3.4.7: Contestability

Question 1

What is contestability?

Answer 1

• Refers to a threat of entry in the market

Question 2

What are characteristics of a contestable market?

Answer 2

• Perfect knowledge
• Low/ no barriers to entry: this causes freedom of entry and exit causing a relative abscence of sunk costs
• Hit and run competition (firms that come temporarily to take advantage of SN profits).

Question 3

Why may some contestable firms use limit pricing?

Answer 3

• This reduces the incentive for other firms to enter the market/ when a firm feels there is a threat of an entry of new firms.
• This is as in a contestable market, firms will enter the market if they see other firms making supernormal profits.

Question 4

Why do firms in a perfectly contestable market only make normal profits?

Answer 4

• As they produce at AC=AR (sales maximisation) and becuase new firms will enter the market if price was any higher and they were making monopoly profits.

Question 5

Why are firms likely to be prouctive and allocative efficient?

Answer 5

-Allocative Efficient: firms know that if they charge prices above the competitive level (P=MC) , new entrants can quickly enter the market, capturing market share.
- So firms set prices close to marginal cost (P = MC), ensuring that resources are allocated in the most efficient way, where consumer preferences are met without overcharging.

Productive Efficiency: To remain competitive, firms must costs and operate at the lowest point on their (AC curve).
- If they don’t, more efficient firms can enter and take over the market. This drives firms to adopt the most efficient production methods and technologies, ensuring productive efficiency.