3.4.7 Contestability

Question 1

What is Contestability?

Answer 1

Concerned with the possibility of other firms entering the market if they see the opportunity to make money, rather than the number of firms in the industry at a point in time.

Question 2

What is a constable market?

Answer 2

• One with a high threat of new entrants, which keeps firms producing at a competitive level.
• Even in a monopoly, a firm may be forced to be efficient due to the potential of new entrants to the market.
• Any attempt to make a huge profit will mean other businesses will be attracted to the industry.

Question 3

What are the key charteristics of a contestable market

Answer 3

● Within a contestable market there is perfect knowledge so if one firm is making abnormal profits, other firms will enter the market.
● There is freedom of entry and exit meaning any firms can enter/leave the market. There will be a relative absence of sunk costs. Firms will be able to and have thelegal right to use the best available technology, meaning their average cost curve
will be the same as the original firms’.
● There will be low product loyalty , meaning people don’t consistently use one brand and are happy to switch if a new one enters the market.
● We assume firms are short run profit maximisers and do not collude with each other.

Question 4

What will profits be for those in constable markets be?

Answer 4

• Firms will enter the market if they see other firms are making huge profits.
• They will remain in the market until competition prevents them from making a profit.
• This will take away profit from the original firms, and could even force them out of business.
• The only way to prevent this is by using limit pricing, which reduces the incentive for firms to enter the market.

Question 5

What will profits be in a perfectly contestable market?

Answer 5

firms will only be able to make normal profits and
produce where AC=AR because new firms will enter the market if price was any higher and they were making monopoly profits.

Question 6

What kine of efficency will there be and why?

Answer 6

• Firms are likely to be productive and allocative efficient.
• If they are not producingat the lowest point on their AC curve (i.e. not productively efficient), new firms can enter the market and undercut them by offering lower prices.
• Due to this, and the fact they can only make normal profits in the long run, they must also be allocative
  efficient.
  -Since they can only make normal profits AC=AR, and since they produce at the lowest point on their AC curve AC=MC.
  -Therefore, AC=MC=AR, so the value to society is equal to the cost.

Question 7

What are natural barriers to entry?

Answer 7

include natural monopolies and high entry/sunk cost

Question 8

What barriers to entry may be put in place by existing firms?

Answer 8

patents and copyrights as well as high levels of
advertising and branding

Question 9

how do barriers to entry effect contestablity?

Answer 9

Both the costs to entry and exit must be high for the market to have low contestability, since if entry costs are high but the firm is able to make profit once in business and not lose much of this profit if they leave, then the market is still contestable.

Question 10

What are legal barriers to entry?

Answer 10

-Prevent new firms from entering an industry.
- Laws are put in place which make it more difficult for firms to enter the market, or explicitly mean they cannot enter.
-For example, patents and exclusive rights to production mean other firms cannot enter the market.
- Some industries, such as the taxi industry, gain market licences to operate.

Question 11

What are marketing barriers?

Answer 11

• High levels of advertising build up consumer loyalty, so demand becomes more price inelastic, and consumers are less likely to try other brands. -Sometimes a brand can become associated with a product, (such as ‘Hoover’ with vacuum cleaners). -New firms entering the industry are unlikely
  to have the funds to undertake large scale advertising so struggle to compete with the incumbent firms.
• This may also be a barrier to exit, since losing a brand and consumer loyalty will be a cost of leaving the market.

Question 12

How may pricing decisions of incumbent firms be a barrier to entry?

Answer 12

• Predatory pricing means prices are so low that firms are driven out of the market, and so it would be extremely difficult for new firms to enter.
• Limit pricing discourages the entry of other firms as prices are set at a level to prevent new entrants. -Some firms might employ anti-competitive practices, such as refusing to supply retailers which stock competitors.

Question 13

How may capital start up costs be a barriers to entry?

Answer 13

Some industries have high capital start up costs , for example buying the machinery necessary to begin production. Sunk costs may also be high

Question 14

How may Economies of scale be a barriers to entry?

Answer 14

New firms are unable to produce on the same AC
curve as large, incumbent firms. If they were to enter the industry, their costs would be higher and so prices would be higher and they would be unable to compete.

Question 15

What are barrier to exit, give some examples.

Answer 15

-Prevent firms from leaving a market quickly and cheaply.
-They include the cost to write off assets, pay leases and make workers redundant.

Question 16

What is a sunk cost, give an example.

Answer 16

• Fixed cost that a business cannot recover if it leaves the industry.
  -It includes property (if the lease is longer than it is actually used for), machinery and equipment that cannot be resold, and advertising.
• All businesses will face sunk costs because even if things are resold it is generally for a lower price.

Question 18

How is the degree of contestability measured?

Answer 18

-The extent to which the gains from market entry for a firm exceed the costs of entering the market .
-A market with no sunk costs and no barriers to entry and exit is a perfectly contestable market.
- The more contestable a market, the more unstable it will be as there can be regular hit and run competition.

Question 19

What are the main reasons why contestability may increase?

Answer 19

• The recession has meant that entrepreneurs do not accept the existing market structure
  is fixed. (For example, Aldi/Lidl changed the structure of supermarkets by offering muchlower prices and increasing market share.)
• The deregulation of markets has allowed a reduction of some barriers to entry in some industries (such as telecommunications _and_postal_services,) Moreover, competition policy has meant firms can no longer use predatory pricing and cartels so markets are more contestable
  -The European single market has opened up new markets for firms and so these firms can enter into the market, making them contestable. Globalisation in general has increased contestability, since foreign firms can enter domestic markets. This is a synoptic point.
• Changes in technology has reduced entry costs as capital is more mobile. The rise of internet shopping means that firms no longer have to find retailers for their products and so can easily enter the market and sell their goods online.

Question 20

Why is contestability hatd to test?

Answer 20

-We would need a lot of information about the cost structure of the business.
- Since the theory centres on the threat of entry and not necessarily entry itself, it is difficult to test.
-Even if there has not been new competition over time, this does not necessarily mean the firm isn’t contestable.
-New firms entering the industry and low profits
being made suggests that an industry is contestable.