3.4.7 - Contestability

Question 1

Define sunk costs

Answer 1

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

Question 2

Characteristics of a contestable market

Answer 2

• no/low barriers to exit or entry
• large pool of potential entrants
• perfect information
• no sunk costs
• new firms have no competitive disadvantage compared with new firms; aka incumbent firms are subject to hit and run competition

Question 3

Result of contestable markets

Answer 3

• incumbents cannot set a price that is higher than average cost, becuase as soon as it does, the possibility of hit and run entry by new firms increases, competing away SNP
• so they use a limit price; P=AC or close to P=AC
• comeptitive pricing strategy

Question 4

examples of hit and run firms

Answer 4

• concert tickets -ticketmaster
• stadium - selling merchandise for football teams at a match, afterwards they do not continue selling it

Question 5

How do monopolists avoid hit and run entry firms from competing away SNP

Answer 5

• if they try to profit maximise in a contestable market, they are vulnerable to hit and entry so they need to set price equal to AC - make normal profits so incentive of SNP to enter a market
• this is a limit pricing strategy
• but they are neither productively or allocatively efficient

Question 6

How has internet impacted contestability

Answer 6

• internet has given consumers improved knowledge of market conditions and enable them to make far more informed choices
• Thomas cook failed bc they couldn’t compete with online travel firms and also internet meant individuals made their own holiday plans
• so internet made travel sector more contestable and thus more competitive

Question 7

How else do firms deter new entrants

Answer 7

• raise fixed costs of being in the industry
• heavy advertising; new firms cannot afford such wide reaching advert campaigns so they are deterred
• advertising is a fixed and sunk cost
• research and development; requires lots of investment

Question 8

What can the contestable market theory be applied to

Answer 8

monopoly, oligopoly and monopolistic competition

Question 9

How has technology impacted contestability

Answer 9

1) lowered barriers to exit and entry; no longer have to be physical so reduced start up and sunk costs, no labour costs, easier advertising (big b to entry)
2) increased the pool of potential entrants; cheaper production methods to disrupt incumbents
3) improved information for economic agents; firms find out about tech and costs easier and comms improved

Question 10

What do monopolies do in a contestable market

Answer 10

move from profit maximising to competitive pricing strategy; AC=AR on diagram, making normal profit to eliminate threat of new entry and to prepare if new threat comes in (low price and high quantity)
- in reality we see fir

Question 11

Pros of contestable markets

Answer 11

• limit pricing strategy (move to it) so now we achieve/ move to it
• allocative, efficiency, productive efficiency, x-efficiency, job creation

Question 12

Cons of contestable market

Answer 12

• lack of dynamic efficiency bc low/no profit margins, BUT if new firms come in with new innovation, that in itself is dynamic efficiency
• costs cutting in dangerous areas
• creative destruction; job losses if firms outcomepted by new ideas BUT EVAL by saying these fired people just move to new firms
• anti competitve stratgies; short run contestable market provides benefits but in if firms use limit price, high advertising, predatory pricing, mergers will mean it is not contestable in the long run so static inefficiency created

Question 13

evaluate pros and cons of contestable markets

Answer 13

• length of contestability; if new firms can patent their ideas or anti competitve strategies, not contestable for that long
• role of tech; reduce contestability as it can be patented. tech can improve info firms have of consumers so they price discriminate
• regulation: minimise issues of cost cutting and anticompetitve strategies so these cons are actually reduced
• dynamic efficiecny: no snp so no DE but actually new firms bring new idea so dyanmic efficiency over time

Question 14

Define contestable market

Answer 14

Where an entrant has access to all production techniques available to the
incumbents is not prohibited from wooing the incumbent’s customers, and
entry decisions can be reversed without cost. The key assumption for
contestability is that businesses are free to enter and leave the market.

Question 15

Define hit and run competition

Answer 15

When a business enters an industry to take advantage of temporarily high
(supernormal) market profits. Common in highly contestable markets.

Question 16

Define legal barriers to entry

Answer 16

Legal barriers include patent protection, legal franchises, trademarks and
copyright.

Question 17

Define strategic barriers to entry

Answer 17

Cost advantages of existing, established firms in a market – they might have
benefitted from economies of scale, vertical integration and built up high levels
of customer loyalty. This makes it more expensive for a new firm to enter
successfully

Question 18

Define structural barriers to entry

Answer 18

Also known as structural entry barriers – arise when established firms have
lower unit costs than potential rival firms. Might come about from first mover
advantage.

Question 19

Examples of barriers to entry

Answer 19

• advertising creates strong brand loyalty
• patents give a firm legal protection against copying
• threat of limit pricing - estaimte where rival AC curve is and set price below it to deter new entrants
• trade restrictions deter foreign entrants
• incumbents are vertically integrated so lower costs of raw materials, better quality

Question 20

examples of markets becoming more contestable due to tech

Answer 20

global hotel market
- this market was changed dramatically by entry of airbnb revolutionising travel and accomodation. tech allowed air bnb to come up with a unique way of competing with the established hotel model making it highly contestable.

Question 21

examples of markets becoming more contestable generally

Answer 21

– airline market
- deregulation of industry in early 1990s reduced b to entry so firms can compete with national providers, especially for short haul flights.
- entry of easy jet, ryan air and more recently, norwegian, play and norse atlantic is proof of the contestability of the market which is now starting to branch inot long haul flights as well
- however recent entry could just be hit and run who do not last in the long term; e.g wow air and flybe have left the market and norwegian in trouble

Question 22

Contestability in the takeawy industry

Answer 22

• takeaway delivery is contestable market
• deliveroo disrupted dominant and stagnant market of just eat and hungry house

Question 23

contestability in tax market

Answer 23

• entry of uber opened up market to competition
• use of tech to receive cab rides has allowed them to compete with black cab firms and has led to new entrants following similar strategy; lyft, mytaxi, careem, dett, didi and chuxing (some are international)

Question 24

contestability in supermarket

Answer 24

• rise of aldi and lidl made closed oligopoly of supermarket industry a highly contestable market
• they came in with a unique way of competing with incumbents by offering their own brands of grocery staples at much lower prices so now they have approx combined market share of 17.8% - tesco tried to copy this and open up a discounter shop called jacks but little success