contestable and non contestable markets

• what is a contestable market?

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

  • Competition is based upon the number of firms competing in a market
  • A contestable market is based upon the threat of new entrants
• what are contestable markets 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
• when are contestable markets easily threatened?

   by entry of new firms when there are low sunk cost and and hit-and-run competition exists 
• what is a sunk cost?

   A sunk cost is an investment that has been made that cannot be recovered
• what is a type of sunk cost that will be a barrier to entry and exit?

  • 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.
• what happens to contestability and competition if sunk costs 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
• what is hit and run competition?

  when a firm enters and exits an industry quickly
• when will a firm enter and exit an industry quickly?

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

  occurs when firms set a limit on how high the price will go. A lower price reduces profit and disincentivises other firms from joining the industry.
• what happens when a market becomes more contestable?

  the more the behaviour of firms resembles that of firms in perfect competition
• give an example of what will happen to firms when a market becomes more contestable?

  • 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