Micro 22 - Contestable Markets

Question 1

What does contestable market theory focus on?

Answer 1

Contestable market theory focuses on the threat of potential competition rather than actual competition

Question 2

What is a contestable market?

Answer 2

A contestable market is one in which there is freedom of entry to the industry and where costs of exit are low

Question 3

What are the four main features of a contestable market?

Answer 3

1- There is threat of entry from a pool of potential entrants due to low barriers to entry or exit. This could be because of an absence of sunk costs, perfect information and a low MES
2- There is perfect information - eg. technology available to incumbent firms is also available to new entrants
3- New firms have no competitive advantage compared to incumbent firms
4- Incumbent firms are vulnerable to hit and run competition so only normal profit is likely in the long run

Question 4

What is hit and run competition?

Answer 4

Hit and run competition occurs when firms can enter a market at low cost attracted by high supernormal profits and then leave the market at low cost when profits fall

Question 5

Draw a costs and revenue diagram showing a likely change in objectives for incumbent firms in a contestable market to eliminate the threat of new entrants

Answer 5

• It is a diagram changing from profit max at MR=MC to sales max at AR=AC to stop making SNP which may attract new firms to the market
• The firm will become more productively efficient as they are now closer to the bottom of the AC curve
• They will become more allocatively efficient as the new price is closer to marginal cost
• Label the change in consumer surplus as well

Question 6

What are the limitations of contestable market theory?

Answer 6

• No market is perfectly contestable. In real life there are always some barriers to entry and exit and incumbent firms are realistically likely to have some competitive advantage over new entrants
• It is difficult to predict the behaviour of incumbent firms
• Contestability may change over time as incumbent firms may create their own artificial barriers to entry
• There is never perfect knowledge in an industry

Question 7

What are the factors that affect the contestability of a market?

Answer 7

• Deregulation
• Tougher competition laws
• Changes in technology
• Labour laws
• Patents