4.5- Contestable markets

• What is a contestable market?

  Market structure in which no one firm can dominate enough to make supernormal profits due to the threat of competition.
• What are characteristics of a contestable market?

  No barriers to entry or exit.

  No sunk costs.

  All firms in the market can access new technology.

  Good or perfect information leading to little consumer loyalty.

  Incumbent firms are subject to ‘hit and run’ competition.

  Firms may produce homogenous or differentiated goods.

  Short run profit maximisers.

  Threat of competition keeps profits low in the long run.
• Productive efficiency in a contestable market

  A firm can feel threatened by a firm entering the market and operating at the lowest average cost of production, even if only normal profits are made. To avoid new entrants they will operate towards the bottom of the AC curve increasing productive efficiency.
• Allocative efficiency in a contestable market

  A firm charging high prices, making supernormal profits in the short run would attract a new firm to enter the market at a lower price. So the threat of competition leads to the firm operating at a point where it only makes normal profits (AR = AC) and so would be more allocatively efficient than if there was no threat.
• Contestable market diagram

  AC= AR

  • Eliminate the threat of new entrants
  • Lower profit margins
  • Prepared if threat becomes real
  • Lower price
  • Greater market share

  
• Advantages of contestable market theory

  More allocatively and productively efficient.

  X-efficiency

  Job creation
• Disadvantages of contestable market theory?

  Lack of dynamic efficiency.

  Cost cutting in dangerous areas like health and safety.

  Creative destruction.

  Anti-competitive strategies from the incumbents.

  In reality, a market is unlikely to have no sunk costs and markets have some consumer loyalty.