Comment / Moving beyond competition

Far from a mere euphemism for competition, contestability aims to use the threat of competition to stimulate efficiencies, as David Parkin explains

Believers in the power of markets to improve healthcare did not grieve for long when the 1990s’ NHS internal market died. The competitive ideal that the internal market embodied dates back to the 18th Century and Adam Smith. But the aim was a modern NHS, and fortunately, there was a more recent idea, from the early 1980s, to rescue market-based reforms – ‘contestability’. Even if they have no competitors, healthcare providers may behave as if they do if there are credible potential competitors. Contestability has become a key part of NHS policy. As successive annual operating frameworks have emphasised, introducing independent sector treatment centres (ISTCs) is only the start.

But where does contestability come from? NHS managers could be forgiven for thinking that this is just another term invented by the Department of Health, a euphemism for competition and privatisation and other hard-to-swallow remedies. In fact, it originates from the work of an American economist, William Baumol. As a theory of how markets work, it is different to older models, but more importantly, it also suggests different government competition and regulation policies.

Although it has critics, contestability theory is arguably the main basis of industrial policy worldwide, applied to both private and public sectors. NHS managers can take comfort from knowing that contestability has a respectable background and is in the policy mainstream, not just a Departmental experiment. It is not anti-public sector, although those concerned that ISTCs are simply a rehearsal for extensive private provision might not be comforted.

Baumol argued that it helps to avoid privatisation, which might simply turn a public monopoly into a private one. But contestability may also offer an alternative to nationalisation.

How does theory affect policy? Economic theory traditionally analyses different types of markets distinguished by the number of firms in the industry. The best theoretical type is the extreme case of perfect competition, with so many firms that none has any market power. Prices and costs are as low as possible and production is maximised. The other extreme is monopoly, where one firm completely controls the market. Monopolies have the worst possible price, cost and production outcomes, and undertake sinful activities such as cross-subsidisation and discriminatory pricing. In between is oligopoly – a few firms, having some market power - better than monopoly, but worse than perfect competition.

A naïve conclusion is that industrial policy should promote many-firmed markets, including dismembering monopolies. If that is not possible, prices and profits should be directly regulated or firms nationalised. Policy analysis made heavy use of ‘concentration indexes’ showing how many firms an industry has and their market share. In practice, policy aims were never as simplistic as promoting perfectly competitive markets. It was recognised, for example, that scale economies might offer a monopoly such low costs that competing firms would have higher prices and lower production.

So, factors such as the size of an industry’s market and its technology determine the most efficient way to organise it – not the number of firms. Contestability theory adds to this by suggesting that efficient markets – producing at lowest possible cost – are maintained by firms experiencing the threat of competition. A perfectly contestable market has no barriers to entry or exit. Some entry barriers – such as legal constraints – are obvious, but others are just as important, especially the availability of market information. Exit barriers are really entry barriers, because a firm that thinks it cannot leave a market will not enter it. Financial barriers are most important – firms must be able to leave without losing their investment.

Industry regulators should, therefore, try to replicate what would happen if markets were perfectly contestable. Department policy is about reducing entry and exit barriers – from improving costs and price information to offering favourable terms to ISTCs. But contestable markets cannot just be set up, then left to run – they need managing to sustain contestability.

Existing firms can create entry barriers by, for example, branding, predatory pricing and maintaining over-capacity. New entrants can engage in hit-and-run operations, entering then abandoning a market, which is unacceptable for health services that someone must provide. But ‘cream-skimming’, though unpopular with existing providers, is a legitimate and successful tactic, as examples in industries such as personal banking show.

The hope is that contestability can give the NHS the alleged efficiency-creating benefits of competition without artificially creating many competitors. Crucial to this is local knowledge and management of markets, so we must hope that primary care trusts know enough about contestability to become good market regulators.