Contestable market

Question 1

contestable market

Answer 1

a market in which the existing firm makes only normal profit, as it cannot set a price higher than average cost without attracting entry, owing to the absence of barriers to entry and sunk costs

Question 2

sunk costs

Answer 2

costs incurred by a firm entering the market that cannot be recovered if the firm ceases trading

Question 3

hit-and-run entry

Answer 3

where a firm enters a market to take short-run supernormal profits knowing it can exit without incurring costs

Question 4

predatory pricing

Answer 4

an anticompetitive strategy in which a firm sets price below average variable cost in an attempt to force a rival or rivals out of the market and achieve market dominance

Question 5

What is contestability about

Answer 5

how open a market is to potential competitors, rather than the number of actual competitors

Question 6

6 Characteristics of a perfectly contestable market

Answer 6

1. No barriers to entry or exit
2. No sunk costs
3. No threat of predatory pricing
4. Equal access to technology –
5. No competitive disadvantage compared with the incumbent firm(s)
6. Productively and allocatively efficient

Question 7

Why is there no barriers to entry or exit in a perfectly contestable market

Answer 7

1. No internal economies of scale
2. No vertical integration
3. Low consumer loyalty due to weak brands / ineffective advertising

Question 8

Why is there no sunk costs in a perfectly contestable market

Answer 8

1. Equipment can easily be sold
2. No spending on advertising

Question 9

Why is there no threat of predatory pricing in a perfectly contestable market

Answer 9

Potential entrants do not fear entry will lead to incumbents engaging in a price war

Question 10

What is the threat of increased competition on contestable markets

Answer 10

has the same impact on incumbent firms’ behaviour as actual competition

Question 11

How to avoid hit-and-run entry

Answer 11

Firms in the market are forced to set a price equal to average cost if they are to avoid hit-and-run entry

Question 12

What can perfectly contestable markets deliver the same benefits as

Answer 12

can deliver the benefits of perfect competition without the need for a large number of firms

Question 13

Examples of contestable markets

Answer 13

Fast food
Air travel
Private education
Parcel delivery

Question 14

Analysis of contestable market

Answer 14

shows a monopoly firm in a market. If the monopoly profit maximises, and produces output Q0 at MC=MR and charges price P0, then in a contestable market the firm will be vulnerable to hit-and-run entry. A firm could enter the market, compete away the supernormal profit, and leave the market. The only way the monopoly can avoid this is to produce where price equals average cost, so that are no supernormal profits to act as an incentive for entry. The monopoly would produce at AC=AR with price P1 and output Q1, and have changed its objective from profit maximisation to sales volume maximisation.

Question 15

Analysis perfectly contestable market

Answer 15

a perfectly contestable market. The firms in this market are forced to produce at sales volume maximisation, and make zero SNP, to defend against the threat of entry, and hit-and-run competition, by new firms. This is due to the nature of the market; with zero barriers to entry and exit, no economies of scale, equal access to technology and no sunk costs firms can enter the market, compete away SNP, and leave without cost. This leads to a productively efficient level of output because Q1 is at MC=AC. Furthermore, allocative efficiency is achieved because the price P1 is at P=MC.

Question 16

Advantages of a perfectly contestable market

Answer 16

1. Leads to static efficiency

Achieves both productive and allocative efficiencies – achieving both of these is economic efficiency. Furthermore, firms are forced to be x-efficient.

Question 17

Disadvantages of a perfectly contestable market

Answer 17

1. Equal access to technology reduces dynamic efficiency

If the government is forcing firms to share technology, then there is less incentive to invest in R&D.

2. Lack of SNP reduces dynamic efficiency

Achieving only normal profit in the long run means less scope to invest in R&D.

Question 18

Judgement why contestable market more useful than other market structures

Answer 18

More realistic than perfect competition as it does not rely on a ‘large’ number of firms – a market could be perfectly contestable with any number of firms.

The characteristics of a perfectly contestable market gives actionable advice to government on how to improve the functioning of the market to the benefit of consumers with increased output and lower prices

Question 19

Why contestable market is less useful than other market structures

Answer 19

The assumptions are almost as unrealistic as perfect competition