Competition, Contestability and Lower Prices

Question

The Energy Market Authority (EMA) has fully liberalised the electricity retail market. Although the power grid is still operated by SP Group, consumers can now choose more attractive price plans offered by 12 other approved electricity retailers. However, SP Group remains the sole supplier of gas and water services.

Explain how increased competition and greater contestability may lead to lower prices. [10]

Answer

Contestability refers to the threat of new competitors entering a market — a threat that bites even before any firm actually enters. Firms produce at their profit-maximising output, where marginal cost equals marginal revenue. This answer explains how increased competition and greater contestability each push the equilibrium price down.

Increased competition lowers price through falling demand. As the number of firms in an industry rises — as it did when the EMA admitted twelve electricity retailers — and the market size is held constant, the demand facing each individual firm falls and becomes more price-elastic, since consumers now have more substitutes. Lower demand shifts each firm’s average and marginal revenue downward. At the profit-maximising output where $MC = MR$, the price a firm can charge therefore falls.

Increased competition lowers price by reducing X-inefficiency. Competition also disciplines cost. To maintain its profit margin under pressure, a firm is forced to minimise its cost of production: an incumbent that was previously complacent reviews its processes and cuts waste, lowering average and marginal cost. With cost curves shifting down, the profit-maximising price falls. This channel matters where liberalisation exposes a former monopolist — such as the previously protected electricity retailer — to rivals for the first time.

Greater contestability lowers price through limit pricing. Even without actual entry, a more contestable market lowers price through the threat of entry. Incumbents seek to deter potential entrants — who would erode their market share and profit — by raising the effective barriers to entry. One such deterrent is limit pricing: the incumbent deliberately sets price below the profit-maximising level, accepting less than the maximum supernormal profit in the short run. Because the industry now appears less profitable, potential rivals are less inclined to enter. The deliberate restraint of price below the profit-maximising level is itself the fall in price.

Conclusion. Increased competition lowers price both by reducing the demand each firm faces and by squeezing out X-inefficiency, while greater contestability lowers price through the entry-deterring discipline of limit pricing. Liberalisation of the electricity retail market works through all three channels at once, which is why opening the market to twelve retailers is expected to deliver lower price plans to consumers.