3.4.7 Contestability Flashcards
Contestability
How open a market is to new competitors.
What are the characteristics of a contestable market?
- Low barriers of entry/exit
- No sunk costs
- Incumbent firms/entrants into the market have access to the same level of technology
What are sunk costs?
Costs that cannot be recovered if a firm exits the market.
- These costs might include investment in specialised equipment or expenditure on advertising.
What are barriers to entry?
The factors which make it difficult or impossible for firms to enter a particular market.
What do barriers do for incumbent firms?
Barriers to entry/exit allow incumbent firms to make supernormal profits, before new entrants enter the market and compete these profits away.
How long incumbent firms can make supernormal profits for depends upon:
- The height of the barriers to entry – i.e. how long the barriers can prevent new firms entering the market.
- The level of supernormal profit being earned – this is because the greater the profits to be made, the more effort new entrants will be willing to make to overcome the barriers.
What are incumbent firms?
Firms already in the market.
Hit and run tactics
This is where a firm enters a market while supernormal profits can be made … and then leaving the market once prices have been driven down to normal-profit levels.
- As long as the profit made while in the market is greater than the entry/exit costs, it’s worthwhile for a firm to compete, even for a short time.
What causes hit and run tactics in contestable markets?
The low barriers to entry and exit.
What is an example of a contestable market?
The internet.
This reduces the barriers to entry significantly because businesses can open up without a phyiscal infrastructure.
- For example, a shop could set up and sell their goods on their own website (or via a 3rd party) instead of setting up their own phyiscal shop.
The internet increases competition because it allows people to easily shop around - someone can compare prices between different shops much easier than walking between shops and comparing products.
Sunk costs are also much lower. E.g. Rent vs Website costs
What affects how firms behave in a contestable market?
The threat of increased competition (as well as actual competition).
- For example, incumbent firms will know that high supernormal profits are likely to attract new entrants, and that these entrants are likely to drive down prices.
- So it might make more sense for the incumbent firms to sacrifice some short-term supernormal profits, and set lower prices to avoid attracting new entrants.
- This may be the best way to maximise profit in the long run.
Do firms operate under productive/allocative efficiency?
In contestable markets, firms will operate at productive and allocative efficiency, because supernormal profit is competed away and firms must settle for normal profit.
What is a contestable market?
A market where there is the fear of competition forces incumbent firms to behave competitively.
