3.4.7 Contestability Flashcards
What are contestable markets?
Contestable markets exist when there are low barriers to entry and exit, allowing new suppliers to come into
a market and provide fresh competition to established businesses.
What is a perfectly contestable market?
For a perfectly contestable market, entry into and exit out must be costless. This can have implications for the
behaviour (conduct) of existing firms and then affects the performance of a market in terms of allocative, productive and dynamic efficiency.
What are examples of contestable markets?
What are the conditions required for market contestability?
- A pool of new businesses who are willing and ready to enter the market
- No significant entry or exit costs – this lowers the risks of market entry
- Equal access (for incumbent and potential entrant firms) to available industry technologies
- High rates of customer switching – i.e. relatively low brand loyalty
What does a contestable market look like?
In general, prices tend to be lower and output higher in contestable markets than in markets with high barriers to
entry/exit.
If the market is highly contestable which level of price and output is probable?
- If a monopoly decides to operate at the profit-maximising output (i.e. output Q1 in the diagram above), there
is an opportunity for new entrants to engage in “hit and run” competition to undercut the established
dominant firm and perhaps lower market prices and profits. - Q2 is an output where price = average cost and only normal profits are made. Here there would be no
incentive for firms to enter the market. At Q2, the price is the “limit price” - The price and output in a contestable market is likely to be somewhere between the profit-maximising and
normal profit equilibria. The more contestable is the market, the higher the likelihood that price charged will
be closer to normal profits only i.e. closer to the limit price
Explain key points about contestable markets
- A key point about contestable markets is that the threat of entry affects the day-to-day behaviour of firms
- Firms making supernormal profits are vulnerable to “hit and run” competition
- This means that they are likely to behave more competitively i.e. not earn supernormal profits, in order to
discourage new firms from entering - The outcome (in terms of price, output, and profit) in a highly contestable market will resemble perfect
competition, regardless of the number of firms, since incumbents behave as if there were intense competition - Competition policies such as liberalisation of a market that help to open up an industry to new suppliers or
persuade consumers to switch in greater numbers help to increase contestability
Analyse how firms might be affected by increased contestability
What are barriers to entry?
Barriers to entry are the means by which firms with market power can successfully prevent the profitable entry of new
suppliers into an industry.
What are examples of barriers to entry and exit?
- Hostile takeovers and acquisitions – i.e. taking a stake in a rival firm or buying it up completely!
- Product differentiation through brand proliferation (i.e. developing new products and spending on marketing
and advertising to reinforce brand loyalty). - Capacity expansions designed to achieve lower unit costs from exploiting internal economies of scale.
- Predatory pricing: This happens when a dominant company sustains losses in the short run in the knowledge
it can recoup them and raise prices if competition is forced to exit
Explain examples of sunk costs
- 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
Draw a table comparing characteristics of a monopoly and a contestable market
How have financial markets become less contestable with more regulation on incumbents?
Large existing banks came under significant fire during / following the financial crisis,
and faced much more regulations (certainly in the UK and EU, although less in the US) and as their
operations became more restricted, opportunities arose for ‘challenger banks’ or niche financial services
providers
How has the airline market become more contestable with less regulation?
- Open Skies Agreement in air travel in Europe in the 1990s and the ongoing discussions over Open Skies
between the EU and US
o Led to the rise of low-cost budget airlines (e.g. Easyjet, Ryanair etc), causing incumbents such as BA
to lower their prices and behave more competitively
o However – there remain plenty of barriers to entry in this market so it is not truly contestable!
What are examples of regulation that can increase contestability?
o Banning cross-subsidisation i.e. an existing company using profits in one part of their firm to
subsidise entry into a new market
o Requiring incumbents to provide ‘network access’
o Removing legal barriers to entry
o Preventing mergers & acquisitions, especially vertical integration that reduces access to supply
chains for new firms (n.b. only 12 have been blocked in the UK between 2004 and 2018!)
o Reducing protectionist measures
