3.4.7 contestability Flashcards
What are the characteristics of contestable markets?
- no barriers to entry/exit
- no sunk costs
- new firms have no comparative disadvantage compared to incumbent firms
- all firms must have access to the same technology
- a pool of new businesses who are willing and ready to enter the market
- high rates of consumer churn/switching
What is contestability?
Relates to how easy it is for firms to enter an industry and compete with other firms. The degree of potential competitiveness.
What are the implications of a business making supernormal profits within a contestable market?
- they would become vulnerable to a “hit and run” entry by a new firm, this means they would enter the market, take some profits and exit
- in response to this, the incumbent firm may charge where P = AC where there is no supernormal profit and no incentive for new firms to enter the market
- incumbent firms may also charge a limit price, below the profit maximising price, to deter new entrants
What profits are made by firms in a perfectly contestable market?
In a perfectly contestable market, firms would only make normal profits and produce where AC = AR because new firms would enter if the price was any higher
How efficient are firms in a perfectly contestable market?
They are likely to be productively and allocatively efficient. If they are not producing at the lowest point on the AC curve where AC=MC, new firms can enter the market and offer lower prices (productively efficient). Due to this and the fact that they can only make normal profits where AC=AR, they are also likely to be allocatively efficient. AC=AR=MC, so value to society is equal to the cost.
What are barriers to entry?
Anything which deters/prevents a new firm entering an industry, stifles competition. This provides substantial market power to incumbents (existing firms).
What are barriers to exit?
Factors that prevent a firm from leaving a market. If they are making a loss, it may be more unprofitable for them to leave the market.
How do legal barriers to entry work?
- patents and trademarks = provide firms with legal protection for ideas and designs, preventing other firms from imitating them
- legislation = the government may restrict the ability of firms to compete in a market eg. British Gas was government owned and had the monopoly
How do marketing barriers to entry work?
- advertising = increased brand loyalty and consumer inertia, demand becomes price inelastic.
What is consumer inertia?
Buyers remain loyal to particular brands due to habitual behaviour, advertising, asymmetric information and irrational behaviour. They are unlikely to switch to new alternatives even if they are cheaper or better quality.
How can pricing and anti-competitive practices create barriers to entry?
- predatory pricing = prices are low, driving firms out of the market and discouraging firms from entering the market
- entry limit pricing = prices are set to deter new entrants
- control over outlets = competitors may not be able to get their products to the market
- control over supplies = if a firm has monopoly control over supplies in the industry, other firms are unable to enter
- fear of reactions of existing firms = some firms believe that incumbent firms may begin a price war if they enter the market
How can start up costs create a barrier to entry?
- high capital start-up costs = machinery needed to begin production may be expensive, sunk costs may also be high
- economies of scale = new firms are unable to produce on the same AC curve as existing firms, costs would be much higher and it would be difficult to compete
What is a sunk cost?
A fixed cost that a business can’t recover if they leave the industry eg. property, machinery, advertising
How do sunk costs impact contestability?
If sunk costs within a market are high, the market is less contestable, vice versa. They are seen as a barrier to entry because firms risk making massive losses if they exit the industry.
