Contestable Markets

Question 1

Define a contestable market.

Answer 1

A contestable market is a market which is very competitive due to a lack of barriers to entry and exit.

Question 2

What is the degree of contestability?

Answer 2

The degree of contestability measures the ease of a business entering the market; perfectly contestable markets with no entry or exit cost don’t exist, so this form of measurement is used.

Question 3

Give a charcteristic of a contestable market.

Answer 3

Firms must have freedom to enter and/or exit the market.

Question 4

Give another characteristic of a contestable market.

Answer 4

A new firm should not have a competitive advantage over other firms, they must have access to same technology.

Question 5

Describe a characteristic of a contestable market.

Answer 5

No sunk costs (costs that are incurred but can’t be recovered).

Question 6

Why shouldn’t there be sunk costs in a firm in contestable market?

Answer 6

Sunk costs make it much harder for a firm to enter or leave the market, significantly reducing contestability in the market.

Question 7

For incumbent firms, when does profit maximisation occur?

Answer 7

For incumbent firms, profit maximisation occurs in the short run, so abnormal profits are made here.

Question 8

Explain the strategy new entrants to a contestable market use.

Answer 8

The ‘hit and run’ strategy is used where entrants enter the market for profit maximisation in the short run, aiming to make supernormal profits. But they then leave the market once normal profits are made and prices go down, hence avoiding excessive costs.

Question 9

What method is used by incumbent firms to prevent ‘hit and run’ by new entrants?

Answer 9

Limit pricing can be used here, where prices are set below the profit maximising price, as low as possible to deter new entrants and decrease profit gained.

Question 10

Why do contestable markets make lower profits than a monopoly?

Answer 10

Existing firms who experience short-run profit maximisation at a price (P1), will lower the price below this ensuring this deters new entrants. This prevents the ‘hit and run’ strategy, but also causes less supernormal profits to be made than a monopoly.

Question 11

Give some signs of a highly contestable market.

Answer 11

• Low levels of abnormal profits
• Low sunk costs
• Lack of/Low barriers to entry and exit
• Low levels of collusion

Question 12

Give one way incumbent firms behave.

Answer 12

Create high barriers to entry if they can.

Question 13

Give another way incumbent firms behave.

Answer 13

In the long run, incumbent firms will move towards achieving productive and allocative efficiency.