12) Contestable Markets Flashcards
define a contestable market:
a market in which the existing firm makes only normal profit, as it cannot set a price higher than average cost without attracting entry, owing to the absence of barriers to entry and sunk costs
define sunk costs:
costs incurred by a firm entering the market that cannot be recovered if the firm ceases trading
define hit-and-run entry
where a firm enters a market to take short-run supernormal profits knowing it can exit without incurring costs
what is contestability about?
is about how open a market is to potential competitors, rather than the number of actual competitors
characteristics of a perfectly contestable market,new firms:
5 points
- Face no barriers to entry or exit
- Incur no sunk costs
- having equal access to technology
- face no competitive disadvantage compared with the incumbent firm(s)
- are able to enter and exit rapidly
why are there no barriers to entry or exit?
- No internal economies of scale
- No vertical integration
- Low consumer loyalty due to weak brands / ineffective advertising
why are there no sunk costs?
Equipment can easily be sold
No spending on advertising
why is there equal access to technology?
no relevant patents
how do you avoid hit-and-run entry?
Firms in the market are forced to set a price equal to average cost if they are to avoid hit-and-run entry
how do perfectly contestable markets link to perfect competition?
Perfectly contestable markets can deliver the benefits of perfect competition without the need for a large number of firms
- In contestable markets the threat of increased competition has the same impact on incumbent firms’ behaviour as actual competition
analysis: monopoly linking to contestable markets
If the monopoly profit maximises, and produces output Qo at MC=MR and charges price Po, then in a contestable market the firm will be vulnerable to hit-and-run entry. A firm could enter the market, compete away the supernormal profit, and leave the market.
how can a monopoly avoid hit-and-run entry?
The only way the monopoly can avoid this is to produce where price equals average cost, so that are no supernormal profits to act as an incentive for entry. The monopoly would produce at AC=AR with price P1 and output Q1, and have changed its objective from profit maximisation to sales volume maximisation.
what is the advantage of a perfectly contestable market?
lower prices for consumers and allows for economies of scale
what are the disadvantages of a perfectly contestable market? (2 things)
1) equal access to technology reduces dynamic efficiency
2) lack of SNP reduces dynamic efficiency
when is there the disadvantage of equal access to technology to reduce dynamic efficiency?
If the government is forcing firms to share technology, then there is less incentive to invest in R&D.
eg like BT and Openreach
disadvantage: lack of SNP reducing dynamic efficiency
Achieving only normal profit in the long run means less scope to invest in R&D.
why is a contestable market more useful than other market structures?
1) More realistic than perfect competition as it does not rely on a ‘large’ number of firms - a market could be perfectly contestable with any number of firms.
2) The characteristics of a perfectly contestable market gives actionable advice to government on how to improve the functioning of the market to the benefit of consumers with increased output and lower prices
why are contestable markets less useful than other market structures?
The assumptions are almost as unrealistic as perfect competition the theory does not set out the mechanism by which the market becomes productively and allocatively efficient
