Contestability (Edexcel A Level Economics A)

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 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

Implications of Contestable Markets for Firms

• 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

Types of Barriers to Entry and Exit

• Barriers to entry are conditions that make it difficult or expensive for a firm to enter a market in order to compete with the existing suppliers

• Barriers to exit are factors that either prevent a firm from leaving a market, or make it difficult to leave even if they are making a loss

Types of barriers to entry

Sunk Costs & the Degree of Contestability

• 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