Contestable Markets Flashcards
What Is Contestability?
A market is contestable is one where entry is free and exit is costless. There is a potential threat of competition from new entrants.
What Are Characteristics Of Contestable Markets?
Pool of potential entrants seeking to enter the market.
Entry and exit are costless. No sunk costs. When firms leave the market they can recover all their investment by reselling used assets without loss.
All firms are subject to the same regulations and state of technology.
Mechanisms are in place to prevent limit pricing.
Possibility of “hit and run “ competition as new firms enter the market to make quick profits and exit.
Possibility of normal profits in the long run.
What Is Degree Of Contestability?
The extent to which barriers to entry into a market are non-existent (free) and exit from the market is costless.
No market is perfectly contestable. There are always some barriers to entry and some costs when firms exit the market.
The lower the entry and exit barriers the more contestable a market is likely to be.
What Are Impacts Of Market Contestability On Firm Behavior In Highly Contestable Markets?
Firms are likely to:
Cut prices to remain competitive.
Improve product quality through R&D and innovation (dynamic efficiency).
Become more efficient to benefit from economies of scale (productive efficiency).
Shift from profit maximization to sales maximization to increase market share and to charge lower prices.
Raise artificial entry barriers like advertising to create brand loyalty.
Use pricing strategies like limit pricing to discourage entry of competitors.
Exit the market when profits decrease.
What Are Impacts Of Market Contestability On Firm Behavior In Less Contestable Markets?
Firms are likely to:
Be complacent.
Maintain high prices.
Restrict output to maintain high prices.
Be productively inefficient.
Be X-inefficient.
Be dynamically inefficient.
What Are Costs And Benefits Of Contestability?
Contestable markets make it easier for firms to enter the market. This increases competition. Firms are likely to be productively and allocatively efficient.
Firms will have to keep costs down in order to remain competitive and reduce or eliminate X-inefficiency.
Prices in contestable markets are likely to be lower and nearer to prices in competitive markets. Firms need to be productively efficient to set low prices.
If large firms dominate contestable markets economies of scale lead to lower average costs. This could lead to lower prices and a higher consumer surplus.
There are increased incentives for firms to respond to consumer preferences. Firms are likely to be allocatively efficient.
What Are Costs Of Contestability?
Firms may use limit pricing to deter new entrants and therefore only earn normal profit.
Low normal profit made by firms will reduce funds available for R&D. Firms are not likely to achieve dynamic efficiency
If there is a small number of firms in the market consumer choice will be limited.
