LS14- Contestable Markets

Question 1

What is a contestable market?

Answer 1

A market where there is a threat of competition. There must be low barriers to entry and low sunk costs.

Question 2

Characteristics of a contestable market

Answer 2

• low barriers to entry/exit
• large pool of potential entrants
• good information
• incumbent firms subject to ‘hit and run’ competition

Question 3

How has technology increased contestability?

Answer 3

• it has decreased barriers to entry/exit as businesses do not have to be physical
• has increased the pool of potential entrants (allow for more innovation, allowed for firms to find cheaper ways to produce -> lower start-up costs)
• improved information due to internet

Question 4

Sunk costs

Answer 4

Costs which cannot be recovered if a business decides to leave an industry. The existence of sunk costs makes a market less contestable.

Question 5

Pros of contestability

Answer 5

• allocative efficiency
• productive efficiency
• x-efficiency
• job creation due to new and many firms

Question 6

Cons of contestability

Answer 6

• lack of dynamic efficiency - EV if new firms come in with new ideas we still get the benefits of dynamic efficiency
• cost cutting in dangerous areas e.g. health and safety, wages
• may lead to anti-competitive strategies e.g. collusion

Question 7

Evaluation points for contestability

Answer 7

• length of contestability
• red tape - could reduce contestability due to patents, copyrights etc
• regulation (can minimise cost-cutting in dangerous areas and anti-comp strategies)

Question 8

Contestable market diagram

Answer 8

• same as monopoly diagram but firms produce at AC=AR

Question 9

Why do firms produce at AC=AR in a contestable market?

Answer 9

• to eliminate the threat of competition as there is good information so firms will not be tempted to enter the market for SN profits
• so that they are prepared if firms actually do enter the market
• movements are towards AC=AR and usually do not actually reach that point

Question 10

Factors suggesting contestability

Answer 10

• if there is evidence of firms entering the market
• if there is a gap in the market
• if incumbent firms receive reputational damage -> fall in their brand loyalty
• if incumbent firms are being inefficient

Question 11

Factors suggesting a market is not contestable

Answer 11

• if incumbent firms have strong brand loyalty
• if it requires significant output and financial muscle to reach the MES e.g. car company
• if incumbent firms are advertising as advertising is a sunk cost + increases brand loyalty
• if incumbent firms are efficient