3.4.7 Contestability

Question 1

Characteristics of a contestable market

Answer 1

low barriers to entry and exit (perfectly contestable market, entry into and exit out must be costless)

pool of new businesses who are willing and ready to enter the market

Equal access (for incumbent and potential entrant firms) to available industry technologies

High rates of customer switching – i.e. relatively low brand loyalty

Question 2

What are prices and output like in a contestable market

Answer 2

prices tend to be lower and output higher in contestable markets

Question 3

What pricing strategy do contestable firms operate at

Answer 3

limit pricing

Where pirce=average costs and only normal profit is made

little incentives for new firms to enter the market

but can be between normal profit and profit maximising equilibrium - depending on level of contestability

Question 4

Why do contestable firms not operate making supernormal profits

Answer 4

opportunity for new entrants to engage in “hit and run” competition to undercut the established
dominant firm and perhaps lower market prices and profits

Question 5

Which market theory is a contestable market most similar too

Answer 5

Perfectly competitve

Question 6

Apart from low barrier to entry + exit, what is the one other thing which would allow a firm to be contestable

Answer 6

Low sunk costs

If sunk costs are high this makes it difficult for new firms to enter and leave the market

Question 7

What macro policy is usually aimed to increase contestability

Answer 7

liberalisation

Question 8

Name some examples of barriers to entry

Answer 8

• Economies of scale using capacity expansion achieving lower costs
• Hostile takeovers and acquisitions - buying up a rival firm
• Brand loyalty, expertise and reputation
• predatory pricing - a firm sustaining a sort-term loss to force competition to exit
• Patents + trademarks e.g of drugs or recipes

Question 9

What causes high sunken costs

Answer 9

• Asset-write-offs – e.g. writing-off the value of plant and machinery, stocks and the goodwill of a brand
• Closure or project cancellation costs including redundancy costs, bad debts, contracts with suppliers and the penalty costs from ending leases for property & equipment
• The loss of business reputation and goodwill - a decision to leave a market can damage goodwill among previous customers, not least those who have bought a product which is then withdrawn