3.1.15 - Contestability

Question 1

What is contestability in a market?

Answer 1

A measure of the extent to which a market is open to new entry

Question 2

What characterizes a perfectly contestable market?

Answer 2

No barriers to entry or exit

Question 3

According to contestability theory, what determines market behavior?

Answer 3

The level of barriers to entry, not the number of firms

Question 4

What does contestability theory suggest about monopolistic or oligopolistic markets?

Answer 4

They could have low prices, high output, and be efficient if contestable

Question 5

What is the implication of the threat of new firms entering the market?

Answer 5

It influences existing firms to behave competitively

Question 6

What is ‘hit and run’ competition?

Answer 6

The phenomenon where firms enter a market to exploit supernormal profits and exit when profits diminish

Question 7

How do existing firms respond to the threat of new entrants?

Answer 7

They set prices at a level that only allows normal profits

Question 8

What happens when barriers to entry are reduced in a market?

Answer 8

The market becomes more contestable, allowing new entrants

Question 9

Fill in the blank: A bus company with a license to operate has a barrier to entry, allowing it to charge £3 per journey and make _______.

Answer 9

supernormal profits

Question 10

What occurs when a market is deregulated and licenses are eliminated?

Answer 10

Barriers to entry are reduced, making the market more contestable

Question 11

In the example of the bus company, what effect does the local entrepreneur entering the market have?

Answer 11

It leads to price cuts by the bus company until only normal profits are made

Question 12

True or False: A competitive market can exist with a single firm if the market is contestable.

Answer 12

True

Question 13

What is one potential benefit of a contestable market mentioned in the text?

Answer 13

No inefficiency through duplicated timetables, routes, etc.

Question 14

What does contestability in markets imply?

Answer 14

The threat of competition can lead to desirable properties of perfectly competitive markets

Question 15

What are the conditions necessary for contestability to affect prices and quantity?

Answer 15

No entry or exit barriers

Question 16

True or False: Monopolists can exploit consumers by raising prices in a contestable market.

Answer 16

False

Question 17

How does the threat of competition impact monopolists in a contestable market?

Answer 17

Other firms would enter the market and erode their market share and profit

Question 18

What is the relationship between contestability and market prices?

Answer 18

With contestability, prices can be low

Question 19

What is the relationship between contestability and market quantity?

Answer 19

With contestability, quantity can be high

Question 20

Fill in the blank: The standard belief that monopolists exploit consumers is based on the assumption that they can reduce output, raise prices, and earn _______.

Answer 20

supernormal profits

Question 21

What does the theory of contestable markets argue about productive efficiency?

Answer 21

It argues that if a market is contestable, it will force firms to be productively efficient and produce at the lowest possible average cost.

Question 22

What happens if firms in a contestable market are not productively efficient?

Answer 22

A new entrant could produce at a lower average cost, undercut the existing firm on price, and capture some of the market.

Question 23

In a perfectly contestable market, what is expected of firms regarding their production?

Answer 23

Firms are expected to be productively efficient, producing where average cost (AC) is at its minimum.

Question 24

Fill in the blank: In a contestable market, firms must produce at the lowest possible _______.

Answer 24

average cost.

Question 25

What happens if there is an uncontestable market with a sole firm operating within it?

Answer 25

The firm will be able to make Supernormal Monopoly Profits, as shown on the diagrm

Question 26

What is the lowest price a monopoly will be forced to lower to in a contestable market?

Answer 26

The lowest point on the AC curve, i.e., at price Pcon (price contestable). ## Footnote AC refers to average cost.

Question 27

What occurs if a firm lowers its price to P1 but not all the way to Pcon?

Answer 27

A new firm would be able to enter the market, produce more efficiently at a lower cost, and undercut the firm, taking away its market share. ## Footnote This illustrates the impact of price competition in a contestable market.

Question 28

What does perfect contestability force firms in the market to be?

Answer 28

Productively efficient regardless of the number of firms in the market. ## Footnote This indicates that contestability can influence monopolistic firms to act efficiently.

Question 29

True or False: Contestability can force a monopoly to be productively efficient.

Answer 29

True ## Footnote This is a significant conclusion of contestable market theory.

Question 30

What is allocative efficiency?

Answer 30

Allocative efficiency occurs where MC=P.

Question 31

What must the firm set its price at in a contestable market?

Answer 31

The firm must set its price at the lowest point of the AC curve.

Question 32

What happens to the demand curve when a firm is allocatively efficient?

Answer 32

The demand curve becomes perfectly elastic as in perfect competition where D=MR=AR=P.

Question 33

What occurs if a firm sets a price above the allocatively efficient price?

Answer 33

New firms will enter the market.

Question 34

What happens if a firm sets a price below the allocatively efficient price?

Answer 34

The firm will make a loss and go out of business.

Question 35

In a perfectly contestable market, what can be forced regardless of the number of firms?

Answer 35

Firms can be forced to be allocatively efficient.

Question 36

True or False: In a contestable market, a monopoly can still achieve allocative efficiency.

Answer 36

True.

Question 37

Fill in the blank: In allocative efficiency, price must be equal to _______.

Answer 37

[marginal cost].

Question 38

What is the relationship between MC and AC at the point of allocative efficiency?

Answer 38

MC cuts the AC at its lowest point.

Question 39

What does the diagram for allocative efficiency in a contestable market resemble?

