Contestable & Non-contestable Markets (AQA A Level Economics)

Characteristics of Contestable Markets

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

  • A contestable market and competition are different

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

    • A contestable market is based upon the threat of new entrants

• Contestable markets are characterised by

1. No barriers to entry or exit: barriers to entry and exit are low or non-existent. This allows firms to easily join or leave the market

2. No competitive disadvantages on entry: new firms are able to setup & immediately compete with existing firms & 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 exists

Sunk Costs & Hit-and-run Competition

• Contestable markets are easily threatened by entry of new firms when there are low sunk cost and and hit-and-run competition exists 

Sunk costs

•  A sunk cost is an investment that has been made that cannot be recovered 

• A high sunk cost will be a barrier to entry and exit. Firms will not easily join or leave the market

  • 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 & 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

Hit and run competition

• Hit and run competition occurs when a firm enters and exits an industry quickly

• Firms are attracted by the short-run supernormal profit and once they have acquired these profits, they exit just as quickly

Significance of Market Contestability

• 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