3.4.7 Contestability

Question 1

What is a contestable market?

Answer 1

• one in which new entrants can easily enter + compete with established firms, even if those firms have a significant market share
• new entrants can easily has equal access to all production techniques available to the incumbents + it is possibly to leave without cost

Question 2

Characteristics of a contestable market

Answer 2

• low barriers to entry = low/no sunk costs (irretrievable costs when firms leave)
• perfect info = new entrants have the same access to technology as incumbents + new entrants can attract customers from incumbent firms
• low barriers to exit
• lack of brandy loyalty since new firms can easily attract customers from incumbent firms

Question 3

Monopolist behaviour in a contestable market

Answer 3

• if the market is contestable, there is a downward pressure on price because the existence of supernormal profit acts as a signal to new entrants
• a monopolist facing potential entrants in a contestable market would fear entry + reduce price with profits falling to normal profit = entry limit pricing
• suggests firms may not set the profit max price if the market is contestable - it is the fear of entry that can cause the price to be below profit max
• HOWEVER, it is more likely the firm will set profit max price + react to the new entrant when they enter

Question 4

What threat is there in a contestable market?

Answer 4

• hit + run entry = when an entrant takes advantage of temporarily high supernormal print + then exits
• leads to incumbent firms choosing to limit pricing over profit maximisation
• they may also focus on non-price competition e.g. sales maximisation to establish a market foothold

Question 5

Is a contestable market efficient?

Answer 5

• lower prices = improved allocative efficiency since firms are under pressure to keep prices low since if they raise prices, new entrants are encouraged who could undercut them using hit + run entry
• dynamic efficiency = firms are encouraged to innovate to develop new products or services + gain a competitive advantage
• productive efficiency = strong incentive to keep unit costs low + avoid organisational slack (X-inefficiencies) - economies of scale can give a firm a competitive advantage

Question 6

Examples of barriers to entry

Answer 6

• high start up costs
• limited access to resources = incumbent firms own resources that are essential to the production of a product
• regulatory restrictions = government licences, patents, copyright
• anti-competitive behaviour = entry limit pricing
• technological entry barriers

Question 7

Examples of barriers to exit

Answer 7

• sunk costs = to enter the firm may have acquired expensive assets that are highly specialised + difficult to resell
• if sunk costs are high, it will limit competition + decrease contestability as firms will be more hesitant to enter