Contestability

Question 1

what is a contestable market

Answer 1

A perfectly contestable market is one where there are no barriers to entry or exit due to an absence of sunk costs

Question 2

what is a sunk cost

Answer 2

a cost that cannot be recovered upon exiting an industry

Question 3

what are the characteristics of a contestable market

Answer 3

• no barriers to entry or exit
• no sunk costs
• new firms have no competitive disadvantage over incumbent firms
• new firms have access to the same technology as incumbent firms

Question 4

in contestable markets, why is there the fear of hit and run, and what is hit and run competition

Answer 4

• concerned with the threat of competition
• if firms are making supernormal profits, then new firms may be able to enter the market, take some supernormal profits, and exit again
• the implication of this is that incumbent firms should only make very little profits, or produce where AC = AR, and make normal profits, in order to deter other firms from entering the market.

Question 5

what are the factors that make a market more contestable?

Answer 5

• no sunk costs
• growth of the internet
• improved information
• deregulation - lack of patents protecting information, and preventing firms from entering markets. Deregulation can make a market more contestable by lowering the barriers to entry and exit
• tougher competition policy - laws acting against predatory behaviour by existing firms makes markets more contestable, by improving the opportunities for competition

Question 6

what are the factors making a market less contestable

Answer 6

• high sunk costs - costs paid to enter an industry which cannot be paid upon exit from an industry
• large economies of scale
• information asymmetries
• intellectual property rights (patents) - limits competition between firms, and increases the barriers to entry and exit
• existence of well known brand names

Question 7

if a market is highly contestable, how does impact the efficiency of the firm

Answer 7

• allocative efficiency - increases
• productive efficiency - increases
• x-inefficiency - decreases
• dynamic efficiency - decreases due to fall in profit
• health and safety - falls (maybe, cutting costs)

Question 8

Evaluation of contestability

Answer 8

• difficult to measure contestability - the degree of contestability is measured by the extent to which the gains from entering a market outweigh the costs of leaving the market
• might not be desirable - some markets require dynamic efficiency gains
• threat of hit and run competition is often not enough to keep prices low - markets are never fully contestable, so firms could make supernormal profits and only cut prices below AVC if firms enter the market
• markets change over time