Th3.4: Implications

Question 1

What will firms do in a contestable market?

Answer 1

enter the market if they see other firms are making huge profits - they will remain in the market until competition prevents them from making a profit. this will take away profit from the original firms and could even force them out of business

Question 2

What is the only way to avoid this?

Answer 2

using limit pricing, which reduces the incentive for firms to enter the market

Question 3

In a perfectly contestable market, why will firms only be able to make normal profits and produce where AC = AR?

Answer 3

because new firms will enter the market if price was any higher and they were making monopoly profits

Question 4

What kind of efficiency are these firms likely to be?

Answer 4

productive and allocative efficient

Question 5

What happens if these firms aren’t producing at the lowest point on their AC curve?
(i.e not productively efficient)

Answer 5

new firms can enter the market and undercut them by offering lower prices - due to this and the fact they can only make normal profits in the long run, they must also be allocative efficient

Question 6

Since they can only make normal profits…

Answer 6

AC = AR

Question 7

Since they produce at the lowest point on their AC curve…

Answer 7

AC = MC

Question 8

Therefore, AC = MC = AR so the value to society is…

Answer 8

equal to the cost