Contestable markets

• • If the market became perfectly contestable – with freedom of entry and exit, then the existing firm would have an incentive to cut prices to P2 (point B) – Otherwise, new firms would enter the market until normal profits are made.
  • Therefore, contestable markets will have lower profits than monopoly.

  A) supernormal profit in monopoly

  B) threat of entry price

  
• Contestable markets can bring the benefits of competitive markets such as:

  • Lower prices (allocative efficiency)
  • Increased incentives for firms to cut costs (x-efficiency)
  • Increased incentives for firms to respond to consumer preferences (allocative efficiency)
  • movement towards productive efficiency as output increases to exploit economies of scale
• Sunk Costs If sunk costs are high this makes it difficult for new firms to enter and leave the market. Therefore it will be less contestable.  For example, if a new firm had to purchase raw materials, that it wouldn’t be able to resell on leaving the market, this may act as a deterrent.
• Levels of advertising and brand loyalty.  If an established firm has significant brand loyalty such as Coca-Cola, then it will be difficult for a new firm to enter the market. This is because they would have to spend a lot of money on advertising which is a sunk cost. 
• Vertical Integration If a firm does not have access to the supply of a good then the market will be less contestable. E.g. Oil firms could restrict the supply of petrol to petrol stations, making it difficult for new firms to enter
• Access to technology and skilled labour For some industries like car production it is difficult for new firms to have the right technology
• If the market is highly profitable, this suggests the market is less contestable. In theory, if firms are making supernormal profit, it would attract new firms into the market. The persistence of supernormal profits suggests that hit and run competition is not possible and there are barriers to entry.
•  A contestable market could have a low number of firms – as long as there is the threat and possibility of new firms entering. However, if there are only a few firms and it has been many years since any new firms have entered, then it is likely to be less contestable.
• Methods of increasing contestability:

  1. Remove legal barriers to entry
  2. Force firms to allow competitors to use its network For example when BT was privatised, OFTEL forced BT to allow other companies to use its network.
  3. Legislation against Predatory Pricing 
  4. OFT can legislate against abuse of Monopoly power
  5. A government firm. E.g banking industry
• Contestability also increases innovation. Firms know that if they do not innovate, another firm may come along with a better product at a lower price. So, firms invest in R&D to improve products and reduce costs.
• There are many barriers to entry that the government can’t solve. The government can’t alter the economies of scale in an industry.
• Disadvantages of contestable market theory

  1. Lack of dynamic efficiency​
  2. Cost cutting in dangerous areas?
  3. Creative destruction
  4. Anti-competitive strategies from the incumbents​
  5. In reality, a market is unlikely to have no sunk costs
  6. In reality, most markets have some consumer loyalty
• Increase in output could lead to job creation as labour is a derived demand
• Over time, firms may use anti-competitive:

  • limit pricing, mergers, flooding the market, heavy advertising

  thus contestability will not last long term
• Hit-and-run competition is a term used in economics to describe a short-term, aggressive competitive strategy where a firm enters a market, typically with the intention of capturing a portion of the market share or exploiting temporary profit opportunities, and then exits the market once its objectives are achieved or market conditions change.
• Examples of hit and run competition: require little capital and initial investment

  • pop up shops
  • uber
  • deliveroo
  • zume pizza challenging dominos with pop up vans
• • Temporary Supply Shortages: Firms may enter a market during times of supply shortages (e.g., natural disasters, product recalls) to take advantage of increased demand and higher prices. Once supply normalises, they may exit.
• Characteristics of hit and run competition:

  • short term focus
  • aggressive pricing
  • quick entry and exit
  • limited investment
• Examples of contestable markets:

  • fast food industry
  • peer to peer lending networks (monzo, revolut)
  • hotel/ room sharing sector