Contestable Markets

• What is a Contestable market?

  occurs when there is freedom of entry and exit into the market.
• Contestable Market

  there will be low sunk costs
• Due to freedom of entry and exit – existing firms always face the threat of....?

  new firms entering the market.
• What does threat of entry do to the price?

  This threat of entry is sufficient to keep prices close to a competitive equilibrium and profits low – otherwise, new firms enter.
• What is the most important in a contestable market?

  In a contestable market, it is not the number of firms that is important, but the ease by which new firms can enter the market.
• Contestable Market Diagram

  Contestable markets will have lower profits than monopolies

  A) P

  B) MC

  C) AC

  D) A

  E) B

  F) P1

  G) C1

  H) Q1

  I) Q2

  J) MR

  K) D=AR

  L) Supernormal profit

  M) non-contestable monopoly

  N) contestable market

  O) threat of entry

  P) P2

  Q) B

  
• Why does contestable markets have lower profits than monopolies?

  • If the market was a monopoly with high barriers to entry, the firm would maximise profits at P1, Q1 (point A)
  • 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.

  
• Contestable markets and the public interest

  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)
• Contestable markets and the public interest


  there could also be significant economies of scale because the theory of contestable markets doesn’t require there to be 1000s of firms.

  • Therefore policymakers should not just look at the degree of concentration, but also the degree of contestability and how easy it is to enter the market.
  • Regulators in the privatised industries have often focused on removing barriers to entry, rather than breaking up big firms.
• Factors that determine the contestability of a market

  It is important to consider the different barriers to entry a new firm may face

  • Sunk Costs
  • Level of advertising and brand loyalty
  • Vertical Integration
  • Access to technology and skilled labor

  Other factors outside Barriers to entry could include

  • Level of Profit
  • Number of Firms
• Factors that determine contestability - 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.
• Factors that determine contestability - 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.  But it may not be sufficient to change customer loyalty to very strong brands.

  It depends on the industry; customer loyalty would be fairly low for a product like petrol because it is quite homogenous. But, for soft drinks, people have greater attachment to their ‘brand’
• Factors that determine contestability - Vertical Integration

  If a firm does not have access to the supply of a good then the market will be less contestable.

  Giving access to different stages of production can make the market more contestable.

  E.g.

  1. Oil firms could restrict the supply of petrol to petrol stations, making it difficult for new firms to enter.
• Factors that determine contestability - Access to technology and skilled labour

  For some industries like car production it is difficult for new firms to have the right technology.

  Nuclear power may require skilled labour that is difficult to get. This makes the market less contestable.

  If you wished to compete with Google, you may find it hard to employ the best software engineers because Google pays its employees a very good wage and is seen as an attractive company to work for.
• Factors that determine contestability - Level of Profit

  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
• Factors that determine contestability - No. of Firms

  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.

  If there are recent examples of firms entering the market, then it is likely to be more contestable.
• Methods to increase contestability

  1. Remove legal barriers to entry
  2. Force firms to allow competitors to use its network
  3. Legislation against Predatory Pricing
  4. OFT can legislate against abuse of monopoly power
  5. Government firm