3.4.7 Contestability

Question 1

What is a contestable market?

Answer 1

A contestable market occurs when there is freedom of entry into a market and where costs of exit, sunk costs are low.

A contestable market is based upon the threat of new entrants

Question 2

Characteristics of a contestable market?

Answer 2

• No barriers to entry or exit: barriers to entry are low or non-existent and there are no sunk costs. This allows firms to easily join or leave the market
• No competitive disadvantages on entry: new firms are able to setup and immediately compete with existing firms and have access to the same technology
• Perfect information: There is no proprietary knowledge that would limit competition (e.g. patents)
• Hit-and-run competition: Short-run supernormal profit acts as a profit signaling mechanism and new firms easily enter the market, extract profit, then leave

Question 3

What is Hit and Run competition?

Answer 3

Short-run supernormal profit acts as a profit signaling mechanism and new firms easily enter the market, extract profit, then leave

Question 4

What does a more contestable market do to the behaviour of prexisting firms?

Answer 4

Firms making supernormal profit may change their pricing strategy from profit maximisation (MC=MR) to limit pricing.

Limit pricing lowers the price disincentivising firms to join the market.

They are even likely to set the price = average cost (AR=AC)

• This will reduce hit and run competition
• It will result in normal profit
• There will be less disruption to the market

Question 5

The more contestable a market, the more the behaviour of firms resemebles X?

Answer 5

The more contestable a market, the more the behaviour of firms resembles that of firms in perfect competition

Question 6

What are sunk costs?

Answer 6

Costs that cannot be recovered once spent.

Question 7

Relevance of sunk costs in the degree of contestability?

Answer 7

• The lower the sunk costs the more contestable the market
• The higher the sunk costs the less contestable the market

Question 8

How are economies of scale a barrier to entry?

Answer 8

Occurs when an increase in the scale of output results in a lower cost per unit e.g purchasing economies.

Basically, it is unlikely you will achieve these EoS straight away so will be at a great disadvantage if you join the market.

Question 9

How are legal barriers a barrier to entry?

Answer 9

Patents, copyright and government licenses prevent competitors from entering the market e.g. 5G licenses in the mobile industry

Question 10

How is “ownership of essential resources” a barrier to entry?

Answer 10

If existing competitors’ own resources that are essential to the production of a product, entry into the industry will be limited

Question 11

Example of ownership of essential resources as a barrier to entry?

Answer 11

Cobalt is essential when manufacturing electric batteries and in 2021, Glencore controlled 22% of the world’s supply

Question 12

What are anti competitive practices and how do they create barriers to entry?

Answer 12

These include predatory pricing, limit pricing and aggressive takeover activity in order to limit the amount of competition.

Question 13

What is predatory pricing?

Answer 13

It involves firms setting low prices to drive out firms already in the industry. In the short run, it leads to them making losses.

As firms leave, the remaining firms raise their prices slowly to regain their revenue.

Question 14

What is limit pricing?

Answer 14

When firms set a limit on how high a price will go in the industry to disincentivise new firms from joining.

Question 15

What is brand proliferation?

Answer 15

When firms use their strong brand image to break into other markets.

For instance, Cadbury & Mars & Nestle breaking into the ice cream industry using their name and image.