3.4.7

Question 1

define a contestable market

Answer 1

when a new market entrant equal access to all production techniques avaiable to incumbent firms and are not prohibited from wooing incumbent customers and where entry decisions can be reversed without a cost

Question 2

what are the characteristics of a contestable market?

Answer 2

• no sunk costs
• low barriers to entry and exit
• weak brand loyalty

Question 3

how do firms behave in a contestable market?

Answer 3

• Price Competition: Firms in contestable markets tend to engage in intense price competition since they know that new entrants can easily undercut their prices if they attempt to charge excessive prices.
• Efficiency and Innovation: Firms have an incentive to operate efficiently and innovate to maintain a competitive edge. In a contestable market, the threat of new entrants drives firms to continually improve their products and processes.
• Short-Term Focus: Firms may have a short-term focus on maximizing profits since they are aware that the market conditions can change rapidly with the entry of new competitors.
• No Monopoly Power: Contestable markets discourage firms from attempting to establish and maintain monopoly power since any attempt to do so is likely to be short-lived.

Question 4

define sunk costs

Answer 4

costs that cannot be recovered if a firm decided to leave the market

Question 5

how do sunk costs impact the level of contestability?

Answer 5

higher sunk costs act as a barrier to entry for new firms, becuase they risk making significant losses if they leave the sector, reducing contestibility

Question 6

what are the types of barriers to enter and exit a market?

Answer 6

• Economies of Scale: Firms that can produce at lower average costs due to economies of scale may deter new entrants, as newcomers may struggle to compete with established firms’ cost advantages.
• Capital Requirements: High startup and capital investment costs can be a significant barrier to entry, especially in industries requiring expensive equipment or infrastructure.
• Government Regulation: Regulatory barriers, such as licensing requirements or safety standards, can limit entry into certain markets.
• Brand Loyalty: Established brands with strong customer loyalty can deter new entrants from gaining market share

Question 7

what is hit and run entry?

Answer 7

when a firm enters a market to take advantage of the temperarily high supernormal profits

a key aspect of a highly contestable market

Question 8

“Analyse how firms might be affected by increased contestability.”

include diagram

Answer 8

A contestable market exists when there is freedom of entry and exit into an industry and there are limited or no sunk costs of production. In the absence of actual competition or threat of a rival entering a market, an unregulated firm could maximise profit where MR=MC. But if a market becomes more contestable – e.g. through a policy of liberalization, then competitive pressures will keep prices down. Instead of profit maximising, existing firms would have an incentive to cut prices perhaps to a level where normal profit is made. This is at an output where price (AR) = average cost. Firms are making enough profit to stay in the market without attracting rivals. Actual and threatened competition intensifies incentives for businesses to control their unit costs by avoiding any X-inefficiencies.