3.4.7 Contestability

• Barriers to entry:

  Factors which make it difficult or impossible for firms to enter an industry and compete with existing producers.
• Barriers to exit:

  Factors which make it difficult or impossible for firms to cease production and leave an industry.
• Examples of barriers to entry:

  1) Capital costs

  2) Sunk costs

  3) Economies of scale

  4) Legal barriers

  5) Marketing barriers

  6) Limit pricing
• How are capital costs a barrier to entry?

  Industries that have capital costs (e.g. airlines, mining) are expensive to enter and therefore only very large companies can enter these industries.
• Sunk costs:

  How are sunk costs a barrier to entry?

  Costs that are not recoverable if a firm leaves an industry, e.g. advertising costs.

  Industries that require large amounts of advertising spending to enter and compete with existing firms are therefore less attractive to enter.
• How are economies of scale a barrier to entry?

  Existing firms are likely to be large (high Q) and therefore can exploit economies of scale to lower AC.

  In contrast, new entrants are likely to be smaller (lower Q) and therefore can't exploit economies of scale and will have higher AC.

  Therefore, existing firms are likely to be able to sell at lower prices which deters new entrants.
• How are legal barriers a barrier to entry?

  Patents can protect companies from competition for years (e.g. pharmaceuticals).

  The government may grant a license to a specific firm that gives it exclusive rights to protection.
• How are marketing barriers a barrier to entry?

  Existing firms may have strong brand loyalty so new entrants may struggle to gain market share.
• Limit pricing:

  How is limit pricing a barrier to entry?

  When a firm sets a low price to deter new entrants.
• Examples of barriers to exit:

  1) The cost of making employees redundant

  2) The firm may have contracts with customers or suppliers that it may have to pay to get out of.
• Contestable market:

  A perfectly contestable market is a market structure with:

  -No barriers to entry or exit (including no sunk costs)

  -New firms must have no disadvantages compared to exiting (incumbent firms)

  -All firms have access to the same technology

  Note: a contestable market can have any number of firms.
• What is the impact of contestability on the behaviour of firms?

  If a market is highly contestable, then this means that it is easy for new firms to join the market.

  Therefore, the threat of competition is high. If firms attempt to sell at a P>AC and make SNP they will attract hit and run competition.

  In order to avoid this, firms may charge a P=AC and only make normal profits.
• Hit and run competition:


  When a firm enters a market, makes SNP and then leaves when profits fall.
• What factors can make a market more or less contestable?

  Depends on barriers to entry.

  High barriers to entry -> not contestable

  Low barriers to entry -> contestable.
• Adv (+) of a market becoming more contestable

  -Firms lower prices to avoid hit and run competition -> more allocative eff (P closer to MC) -> ↑consumer surplus

  -Threat of competition -> firms become less complacent -> less chance of X-ineff -> ↓AC

  -↓prices -> ↑output -> more likely to benefit from EoS -> ↓AC -> improved productive eff

  -Any SNP made more likely to be invested into R&D to improve products and deter new entrants -> dynamic eff
• Disadv (-) of a market becoming more contestable

  -Firms less able to make SNP -> less profit to invest in R&D -> less chance of improved products for consumers (less allocative eff)/less chance of improved production processes, which reduce AC (less productive eff) -> lack of dynamic eff.