4.1.5.9 - Contestable and Non-Contestable Markets

Contestability =

= The extent to which entry and exit in a market is free/costless.

• It is the threat of competition that is important in influecing price & quantity.

Sunk Costs =

Costs that cannot be recovered if a firm ceases operation.

• acts as a barrier to entry

Hit and Run Entry =

When a firm enters a market where supernormal profits are being made and then leaves when profits return to normal.

Cream Skimming =

Business strategy involving only focusing on most profitable segments of the market.

• e.g. only offering business post services and not household mail

Characteristics of Contestable Markets:

• Low Barriers to Entry

• Low Barriers to Exit

• No Sunk Costs

Contestable Market Chain of Analysis

• Less barriers to entry & exit (e.g. reducing regulatory requirements to open a bank, reducing startup costs) → market more contestable

• This increases the threat of competition.

• As a result, any supernormal profits being made act as signal for new firms to enter the market and gain some of the supernormal profit by using hit and run or cream skimming tactics

• To prevent the erosion of the supernormal profit, incumbent firms with monopoly power reduce prices from P1 to P2, whilst increasing quantity from Q1 to Q2, to limit the incentive for new firms to enter

• If perfect contestability (0 barriers to entry), firms will now make normal profit where AC=AR.

• Results in:

  • Lower price

  • Higher output

  • Normal profits

  • Allocative efficiency improved (price closer to MC)

  • Consumer surplus increased → Higher economic welfare

Examples of Contestable Markets

• Low-cost/budget Airlines (e.g. Ryanair, EasyJet)

• Market Stalls (e.g. flowers in town market)

Contestable vs Competitive Market

Contestability is about the THREAT of competition which influences the firm to reduce prices.

In perfect comp, there are a large number of sellers.

In contestable markets, there may only be one.

Evaluations of Contestable markets

• No perfectly contestable markets in reality - always some barriers

• May force firms away from profit-maximising behaviour

• Depends on degree of contestability