13- Contestability

Question 1

What is a contestable market?

Answer 1

A contestable market occurs when there is there is freedom to entry and exit due to low sunk costs.

Question 2

Competition level in contestable market?

Answer 2

High as existing firms face threat of new firms entering the market.

Question 3

Benefits of contestable markets

Answer 3

• Lower prices (allocative efficiency)
• Increased incentives for firms to cut costs (x-efficiency)
• Increased incentives for firms to respond to consumer preferences (allocative efficiency)

Question 4

Factors which determine contestability of a market?

Answer 4

• Sunk costs
• Level of advertising and brand loyalty
• Vertical integration
• Access to technology and skilled labour

Question 5

Methods to increase contestability?

Answer 5

Remove legal barriers to entry. Royal Mail used to be a legal monopoly but now firms are allowed to enter the market for sending letters and parcels.

Force firms to allow competitors to use its network For example when BT was privatised, OFTEL forced BT to allow other companies to use its network. This has also occurred in the Gas and Electricity industries and has made them more contestable. A firm can now gain access to the national network of gas/electricity infrastructure

Legislation against Predatory Pricing If a firm can engage in predatory pricing it can force new firms out of business and make it less contestable.
OFT can legislate against abuse of Monopoly power. If a firm abuses its monopoly power by restricting supply to certain firms the OFT can intervene to overcome this restriction on contestability.

A government firm. In the banking industry, the government has even toyed with creating its own company to help increase competition and increase bank lending to small firms. This could be a last resort where private firms face insurmountable barriers to entry.

Question 6

Conditions for a contestable market?

Answer 6

• Low barriers to entry/exit
• Large pool of potential entrants
• Good information
• Imcumbent firms subject to ‘hit and run’ competition

Question 7

Cons of contestability

Answer 7

• Lack of dynamic efficiency
• Cost cutting in dangerous areas
• Creative destruction
• Anti-competitive strategies- merger, limit pricing