Contestability

Question 1

What does perfect competition and monopolistic competition have in common?

Answer 1

Many small sellers and buyers

Question 2

So a market that isn’t contestable will have:

Answer 2

High barriers to entry e.g. high sunk costs and economies of scale

Question 3

Explain why the airline market has high barriers to entry:

Answer 3

Reasons might include: huge economies of scale, high sunk costs and brand loyalty.

Question 4

Contestable market

Answer 4

A market with low barriers to entry/exit.

Question 5

Contestability

Answer 5

How easy it is to enter a market.

E.g. the airlines market has low contestability because it’s tough to enter.

E.g. the mango market has high contestability because it’s easy to enter.

Question 6

Hit & run competition

Answer 6

In contestable markets, if an incumbent firm is making supernormal profit in the short run, new firms will enter (or “hit”) industry.

They’ll undercut the incumbent firm to steal away its consumers and make supernormal profit.

To get rid of the new entrants, the incumbent firm has to set price = AC so only normal profit can be made. New firm will then leave the market (“run”) because supernormal profit is gone.

Question 7

Explain what will happen to Ted’s supernormal profit as we move into the long run. (4 marks)

Answer 7

Ted’s supernormal profits will incentivise new sellers to enter the market.

Because the star wars origami market is contestable (i.e. there are low barriers to entry/exit), new firms will enter the market and compete by undercutting Ted, stealing his consumers and making their own supernormal profit.

The only way to get rid of the new competitors is for Ted to set the price = AC, so only normal profit can be made and the entrants have no reason to compete

Question 8

If Ted ever puts his price back up above AC:

Answer 8

There are low barriers to entry, so new firms will immediately enter the market and undercut him

Question 9

Explain what will happen to an incumbent firm’s short run supernormal profit when we move into the long run. Refer to the concept of “hit and run competition” in your answer. (4 marks)

Answer 9

If an incumbent firm is making supernormal profit in the short run, its price must be above its AC.

This leaves the incumbent firm open to “hit and run competition”.

The supernormal profit will incentivise new firms to enter the industry and because the market is contestable, there are low barriers to entry/exit, so it will be easy for new firms to enter.

New firms will therefore enter (or “hit”) the industry. They’ll undercut the incumbent firm to steal away its consumers and make supernormal profit.

To get rid of the new entrants, the incumbent firm has to set price = AC so only normal profit can be made.

The new firm will then “run”: they will leave the market because all the supernormal profit is gone.

Question 10

And so to avoid the hassle of hit and run competition, incumbent firms will:

Answer 10

Set price = AC