Answer 39

It resembles the long-run perfect competition diagram.

Question 40

Characteristics of Contestable Markets:

Answer 40

* Contestable markets must face actual and potential competition * Entrants to contestable markets have free access to production techniques and technology * No entry/exit barriers to the industry (e.g. no sunk costs) * There is low consumer loyalty * The number of firms in the market varies

Question 41

What are Barriers to Entry?

Answer 41

* Barriers to entry aim to block new entrants to the market. * They increase producer surplus and reduce contestability

Question 42

How can the exploitation of Economies of Scale serve as a Barrier to Entry?

Answer 42

The exploitation of EoS by firms in the market would make it so new entrants would produce comparatively expensively, so they cannot compete.

Question 43

How can Legal Barriers serve as Barriers to Entry? (2)

Answer 43

* Patents and exclusive rights to production (e.g. in Music/TV industries) may prevent other firms from entering the market. * Some industries, such as the taxi industry, gain market licences to operate, serving as a barrier to entry.

Question 44

How can Marketing Barriers make a market less contestable

Answer 44

* Due to Consumer loyalty and branding, demand becomes more price inelastic, and consumers become less likely to try other brands. * Sometimes, a brand can become associated with a product, such as 'Hoover' with vacuum cleaners.

Question 45

How can Predatory Pricing reduce contestability? (3)

Answer 45

* Predatory Pricing involves firms setting low prices to drive out firms already in the industry * Leads to short-run losses, but as firms leave, remaining firms raise prices slowly to recover their revenue * By pricing their goods/services below their average costs, this reduces contestability.

Question 46

How can Vertical integration create barriers to entry?

Answer 46

It could result in one firm gaining control of important technologies, and they might prevent other firms gaining access to them. * e.g. Apple buying a chip manufacturer so that the manufacturer only produces chips for Apple, and not its competitors.

Question 47

Define Brand Proliferation and how can it make a market less contestable?

Answer 47

Brand Proliferation - When a firm creates multiple brands under its umbrella to target different market segments or expand its reach.

Question 48

How can Brand Proliferation make a market less contestable?

Answer 48

* Due to Brand Proliferation, markets may become oversaturated and uncontestable since the real market concentration between firms becomes disguised to consumers * e.g. Most popular retail Ice Cream brands, Ben and Jerry's/Magnum/Wall's were all set up under the Unilever umbrella.

Question 49

What are Barriers to Exit?

Answer 49

* Barriers to exit prevent firms from leaving a market quickly and cheaply * This may dissuade individuals from entering the market in the first place.

Question 50

How can Costs make markets less contestable (Barrier to Exit)

Answer 50

Costs involved with exiting a market may include the cost to write off assets and pay leases. Firms must pay off leases and contracts, even after closure. This may put the firm in the situation where it would be cheaper to stay in the industry than to leave.

Question 51

How can Brand Loyalty serve as a barrier to exit?

Answer 51

Losing a brand and consumer loyalty is hard to put a monetary value on, but is still considered a cost of leaving the market.

Question 52

How can redundancy costs serve as barriers to exit?

Answer 52

The cost of making workers redundant might discourage firms from leaving an industry.

Question 53

What is the concept of contestability in markets?

Answer 53

Contestability refers to the potential for new firms to enter a market and compete with existing firms, depending on costs and consumer loyalty. ## Footnote No markets are perfectly contestable; they generally have varying degrees of contestability.

Question 54

What factors increase the contestability of a market?

Answer 54

* Higher profit levels available * Lower barriers to entry * Lower barriers to exit ## Footnote A market's contestability is a matter of degree, not a binary yes or no.

Question 55

What is a major barrier to exit in a market?

Answer 55

Sunk costs. ## Footnote Sunk costs are costs that cannot be recovered once spent.

Question 56

How do sunk costs affect market contestability?

Answer 56

High sunk costs make a market less favorable to enter due to higher associated risks. ## Footnote For instance, advertising costs are considered sunk costs.

Question 57

What is the implication of high sunk costs on market structure?

Answer 57

High sunk costs are likely to push a market towards a price and output structure similar to that of a monopoly. ## Footnote This is because the risks of entry increase with high sunk costs.

Question 58

What does Baumol suggest regarding sunk costs and contestability?

Answer 58

Markets would be contestable provided there were no sunk costs. ## Footnote This implies that lower sunk costs enhance contestability.

Question 59

How should government competition policy be influenced by the theory of contestability?

Answer 59

It should focus on reducing barriers to entry and exit, not just on the levels of competition. ## Footnote The theory suggests that the mere threat of competition is sufficient for market dynamics.

Question 60

Fill in the blank: A market is more contestable when there are _______.

Answer 60

lower barriers to entry and exit.

Question 61

True or False: Perfectly contestable markets exist in reality.

Answer 61

False. ## Footnote Baumol noted that perfectly contestable markets do not exist, similar to perfectly competitive markets.

Question 62

What is an example of a strategy a firm might use to mitigate sunk costs?

Answer 62

Leasing equipment instead of purchasing it. ## Footnote For example, a new airline might lease aircraft to avoid sunk costs.

Question 63

What challenges might a government face in reducing barriers to entry?

Answer 63

Brand names, high advertising spends, access to technology, better information. ## Footnote These factors can create significant barriers for new entrants.