Characteristics of Contestable Markets
- A contestable market occurs when there is freedom of entry into a market & where costs of exit are low
- A contestable market & competition are different
- Competition is based upon the number of firms competing in a market
- A contestable market is based upon the threat of new entrants
- A contestable market & competition are different
- Contestable markets are characterised by
- No barriers to entry or exit: barriers to entry are low or non-existent & there are no sunk costs. This allows firms to easily join or leave the market
- No competitive disadvantages on entry: new firms are able to setup & immediately compete with existing firms & have access to the same technology
- Perfect information: There is no proprietary knowledge that would limit competition (e.g. patents)
- Hit & run competition: Short-run supernormal profit acts as a profit signaling mechanism & new firms easily enter the market, extract profit, then leave
Implications of Contestable Markets for Firms
- The more contestable a market, the more the behaviour of existing competitors may be modified
- 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 & run competition
- It will result in normal profit
- There will be less disruption to the market
- The more contestable a market, the more the behaviour of firms resembles that of firms in perfect competition
Types of Barriers to Entry and Exit
- Barriers to entry are conditions that make it difficult or expensive for a firm to enter a market in order to compete with the existing suppliers
- Barriers to exit are factors that either prevent a firm from leaving a market, or make it difficult to leave even if they are making a loss
Types of Barriers to Entry
| Economies of scale | Legal barriers |
|
Occurs when an increase in the scale of output results in a lower cost per unit e.g purchasing economies (see sub-topic 3.3.3) |
Patents, copyright & government licenses prevent competitors from entering the market e.g. 5G licenses in the mobile industry |
| Ownership of essential resources | Anti-competitive practices by competitors |
| If existing competitors' own resources that are essential to the production of a product, entry into the industry will be limited e.g cobalt is essential when manufacturing electric batteries and in 2021, Glencore controlled 22% of the world's supply | These include predatory pricing, limit pricing & aggressive takeover activity in order to limit the amount of competition |
Sunk Costs & the Degree of Contestability
- One of the main barriers to exit is the existence of sunk costs
- E.g. To enter the industry, the firm may have acquired expensive assets that are highly specialised & difficult to resell
- Other examples include money spent on advertising, research & development, branding etc.
- If sunk costs in an industry 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
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