Contestable markets Flashcards
Contestable market
A market where new entrants/firms can easily enter and compete with established firms, even if those firms have significant market share
Incumbents
Established/existing firms in a market
What does the threat of new competitors/firms do in a contestable market?
The threat of new competitors/firms entering the market keeps existing firms on their toes, spurring them to be more efficient and competitive and ultimately leading to lower prices and better products for consumers(lower profits aren’t as attractive for new entrants)
Examples of barriers in contestable markets
Product differentiation, leads to brand loyalty, which enhances confidence the new entrants can’t come in(brand loyalty may entitle you for copyright, so no other firms can replicate your products)
Key idea in a contestable market
If entry into the market is relatively easy and exit is not costly(no worrying about sunk costs), even a monopoly or a small number of dominant firms will act as if they’re in a highly competitive environment
Examples of entrants in a contestable market
Metro Bank only emerged a few years ago as a new entrant to the banking system, but the banking system has already had other existing firms on the High Street, therefore the banking system could be seen as a contestable market.
“Hit and run”
An entrant coming into the market, grabbing profit and then exiting, taking advantage of temporarily high supernormal profits. Contestable markets are vulnerable to this, due to low barriers of entry/exit.
Example of hit and run competition - protein drinks
Contestable market
Where a new market entrant has equal access to all production techniques available to the incumbents, and where entry decisions can be reversed without cost. Market entrants don’t have to worry about sunk costs
Contestable market main characteristics
Absence of sunk costs(firms go in to a market, take money and get out)
Equal access to technology
Weak brand loyalty(if there’s no strong brand loyalty, customers are willing to switch easily)
Low barriers to entry
Freedom of exit(no significant entry or exit costs)
Perfect information
Fear of entrants(due to existing firms wanting to continue to earn supernormal profits)
Low barriers to entry in a contestable market
New firms can easily enter and start operating without facing significant obstacles. Barriers can include high startup costs, limited access to resources, regulatory restrictions and technological entry barriers.
Freedom of exit in a contestable market
Without incurring substantial costs or losses - firms can withdraw from the market if conditions become unprofitable without suffering excessive financial harm
Perfect information(contestable market)
For market participants, including potential entrants - information covering market conditions, prices and the strategies of existing firms, allowing firms to make informed decisions
No sunk costs(contestable market)
Sunk costs should be minimal or non-existent, reducing the risk associated with entering the market and making it easier for potential entrants to consider market entry
What can be used to increase brand loyalty?
Loyalty cards(in shops)
Sunk costs-
Costs that can’t be recovered if a business decides to leave an industry. The existence of high sunk costs makes a market less contestable.
Impact of massive sunk costs
Firms disappearing on High Street
What happens when a firm leaves a marke?t
Fire-sales of business assets and unsold stock at rock-bottom prices may be needed
Costs to a firm leaving an industry/other examples of sunk costs
Lost business goodwill and customer loyalty(which is worth a lot of money)
A company has invested £50 million in a factory, but the factory is now outdated and unable to compete with newer technologies. The £50 million has already been spent and cannot be recovered, so it shouldn’t be taken into consideration when deciding whether to renovate the factory or shut it down.
Examples of markets that have become more contestable in recent years
Food retailing(new entrants such as Lidl have caused quick growth, faster than incumbents)
Fast Food Industry
Book selling
Differences between perfect competition and contestable markets
Perfectly competitive markets have many suppliers, contestable markets have no set number of suppliers.
Perfect competitive markets sell homogenous products, while contestable markets sell differentiated products.
There are no entry or exit barriers in perfectly competitive or contestable markets - no exit costs in contestable markets due to assumptipn of no sunk costs
Perfectly competitive markets have no firms which have pricing power(each firm is a price taker, as AR= MR), while firms in a contestable market have some pricing power, but they’re influenced by the threat of hit and run competition
What can help make a market more contestable?
- Lowering legal barriers to entry such as reform of patents/allowing more operating licences
- Impact of new technologies such as e-commerce which make it easier for smaller firms to enter - innovative digital entrants can scale quickly
- Trade agreements that make it easier for competition from imports. Globalisation also brings a reduction in trade protectionism, the most likely explanation for such an increase in contestability.
- Entrepreneurial zeal can make a difference
- Stronger government laws against the growth of monopoly through merger
Example of increased contestability: The UK parcel delivery market has become highly contestable with new entrants, while Brewdog is fast becoming a challenger to established industrial brewers
Deregulation
Removing some of the barriers to competition e.g. by allowing more licences for new competitors to operate. This then increases market contestability.
Types of entry barriers
Economies of scale(cost asymmetry)- the greater the economies of scale a firm exploits, the less likely it is a new firm enters the market, because they would produce comparatively expensively(innocent barriers to entry).
Vertical integration: one firm gains control of the market, creating a barrier to entry
Brand loyalty - demand’s more price inelastic: consumers are less likely to try other brands
Expertise, goodwill and reputation
Legal barriers e.g. patent protection, copyright and trademark
How trade barriers impact contestability
Trade barriers between countries such as quotas decrease contestability, because it then limits the volume of goods and services that can come in to compete directly with domestic firms
How might the behaviour of firms be different in a contestable market?
Threat of potential competition means existing firms might choose limit pricing over profit maximisation(example of strategic barriers to entry)
They also focus on non-price competition.
New entrants might go for sales growth max - in a bid to establish market foothold
How a highly contestable market leads to economic efficiency?
Contestable markets bring:
1. Lowered prices(improved allocative efficiency)
2. Incentives for firms to cut costs(improved x-efficiency): keep unit costs under control and avoid managerial slack(competitive advantage for firms)
3. Incentives for firms to innovate(dynamic efficiency)- to gain a competitive advantage
4. Scope for economies of scale(large firms can exist!)
5. Productive efficiency
Why an increase in market contestability is likely to improve allocative efficiency
Increased competition puts downward pressure on prices towards MC as firms strive to offer better deals to customers. They face actual competition and the threat of hit and run entry.
What explains the survival of small firms when large and small firms often exist side by side in industries, in many developed economies?
Small firms provide a more personal level of consumer service than larger firms.
