 11 bankruptcy laws have allowed weak airlines to continue flying without having to make interest payments or pension-fund payments, thus inhibiting a proper share-out of the industry.


Deregulation is procontestable and must be pursued at EU level. It leads to higher productivity, improved quality and lower prices. Yet one must remember that, in the words of Baumol 1982 '...perfect contestability serves not primarily as a description of reality, but as a benchmark for desirable industrial organisation which is far more flexible and is appreciable far more widely than the one which was available to us before.'


Glaister, S, 1982: Fundamentals of Transport Economics

Nash, C.A., 1982 Economics of Public Transport

Thomson and Hunter, 1973 The Nationalised Transport Industries

Baumol. W, 1982 ;'Presidential Address to the AEA' in the American Economic Review.