3.4.7 Contestability Flashcards
Contestability
Market with a high threat of new entrants, which keeps firms producing at a competitive level. Even in a monopoly, a firm may be forced to be efficient due to the
potential of new entrants to the market.
- This model is concerned with the possibility of other firms entering the market if they see the opportunity to make money, rather than the number of firms in the industry at a point in time.
- Any attempt to make a huge profit will mean other businesses will be attracted to the industry.
Characteristics of contestable markets
● Within a contestable market there is perfect knowledge so if one firm is making
abnormal profits, other firms will enter the market.
● There is freedom of entry and exit meaning any firms can enter/leave the market.
There will be a relative absence of sunk costs. Firms will be able to and have the
legal right to use the best available technology, meaning their average cost curve
will be the same as the original firms’.
● There will be low product loyalty , meaning people don’t consistently use one brand
and are happy to switch if a new one enters the market.
● We assume firms are short run profit maximisers and do not collude with each other.
Contestable markets examples
Some examples of contestable markets are:
- the taxi industry, with the introduction of
Uber
- the hotel market, with AirBnB
- fast food, due to Five Guys .
Another example of contestability is Ocado, who are set to replace M&S in the FTSE 100
(2018), showing the new replacing the old.
Implications of contestable markets for the behaviour of
firms
● In a contestable market, firms will enter the market if they see other firms are making
huge profits. They will remain in the market until competition prevents them from
making a profit. This will take away profit from the original firms, and could even force them out of business. The only way to prevent this is by using limit pricing, which reduces the incentive for firms to enter the market.
● In a perfectly contestable market, firms will only be able to make normal profits and produce where AC=AR because new firms will enter the market if price was any
higher and they were making monopoly profits.
● Firms are likely to be productive and allocative efficient. If they are not producing
at the lowest point on their AC curve (i.e. not productively efficient), new firms can enter the market and undercut them by offering lower prices. Due to this, and the fact they can only make normal profits in the long run, they must also be allocative
efficient. Since they can only make normal profits AC=AR, and since they produce at the lowest point on their AC curve AC=MC. Therefore, AC=MC=AR, so the value to society is equal to the cost.
Natural/innocent barriers to entry
Some barriers are natural barriers, sometimes called innocent entry barriers. These include natural monopolies and high entry/sunk costs. However, others are put in place by existing firms in the industry. They include patents and copyrights as well as high levels of
advertising and branding.
Barriers to entry and contestability
- Legal barriers
- Marketing barriers
- Pricing decisions of incumbent firms
Types of barrier to entry and exit
Sunk costs
A fixed cost that a business cannot recover if it leaves the industry.
- includes property (if the lease is longer than it is actually used for),
machinery and equipment that cannot be resold, and advertising
Sunk costs and the degree of contestability
All businesses will face sunk costs because even if things are resold it is generally for a lower price.
● The degree of contestability is measured by the extent to which the gains from
market entry for a firm exceed the costs of entering the market . A market with no
sunk costs and no barriers to entry and exit is a perfectly contestable market. The
more contestable a market, the more unstable it will be as there can be regular hit
and run competition.
● In reality, no market is likely to be perfectly contestable as there is always likely to be some sunk cost.
Reasons for increasing contestability
