Contestability Flashcards
Define what a contestable market
A market structure where it is easy for firms to join the market and compete
Characteristics of a contestable market
-Perfect knowledge
-No barriers to entry
-No brand loyalty
-No collusion
-prescence of “hit and run” competition
-High THREAT of competition
Describe hit and run competition
When new firms see that there are supernormal profits to be made, they will join that market then leave once they are satisfied with their returns.
Types of barriers to entry and exit
1.Legal barriers:
-Patents
-Copyrights
2.Sunk costs
3.Economies of scale
4.Brand loyalty
Define and give examples of sunk costs
Costs that cannot be recovered once they are made
-Advertising/Branding
-Research & development
-Specialist Machinery
Advantages and Disadavtages of a contestable market structure
Advantages:
1. Lower Prices Due to Threat of Entry
Even if a market is dominated by one firm, the threat of new entrants encourages it to keep prices low.
→ Firms behave competitively to deter entry.
→ Leads to prices closer to marginal cost, improving allocative efficiency.
→ Consumers benefit from greater consumer surplus.
- Increased Efficiency – Productive and Allocative
To remain competitive and avoid entry, firms aim to minimise costs and price competitively.
→ Encourages productive efficiency (producing at lowest cost) and allocative efficiency (price = MC).
→ Firms have to behave as if they’re in a perfectly competitive market — even if they’re not. - Greater Incentive to Innovate and Reduce Waste
To maintain competitive advantage and discourage entry, firms invest in new products, better tech, or customer service.
→ Dynamic efficiency is promoted even in concentrated markets.
→ Firms can’t afford to become inefficient or complacent.
Disadvantages:
1. In Reality, True Contestability Is Rare
Most markets have sunk costs, legal barriers, or brand loyalty (e.g. telecoms, airlines).
→ These prevent true contestability.
→ Incumbents can continue charging higher prices, reducing consumer welfare.
→ The theory may not match real-world outcomes.
- Short-Term Focus – Lack of Long-Term Investment
If entry is easy, firms may fear hit-and-run competition.
→ They may avoid long-term R&D or capital investment in case they don’t recover costs.
→ Reduces dynamic efficiency, harming innovation and long-term service quality. - Risk of Price Instability or Unsustainable Pricing
New firms may undercut prices unsustainably to break into the market.
→ May lead to short-term price wars and firm failure, then higher prices once competition drops.
→ Can hurt both firms and consumers. - Quality May Suffer if Firms Cut Costs
Firms focused on staying competitive may cut corners, reduce after-sales service or lower product quality.
→ Leads to productive efficiency, but at the cost of consumer experience.
→ Damaging in sectors like healthcare, transport, or education. - Hit-and-Run Entry May Create Market Uncertainty
If markets see frequent entry/exit, it may cause instability.
→ Existing firms may struggle to plan investment or maintain consistent employment.
→ Long-term market confidence and supply chains may weaken.