Contestability

Question 1

What is a Contestable Market?

Answer 1

Where a new market entrant has equal access to all production techniques available to the incumbents and where entry
decisions can be reversed without cost

Question 2

Barriers to ___: costs associated with leaving an industry

Answer 2

exit

Question 3

What are Sunk Costs?

Answer 3

Sunk costs are costs that cannot be recovered (in whole or in
part) if a business decides to leave an industry

Question 4

What is a Hit-and-Run Entry?

Answer 4

When a business enters an industry to take advantage of temporarily high (supernormal) market profits

Question 5

Characteristics of a Contestable Market?

Answer 5

• Low barriers to entry & exit and no sunk costs

• Equal access to technology – existing firms do not have an advantage

• No collusion

• Weak brand loyalty

It does not matter how many firms are in the industry, but there must be free/easy entry and exit into and out of the industry

Question 6

How contestable markets work…

Answer 6

• Existing or incumbent firms (i.e. firms already in the industry) are under constant threat of competition as there are no/low barriers to entry and exit

• If this threat of potential competition is credible, firms (even a monopoly) will have to behave more competitively or new firms will join to try and compete for a share of the supernormal profits

• Existing firms might choose limit pricing over profit maximisation

• They may also focus on non-price competition

• New entrant(s) might go for sales growth max– in a bid to establish a market foothold; entry can also be ‘hit-and-run’ from a challenger firm

Question 7

What benefits can Contestable Markets bring?

Answer 7

• Lower prices (improved allocative efficiency)

• Incentives for firms to cut costs (improved x-efficiency)

• Incentives for firms to innovate (dynamic efficiency)

• Scope for economies of scale (large firms can exist!)