Contestable Markets

Question 1

Contestable Markets

Answer 1

• A contestable market is a market where there is free and costless entry and exit. This requires low sunk costs.
• Incumbent firms will always have the threat of new firms entering the industry. Therefore such a market will have a competitive equilibrium, even if there are a small number of firms.
A perfectly contestable market has the following three features:
1. Absence of sunk costs
2. Perfect information
3. Freedom to advertise and a legal right to enter the market

Question 2

Hit and Run Competition

Answer 2

• If there are low entry and exit costs then firms can engage in hit and run tactics. This means that if an industry is making supernormal profits then a firm can enter and take advantage of high prices.
• If prices fall and the industry is no longer profitable, then the firm will leave.
• Therefore, in a contestable market a firm should be satisfied with normal profits otherwise it would encourage hit and run tactics from other firms.

Question 3

Contestable Markets and the Public Interest

Answer 3

Contestable markets can bring the benefits of competitive markets such as:
• Lower prices
• Increased incentives for firms to cut costs
• Increased incentives for firms to respond to consumer preference.
• However there could also be significant economies of scale because the theory of contestable markets doesn’t require there to be many firms.
Therefore, policy makers should not just look at the degree of concentration, but also the degree of contestability and how easy it is to enter the market.
Regulators in the privatised industries have often focused on removing barriers to entry, rather than breaking up big firms.

Question 4

Methods to Increase the Contestability of Markets

Answer 4

• Remove legal barriers to entry
• Force firms to allow competitors to use its network
• Legislation against predatory pricing
• OFT can legislate against abuse of monopoly power