LS14 - Contestable Market Flashcards
What are the characteristics of a contestable market?
• Low barriers to entry & exit and no sunk costs
- Perfect knowledge
• Equal access to technology – existing firms do not have an advantage
• No collusion
• Weak brand loyalty
It does not matter how many firms are in the industry, but there must be free/easy entry and exit into and out of the industry
What is a sunk cost?
These are costs that cannot be recovered (in whole or in part) if a business decides to leave an industry. this is
What benefits or costs can contestable markets bring?
Price Competition: Firms in contestable markets tend to engage in intense price competition since they know that new entrants can easily undercut their prices if they attempt to charge excessive prices. Lower prices (improved allocative efficiency)
Efficiency and Innovation: Firms have an incentive to operate efficiently and innovate to maintain a competitive edge. In a contestable market, the threat of new entrants drives firms to continually improve their products and processes. Incentives for firms to cut costs (improved x-efficiency). Incentives for firms to innovate (dynamic efficiency)
Short-Term Focus: Firms may have a short-term focus on maximizing profits since they are aware that the market conditions can change rapidly with the entry of new competitors.
No Monopoly Power: Contestable markets discourage firms from attempting to establish and maintain monopoly power since any attempt to do so is likely to be short-lived.
What is a hit and run entry?
when a business enters an industry to take advantage of temporarily high (supernormal) market profits.
Why do incumbent firms in a contestable market have to be competitive?
Existing or incumbent firms (i.e. firms already in the industry) are under constant threat of competition as there are no/low barriers to entry and exit
• If this threat of potential competition is credible, firms (even a monopoly) will have to behave more competitively or new firms will join to try and compete for a share of the supernormal profits
• New entrant(s) might go for sales growth max– in a bid to establish a market foothold; entry can also be ‘hit-and-run’ from a challenger firm
How might incumbent firms in a contestable market, prevent the entry of new firms into the industry? (Using price/profit)
• Existing firms might choose limit pricing over profit maximisation
• They may also focus on non-price competition
What is limit pricing?
firm sets its price low enough to deter new entrants
(AR=AC).
Define contestable market
Where an entrant has access to all production techniques (IT/infrastructures) available to the incumbent firms, the entrant is not prohibited from taking the incumbent firms’ customers, there are no sunk costs. The key assumption of a contestable market is free entry into and exit from the market.
Explain two ways in which incumbent firms may increase their competitiveness using non-deterrence strategies.
Advertising and publicity: advertising is a fixed cost and it may become difficult for new firms to become established as they will need to advertise widely in order to attract customers. Incumbent firms may spend heavily to achieve a well-known brand image to ensure customer loyalty. Advertising costs cannot be recovered if the new farm fails to gain a foothold this reduces the contestability of a market.
Research and development: this is another component of fixed costs and includes heavy expenditure undertaken on research and development . A prominent example is a pharmaceutical industry where there is much spending on research into new drugs. This reduces contestability as new firms who wish to enter the market need to invest heavily in R&D to become competitive.
What are the objectives of tacit collusion?
To coordinate prices, avoid competitive price cutting, limit competition, reduce uncertainties, and increase profits.
What are some examples of barriers to entry/exit
Economies of Scale: incumbent firms who produce at lower average costs may deter new entrants, as newcomers may struggle to compete with established firms’ cost advantages.
Capital Requirements: High startup and capital investment costs can be a significant barrier to entry, especially in industries requiring expensive equipment or infrastructure.
Government Regulation: Regulatory barriers, such as licensing requirements or safety standards, can limit entry into certain markets.
Access to Distribution Channels: Difficulty in accessing distribution channels or securing shelf space can act as a barrier, particularly in industries with established distribution networks.
Brand Loyalty: Established brands with strong customer loyalty can deter new entrants from gaining market share.
Network Effects: it can be challenging for new entrants to compete with established networks.
Patents and Intellectual Property: Firms with strong patent protection or proprietary technology can create barriers to entry by preventing others from using their innovations
What are network effects?
Where the value of a product or service increases with the number of users
