Contestable Markets

Question 1

What is a contestable market?

Answer 1

A fully contestable market is a market without barriers to entry or exit, it can still be dominated by one or a few firms if normal profits are earned

Question 2

What are 4 conditions of a perfectly contestable market?

Answer 2

• There are low or zero barriers to entry
• Infinite firms must be ready to enter the market when supernormal profits are earned
• Perfect information
• Susceptible to hit and run competition

Question 3

Why do technological improvements increase contestability, and why might it actually decrease contestability?

Answer 3

Technological improvements generally reduce: start up costs, sunk costs and economies of scale (technical barriers to entry)

It may decrease contestability if the technology is high end with large costs

Question 4

Why do firms in a contestable market earn normal profit?

Answer 4

To prevent the entry of new firms which means they’d lose market share and revenue. Normal profit = earning the same amount of profit as other markets/ profit isn’t high enough to attract new firms

Question 5

What is another name for contestable firms moving their price to normal profit?

Answer 5

Limit pricing

Question 6

What is hit and run competition?

Answer 6

When firms enter a market temporarily when supernormal profits are available

Question 7

What is cream skimming competition?

Answer 7

When firms operate in a subsection of a market that is most profitable

Question 8

What are the efficiency gains of a contestable market?

Answer 8

• Allocatively efficient
• Increased consumer surplus due to decreased price
• Removed dead weight loss
• More choice for consumers as output is higher
• Greater productive efficiency, AC does not equal MC but firms have to reduce AC to keep AR at limit price
• Decreased X inefficiency as firms need to keep AC low to limit price
• Job creation as labour is derived demand and firms increase output

Question 9

What are the inefficiencies of contestable markets, and counters to some of these?

Answer 9

• Reduced dynamic efficiency due to normal profits (though new firms entering the market can innovate forcing incumbents to innovate too)
• Cost cutting to reduce X inefficiency can reduce quality or cause unintended consequences
• Job losses if firms are outcompeted (but overall reduction in unemployment due to overall increase in output
• Incumbents may act anti competitively in the long run (strategic barriers to entry)

Question 10

Why may a market that’s been made more contestable only be contestable in the short run?

Answer 10

Incumbent firms may create strategic barriers to entry and new inventions/ innovation may also cause barriers to entry