3.4.7 - Contestability

Question 1

What are the characteristics of a contestable market ?

Answer 1

• Low barriers to entry and exits : Meaning firms can enter the market easier, and so therefore are low sunk costs e.g minimal advetsing spend
• Large pool of potential entrants
• Good information
• Incumbent firms
• Low rate of existing consumer loyalty

Question 2

What are the different type of barriers to entry

Answer 2

• Legal barriers
• Sunk costs
• Economies of scale : enables firms to keep their costs and prices low which may be hard for new firms to compete with low prices as they may not benefit from economies of scale.
• Brand loyalty : Strong branding and bran loyalty of incumbent firms will make it hard for new firms entering the market to make any sales.
• Anti-competitive practice (watch the up learn video on this). - Firms can vertically integrate to take control of scarce resources (like the power grid or the oil extraction firm); and then refuse to let new firms use these scarce resources, stopping them from entering the market.

Question 3

What are legal barriers and give real life example when they were used ?

Answer 3

• Include patents, copyrights and trade marks that stop new firms that are entering the market from using the ideas of incumbent firms.
• E.g incumbent firms microsoft has filed patents on all of their technology this has prevented other firms from using their ideas preventing them from entering the market
• Pharma companies patent any new medicine they can come up with so their rivals can’t produce the same drugs.
• Richard dyson patented his bagless vacuum cleaner which ended up hoover a different company getting fined £4m and was order to leave the market

Question 4

What are sunk costs

Answer 4

• Unrecoverable cost
  e.g R&D, advertisement, specialist machinery that is only for your company.
• High sunk costs are a barrier to entry as they deter other firms from entering the market this is because firms know that the cost of failure is high.

Question 5

Why must firms have good information for the market to be contestable

Answer 5

• New firms looking to join must have good information about the market (cost and technology) so that they can compete on a level basis.

Question 6

How has technology increased contest-ability ?

Answer 6

1. It has reduced barriers to entry and exit as business don’t have to be physical anymore. This helps to reduce start up and sunk cost. They also may not have to hire as many workers. Technical economies of scales can be reached much faster. Advertising is also easier as well so brand loyalty can be overcome mech faster.
2. Technology has also increased inovation so new firms can come in and disrupt markets e.g uber and air bnb.
3. Technology has also allowed firms to find lower costs of producing things.
4. It has allowed for better information on costs which allows firms to be aware better and helps them to find way to avoid these costs increasing contestability.

Question 7

Explain how a monopoly would work in a contestable market. Like how would they operate.

Answer 7

When there is a threat of new entrant to a monopoly they would move towards limit pricing (where AR=AC), this helps them to reduce price which also reduces their profits (see explanation). This bring price done to Pm to Pc. Also reducing their SNPs box (write that).

Question 8

Pros of a contestable market ?

Answer 8

1. Movement towards allocative efficiency - Lower prices, higher consumer surplus, better quality and increased quantity and more consumer choice.
2. Movement towards productive efficiency - Greater exploitation of economies of scale which can be used to lower cost and therefore consumers will experience lower prices.
3. X - efficiency - Minimising waste which helps to lower costs and therefore consumers will experience lower prices.
4. Job creation - Firms will have to higher new workers to increase quantity (eval : Depends on how productively efficient the current workers are). Additionally if there is increased demand due to lower prices, then since labour is demand derived then they will need more workers.

Question 9

Cons of contestability

Answer 9

• If firms react by lowering prices which lowers their profit margin we may see a reduction in dynamic efficiency as there would be a reduction in investment in technology and into their business which reduces dynamic efficiency (eval : However if new firms come in with innovative ideas that itself is the benefit of dynamic efficiency)
• Cost cutting in dangerous areas e.g product safety, health and safety, environmental standards and wages.
• Creative destruction : When new firms come in with creative ideas, forcing other firms out of the market then they may be job losses (this is the eval point for job creation) but then if those new firms get bigger then they may higher these workers in the same industry that have lost their jobs
• Anti-competitive strategies : However if firms use limit pricing, predatory pricing to eliminate threat then maybe contestability will not last over time.

Question 10

Eval of contestable market

Answer 10

• The length of contestability : How long will the market be contestable for. If new firms come in with better technology an innovative ideas and can patent their ideas then the market may not be contestable for long. As well as if firms are going to use anti-competitive strategies then contestability will decrease overtime
• Role of technology : Patents and copyright in technology can reduce constable (kinda links to the first point). Technology can improve information for firms in acquiring consumer data so firms can practice price discrimination a lot more (1st and 3rd degree)
• Regulation : It can minimise cost cutting in dangerous areas as well as the practice of anti competitive strategies which negates the effect of some of the cons of contestability

Question 11

Definitions :
- Contestable market
- Sunk cost
- Freedom to entry or exit a market
- Perfect knowledge
- Hit and run entry

Answer 11

• A contestable market exists when there is freedom of entry and exit into an industry and there are limited or no sunk costs of production.

Question 12

Blurt some quick facts about sunk costs

Answer 12

Question 13

Example of some contestable markets

Answer 13

• Fast Food
• Hairdressing
• Online clothing

Question 14

What are incumbent firms

Answer 14

Firms that are currently in the market

Question 15

What does it mean for barriers to entry and exit

Answer 15

It means that no firm in the market has a competitive advantage which is a barrier to other firms from entering a market

Question 16

Blurt what you know about hit and run competition

Answer 16