3.4.7 - Contestability Flashcards
What is a contestable market?
This is a market that is competitive due to a lack of barriers to entry. The possibility of new firms entering the market puts pressure on incumbent firms. These incumbents know that if they set prices too high or are inefficient, new entrants can undercut them and capture market share.
To avoid attracting new entrants, incumbent firms aim to:
Be Efficient: Keep their costs low to maintain profitability while charging competitive prices.
Produce at Competitive Levels: Avoid overpricing or under-delivering on quality, as this would create opportunities for new entrants to exploit.
What are the characteristics of a contestable market?
No/Low Barriers to Entry or Exit:
This ensures that new firms can challenge incumbents without risking significant losses if the venture fails.
Threat of Potential Entry:
The mere possibility that new competitors can enter the market easily forces existing firms to behave competitively (e.g., offering fair prices and quality services) to deter entry.
Hit-and-Run Entry:
In a perfectly contestable market, firms can enter to take advantage of short-term profits and exit once the opportunity diminishes.
Perfect Knowledge:
Both consumers and potential entrants have access to information about prices, costs, and market conditions.
This transparency allows new entrants to assess whether entering the market is profitable.
Absence of Brand Loyalty:
If consumers can easily switch between providers and there is no strong preference for existing brands, new entrants can capture market share more readily.
What are perfectly contestable markets?
No Barriers to Entry/Exit: Firms can enter and leave freely, incurring minimal costs.
No Sunk Costs: Firms do not face irrecoverable costs upon entering or exiting.
Perfect Information: Both entrants and consumers have complete knowledge of prices, products, and market conditions.
Threat of Hit-and-Run Entry: Firms can exploit profit opportunities and exit quickly if conditions change.
Are there profits in contestable markets?
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 supernormal profits.
Are contestable markets allocatively efficient?
They are allocatively efficient:
Allocative efficiency occurs when resources are distributed in a way that maximizes consumer welfare, when P = MC.
The threat of potential entrants forces incumbent firms to price competitively to avoid being undercut.
As a result, prices tend to equal marginal cost (P = MC), ensuring that resources are allocated according to consumer preferences.
Are contestable markets productively efficient?
Productive efficiency is achieved when firms produce at the lowest point on their average cost curve (AC).
Firms are incentivized to minimize costs because high costs would make them vulnerable to new entrants who could produce more cheaply.
To survive, firms must produce at the lowest cost possible, ensuring productive efficiency.
Are contestable markets dynamically efficient?
Dynamic efficiency refers to improvements in productivity and innovation over time.
The constant threat of new entrants encourages firms to innovate and improve products/services to maintain a competitive edge.
Firms invest in R&D and adopt new technologies to differentiate themselves and retain customers.
What are degrees of contestability?
This is how contestable a market is:
Perfectly contestable, highly contestable, moderately contestable, low contestability.
For example taking the characteristic of low barriers to entry
Perfectly contestable market would have NO barriers, highly contestably wold have LOW barriers, moderately would have SOME barriers, and low contestable markets would have HIGH barriers.
Rest of the spec:
The rest of the spec includes the barriers to entry and sunk costs. The notes on my worksheets that valavan has given is good for this and flashcards are not necessary.
