9.8 Contestable Markets Flashcards
What are the characteristics of a perfectly contestable market?
A perfectly contestable market is characterized by the absence of barriers to entry or exit for firms, a large potential pool of new entrants, perfect information/knowledge of market conditions for both consumers and producers, and the vulnerability of incumbent firms to “hit and run” competition.
How does the absence of barriers to entry or exit affect a perfectly contestable market?
In a perfectly contestable market, there are no barriers to entry or exit for firms, including sunk costs, which makes entry and exit completely costless. This means that firms attracted by supernormal profits can enter and then exit straight away. The threat of entry into the market is strong, which may force incumbent firms to alter prices and quantities.
Why is the large potential pool of new entrants significant in a perfectly contestable market?
The large potential pool of new entrants in a perfectly contestable market is significant because it makes the threat of actual market entry real. These firms don’t have to enter the industry to change the prices and charged and quantities produced by incumbent firms, but their presence provides a threat of entry, which is enough on its own.
What is perfect information/knowledge in a perfectly contestable market?
In a perfectly contestable market, there is perfect information/knowledge of market conditions for both consumers and producers. Consumers have perfect information over prices charged, and producers have perfect information over costs and technology in the industry as well as prices charged, which can be replicated upon entry into the market.
What is “hit and run” competition in a perfectly contestable market?
In a perfectly contestable market, incumbent firms are vulnerable to “hit and run” competition. This is where new firms enter the market attracted by supernormal profits, pricing lower than incumbent firms to take a portion of the profits before the incumbent can react. When a reaction arrives, the firm can leave the market without cost with profits intact. The threat of such competition can again make incumbent firms price and produce differently instead of at the profit maximization point.
How have technology advancements reduced barriers to entry and exit in various markets?
Technology advancements, especially the growth of internet capability, have reduced barriers to entry and exit in various markets by significantly reducing start-up costs, eliminating the need for physical premises and employment regulations. The use of effective and affordable advertising online and through social media provides opportunities for new firms to compete with more established incumbent firms. Furthermore, technology advancements have reduced sunk costs and concerns over brand loyalty.
Evaluation: How can technology raise barriers to entry in some markets?
Technology can raise barriers to entry in some markets through an increased number of patents issued as technology allows for greater innovation and product developments. Moreover, technology can allow firms to engage in anti-competitive practices, such as using their size and financial advantages to advertise heavily and limit competition.
How has technology allowed for a greater pool of potential entrants into a market?
Technology has allowed for a greater pool of potential entrants into a market by creating new innovations that have created gaps in the market for new firms to compete with more established companies. Additionally, new companies have found more efficient ways of producing the same goods/services, allowing them to outcompete incumbent firms.
Evaluation: How might incumbent firms limit potential entrants to a market?
If incumbent firms react to the greater threat of entry by using anti-competitive strategies, such as limit pricing or heavy advertising, the number of potential entrants will not necessarily rise. Furthermore, a common strategy for incumbent firms is to merge with or buyout start-up companies that could become a threat. Additionally, new entrants into a market with brand new innovative products or a more efficient production process could patent their ideas, actually closing up the market to new entrants.
How has technology improved the level and spread of information for both consumers and producers?
Technology has certainly improved the level and spread of information for both consumers and producers. The internet and smartphone technology have meant that consumers are able to get better and clearer information over prices and quality of goods and services offered, while firms can easily understand the nature of costs and current technology, encouraging market entry.
Evaluation: How might technology advancements be used to exploit consumers?
Information improvements via technology advancements could easily be used to exploit consumers by collecting and storing data for the intention of price discrimination. Moreover, firms, knowing how much consumers seek information regarding price and quality, could alter information to misguide consumers or present information in a confusing manner for consumers to make irrational decisions that favor the firm’s own self-interest.
Perfectly Contestable Market Firm Behaviour
1) Firms in a perfectly contestable market will not able sustain producing and pricing at.the profit maximising level of output Qm and Pm, where MC=MR. This is because the large supernormal profits being made will increase the threat of new entry into the market and with no barriers to entry or exit, this threat could become actual competition. Therefore firms change their behaviour to reduce this threat by making normal profits pricing at the entry limit price where AC=AR resulting in lower prices at Pc and higher quantities at Qc. At this point the incentive for new entry is taken away, thus the threat of entry diminishes. Over time, the incumbent can return to profit maximisation making supernormal profit.
How do firms change their behavior from monopoly pricing towards entry limit pricing in response to the threat of new entrants?
Firms will change their behavior from monopoly pricing towards entry limit pricing to be prepared if the threat of new entrants becomes real. By setting a lower price and higher quantity, the firm becomes competitive and thus prepared for competition if new firms actually enter the market. Entry limit pricing is a preemptive strategy used by firms to deter potential entrants by signaling to them that any attempt to enter the market will result in low prices and reduced profits.
What are the allocatively efficient outcomes that can be achieved in a contestable market?
In a contestable market, allocatively efficient outcomes can be achieved as firms are forced to reduce prices and increase quantities to negate the threat of new firms entering the market and to be as competitive as possible in case the threat becomes actual competition. Resources are more likely to be allocated according to consumer demand, with consumers getting what they demand at the quantity they desire. Consumer choice is high, and prices are low, increasing consumer surplus in the market compared to prior outcomes. Producers also benefit from such behavior as reducing the threat of entry allows for long-run profit maximization, and if the threat becomes a reality, the firm is well-positioned to compete successfully.
How can productive efficiency be achieved in a contestable market?
In a contestable market, productive efficiency can be achieved because firms will produce greater quantities where production takes place closer to the minimum point of the average cost curve to be competitive if firms enter the market. This means greater exploitation of economies of scale, which lowers average costs, translating into lower prices for the consumer and greater consumer surplus.
