3.4.7 Contestability


    a) Characteristics of contestable markets
    Contestable markets face actual and potential competition
    Entrants to contestable markets have free access to production techniques and technology
    No significant entry or exit barriers to industry
    No sunk costs in a contestable market
    Threat of ‘hit and run’ entry from new firms helps industry operating at a competitive price/output
    Low customer loyalty
    Number of firms in the market varies (typically a small number)
    Contestable market vs. perfectly competitive market
    Different as possible for one firm to dominate industry
    Each firm provides a differentiated product
    3 conditions for contestability:
    • Perfect information, freedom to advertise, enter and exit the market, absence of sunk costs

    b) Implications of contestable markets for the behaviour of firms
    Firms are more likely to be allocatively efficient if markets are contestable
    In long run, firms operate at bottom of the average cost curve –productively efficient
    Threat of new entrants affects firms’ the same as existing competitors
    • Low barriers to entry provides easy access to market – firms are wary of new entrants taking SNP then leaving
    Highly contestable markets are akin to perfectly competitive market
    • Because existing firms act as though there’s a lot of competition
    SNP in short run and normal profits in long run
    • In short run – new firms enter and take advantage of SNP • In practice firms only earn normal profits in short run (to prevent potential competition) • Without SNP – less incentive for new firms to enter even if barriers to entry and exit are low
    Price wars
    Predatory Pricing (BARRIER TO ENTRY):
    Anti-competitive strategy – firm sets price below AVC (shut-down point) in an attempt to force rivals out of the market and achieve market dominance – they make a loss
    Successful predator can then raise prices to profit max level once their rival has left the market (disadvantage for consumer in long run) – reduces contestability
    New firms can choose to hold out if they believe is profitable in long-run (winner is which firm lasts longest at this output)
    KLM aggressively lowered prices in response to easyJet entering market in 1996

    Limit Pricing (BARRIER TO ENTRY):
    Highest price an existing firm can set without enabling new firms to enter market and make a profit
    Assumes incumbent firm has cost advantage over potential entrants (consumer loyalty/ economies of scale)
    If natural barriers of entry are weak – attracts potential entrants to achieve SNP
    Will immediately push price down (diagram below) – original firm may still make SNP but at a lower level than before – new firms have competed away some of SNP

    d) Sunk costs and the degree of contestability
    Sunk costs
    Sunk costs are a barrier to contestability
    Costs which can’t be recovered once they have been spent should a firm decide to leave the market
    E.g. advertising incurs a sunk cost
    A market with high sunk costs is less favourable to enter, because risks associated with entering the market are high (represents a barrier to entry as if a firm fails they waste their sunk costs)
    A past loss cannot be altered by current/future actions
    High sunk costs are likely to push market towards a price and output that is similar to a monopoly (Risk of allocative efficiency)
    Degree of contestability
    Different degrees of contestability across markets
    All markets have potential to be contestable – depends on what kind of costs firms face and how loyal customers are
    No markets are perfectly contestable
    Hard to judge degree of contestability – in reality will be some costs to entry and exit
    UK Markets that have become more contestable
    Gas/electricity, opticians
    • Used internet to lower distribution costs • Maximise utility of aircraft – more seats • No free airline food – reduces cleaning costs • Use smaller airports, ticketless travel, direct sale only • Commodity allowances for continuing staff/ efficiency • Ryanair entered market cheaply by choosing less popular landing slots but in recessions market is less profitable
    Bus industry
    • Government helps to make industry more contestable





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