Contestable Markets

Question 1

Define a perfectly contestable market

Answer 1

A perfectly contestable market is one where ‘entry is absolutely free and exit is absolutely costless’. Hence, allowing the possibility of Hit-and-Run entry.

Question 2

What does the limit price do?

Answer 2

Maximises total surplus subject to a break even constraint (P=AC)

Question 3

Describe the sufficient conditions for a perfectly contestable market

Answer 3

1. All producers share the same technology
2. The technology is featured by economies of scale, but involves no sunk fixed costs
3. An entrant can enter and instantaneously produce at any scale
4. The incumbent’s response time is greater than the exit time of the entrant

Question 4

A market is contestable if its equilibrium industry configuration must be SUSTAINABLE. What do we mean by sustainable?

Answer 4

A sustainable industry configuration is FEASIBLE and such that no entrant with access to the same technology can profitably enter.
Feasible consists of an output for each firm and price such that the firms at least break even and the market clears.

Question 5

Should we regulate a perfectly contestable market?

Answer 5

NO! There’s no point if firms are producing at P=AC with zero profit to restrict entry. No anti-competitive behaviour

Question 6

What is the impact of economies of scale?

Answer 6

The threat of hit-and-run entry is restrained but does not eliminate it completely. Therefore, the issues of market power in markets with LONG RUN FIXED COSTS need not be a concern, regardless of the number of firms in the industry

Question 7

In a perfectly contestable market what is the important factor about sunk fixed costs to consider?

Answer 7

There aren’t any! Fixed costs by definition do not depend on output - they should depend on the time of employment of the fixed output. Hence, by entering and having intensive production in an extremely short period of time, a firm can eliminate the fixed sunk costs by exiting straight away.

Question 8

How can the robustness of contestability be tested?

Answer 8

The relationship between the extent to which costs are sunk, the response time and the price the monopolist can change without inviting entry

Question 9

Discuss a piece of empirical evidence

Answer 9

Airline industry - mobile so fixed costs are not sunk! The theory predict there would be a correlation between market structure and pricing (not supported by evidence). Why? Because despite the mobility of air-planes there are other sunk expenditures e.g. marketing. There is no response time lag, the incumbents can match the entrants swiftly and aggressively.

Question 10

What do we mean by barriers to entry?

Answer 10

Anything that allow incumbent firms to make supernormal profit without attracting entry, then there are no barriers to entry in a perfectly contestable market.
The height of barriers to entry is the extent to which the incumbent can raise prices about LR min costs without inducing entry (BAIN)

Question 11

Factors contributing to barriers to entry

Answer 11

Economies of scale
Absolute cost advantage
Product differentiation