Contestable Markets

Question 1

What are the factors of a contestable market?

Answer 1

• A contestable market is a market where there is free and costless entry and exit. This requires low sunk costs.
• Sunk costs are costs that cannot be recovered when leaving the market, e.g. expenditure on advertising is lost.
• In a contestable market, 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.

Question 2

What is 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

Pros and cons of contestable markets

Answer 3

Pros:

• 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.

Cons:

• 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.
• It can be important to allow firms to share a distribution network, which is a natural monopoly, e.g. consumers can buy gas from different companies selling gas, whilst using the same national network of gas pipes.

Question 4

What is a horizontal integration?

Answer 4

This occurs when two firms at the same stage of production merge e.g. Guinness and Heineken, two beer-brewing companies.

Question 5

What is a vertical integration?

Answer 5

When two firms at a different stage of production merge. For example, a company who produces beer could buy a chain of pubs to sell the beer.

Question 6

What is a forward vertical integration?

Answer 6

This is when a firm acquires another firm at the next stage of production, e.g. a firm like Ford which manufactures cars could purchase a car sales room.

Question 7

What is a backward vertical integration?

Answer 7

When a firm acquires another firm at a previous stage of production,e.g. a clothes retailer buying a manufacturer
of clothes ,or a beer producer buying a farm which produces hops (ingredient used for brewing beer).

Question 8

Pros and cons of intergration

Answer 8

Pros:

1. Economies of scale. This occurs when a larger firm with increased output can reduce average costs. This is important for industries with high fixed costs.
2. Mergers can help firms compete on an international level.
3. Mergers may allow greater investment in R&D, because the new firm will have more profit. This can lead to a better quality of goods for consumers.

Cons:

The legal definition of a monopoly is a firm with more than 25% of the market. If the firm has monopoly power,
there could be the following disadvantages:

1.Higher prices leading to allocative inefficiency and a reduction in consumer surplus.
2. Monopolies are more likely to be productively inefficient.
3.If there is less competition, complacency amongst firms can lead to lower quality of products, less choice
and less investment in new products.
4.The new firm can pay lower prices to suppliers (monopsony power).
5.Mergers can lead to job losses.
6.Motives for mergers may primarily be based on increasing prestige and wages of workers concerned.
7.If the firm becomes too big,it may suffer from diseconomies of scale