Contestable Markets

Question 1

The theory of contestable market

Answer 1

Potential competition determines how the market behaves
- competition with firms that are not currently in the market

Question 2

What does the theory of contestable market depend upon?

Answer 2

That there is no barriers to entry or exit
- low start up costs etc

Question 3

Why does the theory of contestable market imply that it’s possible for a market to be competitive even if there is only one?

Answer 3

There is potential competition and so incumbent firms fear new firms entering the industry and so are incentivized to charge lower prices
- worried that if prices are really high but outside firms can enter the market with lower prices and steal market share
- so they are going to lower price so this new firm will leave the market
- only make normal profit in the long run due to lowered price

Question 4

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How have markets become more contestable in recent years?

Answer 4

The rise of the internet has massively lowered barriers to entries an exit
- some firms don’t even need a physical premise and can operate online

Question 5

What is the difference between a contestable and uncontestable monopoly?

Answer 5

The prices are lower in a contestable monopoly

Question 6

Is the theory of contestable markets realistic?

Answer 6

In reality, there is going to be some barriers of entry

Question 7

Advantages of contestable markets

Answer 7

1. Lower price
- the price in a contestable monopoly market is lower than a non-contestable market very quickly stole
- due to potential competition determining how firms behave

2. Research and development
- competition so they may invest into R&D to innovate and improve products
- prevents outside ferbs from entering the market
- higher quality products, more choice and improves consumer welfare

3. Closer to productive efficiency
- firms aren’t restricting outputs to increase their price so they are able to benefit from economies of scale
- operating closer to the MES

4. Closer to allocative efficiency
- prices are closer to marginal costs so closer to the optimal allocation of resources

5. X-efficiency
- it would open the door for outside firms to enter the industry as they may be more productive and have lower costs so lower prices
- this incentivizes firms to be more productive to prevent this

6. Output increases
- more people can afford goods and services as lower prices
- derived demand for labour increases so unemployment decreases

Question 8

Disadvantages of contestable markets

Answer 8

1. Higher prices in short run
- the price in a contestable Monopoly market may still be high at these firms may only decide to lower when there is potential competition
- when the potential competition leave the market, the firms may decide to rise the price again

2. Dynamically inefficient
- don’t make any super normal profit and so may not have enough money to invest into R&D

3. May act in an anti-competitive manner
- overtime, firms may decide to act in an anti-competitive manner and take measures that make it harder to enter the market or industry