3.5.10 - Contestable and Non-Contestable Markets

Question 1

What is a contestable market?

Answer 1

A market in which the potential for new firms to enter the market exists.

Question 2

What are the features of a perfectly contestable market?

Answer 2

No entry / exit barriers.
No sunk costs.
Incumbent firms have access to the same level of technology.

Question 3

What is an effective way to reduce monopoly power?

Answer 3

Deregulation and remove barriers to market entry.

Question 4

How did governments deal with abuse of monopoly power up until about 40 years ago? (made in 2023)

Answer 4

An extension of government regulation into the activities of private-sector firms.

Question 5

Why did governments deal with abuse of monopoly power in the way they did until about 40 years ago? (made in 2023)

Answer 5

They believed that regulatory powers must be strong enough to countervail the growing power of huge business organisations to make monopolies behave in a more competitive fashion.

Question 6

How was monopoly defined in the past?

Answer 6

The number of firms in the market alongside the share of the leading firms (concentration ratio).

Question 7

What was the main dilemma facing policy creation to quell monopoly power?

Answer 7

There had to be a reconciliation between potential large-scale productive efficiency (economies of scale) with the fact that competitive pressure can lead to monopoly abuse and consumer exploitation.

Question 8

How does contestable market theory define monopolies?

Answer 8

The ease / difficulty with which new firms may enter the market.

Question 9

What does contestable market theory think about industrial concentration?

Answer 9

Not really a concern, provided that new firms can enter / exit the market to contest the market.

Question 10

What is more important in contestable market theory?
Actual or potential competition?

Answer 10

Potential competition.

Question 11

How does contestable market theory square actual competition vs. potential competition?

Answer 11

Actual competition is not essential although invited. Potential competition should ensure efficient and non-exploitative behaviour by existing firms.

Question 12

Has contestable market theory been adopted by lawmakers?

Answer 12

Yes, it has had a major impact on UK monopoly policy.

Question 13

What does contestable market theory imply about monopoly policy?

Answer 13

Provided there is adequate potential for competition, a conventional regulatory policy is superfluous.
Deregulatory policies should be used to develop conditions in which barriers to entry / exit are minimised to ensure a reasonable level of contestability is reached.

Question 14

What policies are suggested under contestable market theory?

Answer 14

Removal of:
Licensing regimes for public transport, television and radio transmissions
Controls over ownership (nationalisation)
Price controls that act as a barrier to entry (aviation industry in the past)

Question 15

What is hit-and-run competition?

Answer 15

A new entrant can enter the market, then leave given that there are no / low barriers to enter / exit.

Question 16

What are sunk costs?

Answer 16

Costs that are irrecoverable if the firm decides to leave the market.

Question 17

What is the difference between sunk costs and fixed costs?

Answer 17

Sunk costs cannot be recovered, whereas fixed costs can be recovered provided you can sell them on.

n.b. fixed costs can be sunk costs, but sunk costs are not necessarily fixed costs.

Question 18

What is an example of a sunk cost?

Answer 18

Advertising expenditure

Question 19

What do sunk costs discourage?

Answer 19

Hit-and-run competition.

Question 20

When do firms engage in hit-and-run competition?

Answer 20

When abnormal profits are available to be made, then they leave when they have been completely competed away.

Question 21

Is hit-and-run competition a feature of contestable markets?

Answer 21

Yes.

The sunk costs are very low so barriers to entry / exit are also low and is therefore a feature of contestable markets.

Question 22

How does potential ease of entry ensure a market remains contestable?

Answer 22

The threat of hit-and-run competition (in contestable market theory), is sufficient to keep prices and profits at their lowest possible levels, thereby increasing consumer surplus.

Question 23

Why would a monopoly set the price at Pc despite having price setting power?

Answer 23

Due to the low barriers to entry, the monopoly is acutely aware of the possibility of hit-and-run competition taking their profits. To ensure this does not happen, the monopoly limit prices in the long-run as prices are assumed to be ‘sticky’.

Question 24

Is limit pricing good in contestable market theory?

Answer 24

As the limit pricing is done to ensure the monopoly retains their status, it is a negative.
However, as the firm must limit price in the long-run to prevent any firms from entering and making income from hit-and-run competition, the consumer surplus is massively increased relative to imperfectly competitive markets.