3.4.7 Contestability

Question 1

Contestable market

Answer 1

• must have no barriers to entry or exit
• have no sunk costs – a firm’s start-up costs that they cannot recover if they exit the market
• new firms must have no competitive disadvantage compared to the incumbent
• must have access to the same technology.

Question 2

Incumbents

Answer 2

• they cannot set a price above AC - if they do and earn supernormal profits others will enter and compete the profits away

Question 3

What happens if businesses make supernormal profits?

Answer 3

• this would make them vulnerable to a ‘hit and run’ entry by a new firm
• they would come into the market, take some profits and then exit again.

Question 4

How might incumbent firms prevent new firms from entering?

Answer 4

• the incumbent firm may charge where P=AC where there are no supernormal profits and no incentive for entry to the market.
• Alternatively the incumbent firm(s) may charge a limit price, i.e. one below the profit maximising price and low enough to deter new entrants.

Question 5

Barriers to entry

Answer 5

obstacles that limit a firm’s ability to enter, set up or extend into new markets.

Question 6

Barriers to exit

Answer 6

factors that prevent firms leaving a market or, when a firm is making a loss, make it more unprofitable to leave.
- Examples of this include sunk costs – costs that are irretrievable – such as advertising.

Question 7

Examples of barriers to entry

Answer 7

• illegal anti-competitive practices by incumbents, including predatory and limit pricing
• the nature of the business causing barriers to exist, such as economies of scale
• legally imposed barriers –patents, state-owned franchises such as train operating companies and legislation that allows firms to operate such as postal services and 4G licenses.

Question 8

Sunk costs

Answer 8

costs that are irretrievable
- e.g advertising costs.
- high sunk costs = make entry to and exist from that market less attractive and therefore make the market less contestable.

Question 9

Assumptions of contestable markets

Answer 9

1. No single firm has a significant share of the market
2. Freedom of entry and exist
3. Firms compete and do not collude to fix prices
4. Firms are short run profit maximisers
5. There’s perfect knowledge in the industry

Question 10

Impact of nationalisation of rail industry on employees

Answer 10

• won’t protect employees due to maximum wage

Question 11

How can nationalisation protect other workers by preventing the abuse of power?

Answer 11

• executives likely to managerial objective and there might be x inefficiency
• prevent managers from seeking profit for their own personal gain but rather for the benefit for other workers and consumers.

Question 12

Impact of nationalisation on efficiency evaluation

Answer 12

• in reality, railway might not increase inefficiency
• current train strikes is evident that the system isn’t working and govt isn’t willing to increase wages or provide funds
• govt is willingly to underpay state teachers and nhs workers therefore are willing to extract surplus (current public sector workers struggle over pay rise)
• therefore it’s unlikely train can do better under state control

Question 13

Impact of nationalisation on efficiency evaluation

Answer 13

Their short term priority is winning votes and election, without looking at long run goals. Private and govt sector can under invest and under pay.

Question 14

Why are some arguments for maximum wage?

Answer 14

• people earn too much
• Prevents the most skilled labour migrating to the highest paid jobs.

Question 15

Example of maximum wage

Answer 15

• Southern rail
• professional footballers in England up until 1960

Question 16

Should Football League have maximum wage?

Answer 16

• With many clubs on the face of bankruptcy, some argue, the Football League should consider a return to a maximum wage = prevent clubs spending more than they can afford on wages.
• However, this is the nature of football clubs – where clubs have a tendency to push themselves towards the brink of bankruptcy.

Question 17

What are some arguments against having maximum wage?

Answer 17

• cold just increase income tax = govt benefit
• disincentives to work (skilled workers might move to lower skills jobs with higher pay)- economy is not being used to full capacity
• high wages often = high value workers/high skill

Question 18

Why might food delivery services be seen as elastic?

Answer 18

• luxury good = not a necessity

Question 19

Why might food delivery services be seen as inelastic?

Answer 19

• as society develops, ppl become lazier = deliveries more attractive due to availability & convenience
• UK lockdown = restaurant closed
• so price paid seems adequate
• high barriers to entry (dominated by small no. Firms) = oligopoly = small firms hard to compete with lower delivery fees = firms often compete with non price factors = lack of substitutes

Question 20

Policies to increase contestability in markets

Answer 20

• market liberalisation
• tougher competition policy
• new technology

Question 21

How has market liberalisation increased contestability?

Answer 21

E.g broadband services & parcel deliveries have both been liberalised over the years = has led to a substantial increase in the intensity of price and non-price competition

Question 22

How has tougher competition policy improved contestability?

Answer 22

• the UK competition & markets authority (CMA) & the EU competition commission have been proactive in investigating allegations of anti-competing practices

Question 23

Example of competition policy

Answer 23

• The CMA stopped the merge between Sainsbury’s and Asda = would lead to a substantial lessening of competition in the retail grocery sector.
• That said, only 12 mergers and takeovers have actually been prohibited / blocked in the UK between the years 2004 and 2018

Question 24

Are barriers to entry coming down?

Answer 24

• rise of lean start-ups (breaking into markets with minimum viable products)
• viral marketing via social media can cut the costs of attracting new sales

Question 25

Advantages of low entry barriers

Answer 25

• market becomes more contestable in the long run
• in theory, more competition = lower prices/improve quality/higher productivity

Question 26

Drawbacks from low barriers to entry

Answer 26

in practice:
* lower snp = less R&D
* lower profits = less tax revenue
* rapid entry of new firms = over supply = drags price lower = make industry less sustainable (renewable energy)
* risk of structural unemployment (e.g tech innovation)
* doesn’t guarantee of a contestable market (old monopoly replaced by new ones e.g Uber)

Question 27

Maximum wage effectiveness

Answer 27

Tax more effective

Question 28

Example of contestable market

Answer 28

low-cost airlines, internet service providers, electricity and gas suppliers,

Question 29

Example of competitive market

Answer 29

Changing technology
(Mobile phones, medicine)

Question 30

What is a contestable market?

Answer 30

• There is a threat of new market entries