Theme 3 Topic 4.7

Question 1

Contestable market

Answer 1

A contestable market occurs when there is freedom of entry into a market and where costs of exit, sunk costs are low

Question 2

A contestable market and competition are different

Answer 2

Competition is based upon the number of firms competing in a market

A contestable market is based upon the threat of new entrants

Question 3

Characteristics of contestable markets

Answer 3

1. No barriers to entry or exit: barriers to entry are low or non-existent and there are no sunk costs. This allows firms to easily join or leave the market
2. No competitive disadvantages on entry: new firms are able to setup and immediately compete with existing firms and have access to the same technology
3. Perfect information: There is no proprietary knowledge that would limit competition (e.g. patents)
4. Hit-and-run competition: Short-run supernormal profit acts as a profit signaling mechanism and new firms easily enter the market, extract profit, then leave

Question 4

Implications of contestable markets

Answer 4

The more contestable a market, the more the behaviour of existing competitors may be modified

E.g. Firms making supernormal profit may change their pricing strategy from profit maximisation (MC=MR) to limit pricing

They are even likely to set the price = average cost (AR=AC)

This will reduce hit and run competition

It will result in normal profit

There will be less disruption to the market

The more contestable a market, the more the behaviour of firms resembles that of firms in perfect competition

Question 5

Types of barriers to entry

Answer 5

1. Economies of scale : Occurs when an increase in the scale of output results in a lower cost per unit e.g purchasing economies
2. Legal barriers : Patents, copyright and government licenses prevent competitors from entering the market e.g. 5G licenses in the mobile industry
3. Ownership of essential resources : If existing competitors’ own resources that are essential to the production of a product, entry into the industry will be limited e.g cobalt is essential when manufacturing electric batteries and in 2021, Glencore controlled 22% of the world’s supply
4. Anti-competitive practices by competitors : These include predatory pricing, limit pricing and aggressive takeover activity in order to limit the amount of competition

Question 6

Sunk costs

Answer 6

One of the main barriers to exit is the existence of sunk costs

E.g. To enter the industry, the firm may have acquired expensive assets that are highly specialised and difficult to resell

Other examples include money spent on advertising, research and development, branding etc.

If sunk costs in an industry are high, it will limit competition and decrease contestability as firms will be more hesitant to enter

The lower the sunk costs the more contestable the market
The higher the sunk costs the less contestable the market