Contestable markets

Question 1

What is a contestable market

Answer 1

A market where there is a threat of competition

Question 2

What are the characteristics of a contestable market

Answer 2

• Low barriers to entry/exit
• Large pool of potential entrants
• Good information as new firms need to know about costs, technology etc as they need to be able to compete on a level playing field if they were to enter
• Incumbent firms subject to hit and run competition

Question 3

What is hit and run competition

Answer 3

Where new firms enter the market quickly to take supernormal profit and leave market quickly before incumbent firms can react and lower their profit margins

Question 4

How has technology impacted barriers to entry, increasing contestability in markets

Answer 4

• Businesses don’t have to be physical anymore, which reduces start up costs, sunk costs, less workers required, less regulations need to be met
• Easier to achieve technical economies of scale so firms are less likely to be driven out by incumbent firm’s lower LRAC
• Easier to advertise which reduces barriers to entry caused by brand loyalty

Question 5

How has technology impacted the pool of potential entrants, increasing contestability in markets

Answer 5

• Caused greater innovation so new firms can easily disrupt markets with new innovative technology e.g. Uber, Airbnb
  This allowed small startups and firms from different industries (e.g. tech) to compete in the market
• More affordable for firms as they can reduce costs of production of goods/services more easily so disrupt existing firms

Question 6

How has technology impacted the availability of information, increasing contestability in markets

Answer 6

• Internet means firms can find out about costs and technology in the market more easily
• Communication has improved so it is easier to get key information across to new firms

Question 7

What is a perfectly contestable market

Answer 7

Same characteristics apart from there are no barriers to entry/exit and there is perfect information

• However regular contestable market can get the same outcomes of contestability

Question 8

How would a monopoly react in a contestable market

Answer 8

• If there are low enough barriers to entry/exit threat of competition could still be high
• Monopoly would increase their output more towards the limit price i.e. AC=AR
  (but could be anywhere from after MC=MR to AC=AR)

Question 9

Why would a monopoly change to the limit price due to the threat of competition

Answer 9

1. Purposefully lower profit margins to reduce the incentive for new firms to enter the market and therefore eliminate the threat by limiting competition. (afterwards, they can go back to making supernormal profit)
2. Means the monopoly is prepared if firms actually enter the market, as they have already had to cut costs and improve productive efficiency to produce at AR=AC, they can build more brand loyalty before the new firm enters, the very low prices could drive new firms out

Question 10

What are the benefits of contestable markets

Answer 10

1. Movement towards allocative efficiency, meaning higher CS surplus, choice, quantity
2. Movement towards productive efficiency, meaning greater exploitation of EoS so lower costs so lower prices
3. Movement towards X efficiency, meaning less waste so lower costs and lower prices
4. Higher quantity means more jobs created as labour is a derived demand

Question 11

What are the cons of contestable markets

Answer 11

1. Less dynamic efficiency over time even though new firms give innovation in the short run
2. Cost cutting could be happening in dangerous areas like health and safety, quality, wages, environmental standards, which is not desired in society
3. Creative destruction destroys existing firms causing job losses
4. Anti-competitive strategies (like limit and predatory pricing, flooding the market, heavy advertising and mergers) can eliminate the threat of competition, meaning contestability doesn’t last over time so benefits don’t occur and there is static inefficiency again in the long run

Question 12

What are the evaluation points of contestable markets

Answer 12

1. Length of contestability e.g. if new firms patent their tech once they enter or anticompetitive strategies are used then market becomes less contestable over time
2. Technology could reduce contestability as it’s easier to get patents/copyrights and improved information could mean more price discrimination, reducing static efficiency benefits
3. Regulation could minimise drawbacks of cost cutting in dangerous areas and anticompetitive strategies
4. If new firms are coming in with innovative ideas, we don’t need as much dynamic efficiency as we already have more innovation in the market
5. When firms are destroyed through creative destruction, workers can move to newer firms and get jobs in the same industry (but maybe the new firm is so innovative, the skills aren’t transferable)