3.4.7 Contestability

Question 1

What is a contestable market?

Answer 1

A contestable market is one where the barriers to entry and cost are low - new firms can enter and leave a market with ease, and because of perfect knowledge all firms know this.

Question 2

What impact does contestability have on performance of firms in an industry?

Answer 2

If a market is perfectly contestable then incumbent firms will have to remain efficient in order to protect themselves from the threat of ‘hit and run’ competition.

Firms in a perfectly contestable market will therefore be more productively and allocatively efficient, and will make only normal profits in the long run in order to deter new entrants.

Question 3

What is meant by sunk costs?

Answer 3

The cost of entering a market that cannot be recouped exiting the market.

Question 4

Give 2 examples sunk costs

Answer 4

• Advertising
• Wages
• Rent

Question 5

What is meant by ‘hit and run’ competition?

Answer 5

Supernormal profits act as a signal to other firms.
If barriers to entry are low, firms will come into the market and try to compete away the supernormal profits, then leave. This is known as hit-and-run entry.

Question 6

What might you notice if a market is contestable?

Answer 6

• Low levels of supernormal profits
• High degree of price competition (limit pricing)
• Cost-cutting activities (productive efficiency)
• Low brand loyalty
• New firms joining and existing firms leaving the

Question 7

To what extent is the supermarket industry contestable?

Answer 7

Factors that make it more contestable:

• Some prices competition (from Aldi and Lidl)
• New firms have entered this market
• Falling profits

Factors that make it less contestable:

• Some brand loyalty
• Relatively high profits
• High barriers to entry such as purchasing economies of scale.

Question 8

What is meant by a barrier to entry?

Answer 8

A barrier to entry is anything that makes it more difficult for a new firm to enter a market.

Question 9

Name 5 barriers to entry

Answer 9

• Economies of scale
• Brand loyalty
• High start up costs
• Patents
• Licenses
• Regulations
• Limit pricing
• Predatory pricing