Contestable Markets

Question 1

What are contestable markets?

Answer 1

A market where there is freedom of entry to the industry and where costs of exit are low.
- in contestable markets, firms face real and/or potential competition
—> states that every market is contestable to a degree, even monopolies or oligopolies. It has a big effect on behaviour of existing firms

Question 2

What are the conditions necessary for a perfectly contestable market?

Answer 2

• perfect information - and the ability and legal right to use the best available production technology in the market
• the freedom to enter the market
• the relative absence of sunk costs - this reduces the risks of coming into a market

Question 3

What are sunk costs?

Answer 3

These are costs committed by a business which cannot be recovered once a firm has entered the industry
E.g. advertising, insurance, specific capital equipment

Question 4

What are the profits in a contestable market?

Answer 4

Supernormal profits can only be earned in the short run
- only normal profits in the long run

Question 5

What does contestable theory suggest?

Answer 5

Depends to a large extent on the costs of exit from the industry.
- assumes a competitor enters an industry and take market share by lowering prices. The response for incumbent firms is to lower prices more so the competitor leaves as cannot compete as costs are too high. As long as the cost of leaving the industry is small, it still makes sense as the competitor earned lots of profits by entering the industry in the short run
- if the firm has not had to spend much on sunk costs or can sell any equipment - or even rented equipment for short term use, the firm has lost little by entering - yet earned much profit

Question 6

What is hit and run?

Answer 6

Short run entry into a contestable market seeking to take one of the supernormal profits available and then get out quickly and costlessly

Question 7

So if an industry is contestable, what might incumbent firms be forced to do?

Answer 7

Act as if they are in competition and only earn normal profits because of the threat of hit and run tactics

Question 8

What is the efficiency like in constestable markets?

Answer 8

—> potential competition may be more important for efficiency than actual competition
- lower prices (allocative efficiency)
- increased incentives for firms to cut costs (dynamic efficiency)
- increased incentives for firms to respond to consumer preferences (allocative efficiency)
—> yet there could be economies of scale - as contestable markets doesn’t require there to be 1000s of firms

Question 9

Why are markets becoming increasingly contestable?

Answer 9

• deregulation
• tougher competition laws
• changing nature of technology has reduced entry costs to some markets - increased capital mobility
• trading blocs
• increased entrepreneurial zeal - persistence by entrepreneurs in challenging the current market structure