3.4.7 - contestability Flashcards
what is contestability
This model is concerned with the possibility of other firms entering the market if they see the opportunity to make money, rather than the number of firms in the industry at a point in time. A contestable market is one with a high threat of new entrants, which keeps firms producing at a competitive level. Even in a monopoly, a firm may be forced to be efficient due to the potential of new entrants to the market. Any attempt to make a huge profit will mean other businesses will be attracted to the industry.
what are the characteristics of a contestable market
● Within a contestable market there is perfect knowledge so if one firm is making
abnormal profits, other firms will enter the market.
● There is freedom of entry and exit meaning any firms can enter/leave the market. There will be a relative absence of sunk costs. Firms will be able to and have the legal right to use the best available technology, meaning their average cost curve will be the same as the original firms’.
● There will be low product loyalty, meaning people don’t consistently use one brand and are happy to switch if a new one enters the market.
● We assume firms are short run profit maximisers and do not collude with each other.
● Some examples of contestable markets are: the taxi industry, with the introduction of Uber; the hotel market, with AirBnB; and fast food, due to Five Guys. Another example of contestability is Ocado, who are set to replace M&S in the FTSE 100 (2018), showing the new replacing the old.
what are the implications of a contestable market ( conclusions that can be drawn )
● In a contestable market, firms will 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. The only way to prevent this is by using limit pricing, which reduces the incentive for firms to enter the market.
● In a perfectly contestable market, firms will only be able to make normal profits and produce where AC=AR because new firms will enter the market if price was any higher and they were making monopoly profits.
● Firms are likely to be productive and allocative efficient. If they are not producing at the lowest point on their AC curve (i.e. not productively efficient), 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. Since they can only make normal profits AC=AR, and since they produce at the lowest point on their AC curve AC=MC. Therefore, AC=MC=AR, so the value to society is equal to the cost.
what are the types of barriers to entry in a contestable market
Legal barriers can prevent new firms from entering an industry. Laws are put in place which make it more difficult for firms to enter the market, or explicitly mean they cannot enter. For example, patents and exclusive rights to production (such as with television) mean other firms cannot enter the market. Some industries, such as the taxi industry, gain market licences to operate.
● Other firms can put up marketing barriers. High levels of advertising build up consumer loyalty, so demand becomes more price inelastic, and consumers are less likely to try other brands. Sometimes a brand can become associated with a product, such as ‘Hoover’ with vacuum cleaners. New firms entering the industry are unlikely to have the funds to undertake large scale advertising so struggle to compete with the incumbent firms. This may also be a barrier to exit, since losing a brand and consumer loyalty will be a cost of leaving the market.
● The pricing decisions of incumbent firms can be a barrier to entry. Predatory pricing means prices are so low that firms are driven out of the market, and so it would be extremely difficult for new firms to enter. Limit pricing discourages the entry of other firms as prices are set at a level to prevent new entrants.
Some industries have high capital start up costs, for example buying the machinery necessary to begin production. Sunk costs may also be high.
● Economies of scale mean that new firms are unable to produce on the same AC curve as large, incumbent firms. If they were to enter the industry, their costs would be higher and so prices would be higher and they would be unable to compete.
● Barriers to exit prevent firms from leaving a market quickly and cheaply. They include the cost to write off assets, pay leases and make workers redundant.
