4.1.5.9 Contestable and non-contestable markets (Paper 1)

Question 1

Define contestable market

Answer 1

A market with freedom of entry and exit

Question 2

General argument in favour of contestable markets

Answer 2

• More contestable markets lead to incumbent firms behaving in more economically desirable ways with regard to pricing and static efficiency

Question 3

Features of perfectly contestable markets

Answer 3

• Freedom of entry and exit from the market
• Therefore no sunk costs
• Perfect information
• Firms produce where P = MC (allocative efficiency)

Question 4

Why is it argued that contestable markets lead to incumbent firms acting in more economically desirable ways?

Answer 4

• Because of the threat hit and run competition - new entrants taking a share of any SNP that might exist if the incumbent firm didn’t behave as if they were in a perfectly competitive industry

Question 5

Define hit and run competition

Answer 5

In contestable markets - where new entrants take a share of SNP and then exit the industry

Question 6

How can the effects of contest ability by shown on diagram

Answer 6

• Firm produces where they only make normal profit (lower price and higher quantity) - in contrast to the usual profit-max price and output of a monopolist (at a higher price and lower quantity)

Question 7

Sunk costs definition

Answer 7

Costs that are unrecoverable once invested - e.g. - marketing, research and development