Contestability

Question 1

Define what a contestable market.

Answer 1

A market structure where it is easy for firms to join the market and compete

Question 2

Characteristics of a contestable market

Answer 2

-Perfect knowledge
-No barriers to entry
-No brand loyalty
-No collusion
-prescence of “hit and run” competition
-High THREAT of competition

Question 3

Describe hit and run competition

Answer 3

When new firms see that there are supernormal profits to be made, they will join that market then leave once they are satisfied with their returns.

Question 4

Types of barriers to entry and exit

Answer 4

1.Legal barriers:
-Patents
-Copyrights

2.Sunk costs

3.Economies of scale

4.Brand loyalty

Question 5

Define and give examples of sunk costs

Answer 5

Costs that cannot be recovered once they are made

-Advertising/Branding
-Research & development
-Specialist Machinery

Question 6

Advantages and Disadavtages of a contestable market structure

Answer 6

Advantages:
1. Lower Prices Due to Threat of Entry
Even if a market is dominated by one firm, the threat of new entrants encourages it to keep prices low.
→ Firms behave competitively to deter entry.
→ Leads to prices closer to marginal cost, improving allocative efficiency.
→ Consumers benefit from greater consumer surplus.

2. Increased Efficiency – Productive and Allocative
   To remain competitive and avoid entry, firms aim to minimise costs and price competitively.
   → Encourages productive efficiency (producing at lowest cost) and allocative efficiency (price = MC).
   → Firms have to behave as if they’re in a perfectly competitive market — even if they’re not.
3. Greater Incentive to Innovate and Reduce Waste
   To maintain competitive advantage and discourage entry, firms invest in new products, better tech, or customer service.
   → Dynamic efficiency is promoted even in concentrated markets.
   → Firms can’t afford to become inefficient or complacent.

Disadvantages:
1. In Reality, True Contestability Is Rare
Most markets have sunk costs, legal barriers, or brand loyalty (e.g. telecoms, airlines).
→ These prevent true contestability.
→ Incumbents can continue charging higher prices, reducing consumer welfare.
→ The theory may not match real-world outcomes.

2. Short-Term Focus – Lack of Long-Term Investment
   If entry is easy, firms may fear hit-and-run competition.
   → They may avoid long-term R&D or capital investment in case they don’t recover costs.
   → Reduces dynamic efficiency, harming innovation and long-term service quality.
3. Risk of Price Instability or Unsustainable Pricing
   New firms may undercut prices unsustainably to break into the market.
   → May lead to short-term price wars and firm failure, then higher prices once competition drops.
   → Can hurt both firms and consumers.
4. Quality May Suffer if Firms Cut Costs
   Firms focused on staying competitive may cut corners, reduce after-sales service or lower product quality.
   → Leads to productive efficiency, but at the cost of consumer experience.
   → Damaging in sectors like healthcare, transport, or education.
5. Hit-and-Run Entry May Create Market Uncertainty
   If markets see frequent entry/exit, it may cause instability.
   → Existing firms may struggle to plan investment or maintain consistent employment.
   → Long-term market confidence and supply chains may weaken.