Contestability

Question 1

What is contestability and what are the conditions(3) for a perfectly contestable market?

Answer 1

The theory of contestability suggests it is not the market structure that determines a firms behaviour, but the contestability of the market.

The idea of a contestable market is that if firms can enter and leave the market easily, then existing firms in the market will not profit maximise because by doing so they will open themselves up to “hit & run attacks” from firms entering a profitable market to take a share. In the long term a firm in a contestable market may be better off making only normal profit and not encouraging “hit&run attacks”.

For a market to be perfectly contestable 3 conditions must be met:

1. Perfect information & access to production techniques
2. Freedom to advertise and legally enter the market
3. No sunk costs

Question 2

What are sunk costs?

Answer 2

Sunk costs are costs a firm would incur if it entered and operated in the market and are irrecoverable if the firm decided to leave the market (barriers to exit).

Question 3

How does a firm in a contestable market act?

Answer 3

The basic idea is that the fear of new entrants will make a firm, even a monopolist, act as if there was competition. That is it will be price competitive. It will try to improve the quality of the product, it will try to be efficient, etc.

If a market is perfectly contestable, then even if the firm is in a monopoly position it will still only make normal profit because of the threat of hit& run tactics of other firms. If the firm were to make supernormal profits other firms would be tempted to enter (no sunk costs) and steal some of the profit. These firms would then leave the market once no profit/a loss was being made. This means the firm would be sales maximising.

In a less than perfectly contestable market the incumbent (existing firm) may make some supernormal profit, so long as it is less than the sunk costs of new firms - that way they are not tempted to enter the market.

Question 4

What implications does the theory of contestability has for the government?

Answer 4

This has significant implications for governments trying to encourage competition - they don’t have to “force” new firms to enter the market (or split up monopolies), just make it possible for new firms to enter.

Question 5

How can we tell if a market is uncontestable(6) or constestable(6)?

Answer 5

An uncontestable market has the following features:

• large existing brand loyalty/sunk costs of advertising
• existence of barriers to entry or sunk costs (industry specific)
• EoS as a barrier to entry. If a firm unable to achieve MES cannot enter the market
• incumbent firm may cross-subsidise & so able to limit price
• high profits may suggest not contestable
• existence of patents

A contestable market may have these features:

• market growing? opportunity for niche markets
• possible diseconomies (&/or lack of synergies, if referring to a merger)
• low profits may suggest is & firms are acting as if there was competition
• impact of internet on contestability
• evidence new firms have entered (by definition must be contestable)
• depends on image/resource of firms entering (cross-subsidising)

Question 6

What are the problems with the theory of contestability?(3)

Answer 6

1. No market is perfectly contestable - there will always be some sunk costs, and the incumbent firm is likely to have better market knowledge
2. Are firms really scared of hut&run attacks? Why not make a large profit until an attack comes, then cut prices heavily to force the newcomer out?
3. If no firms try to enter a market is it because of a lack of contestability or because no new firms want to enter the market?