theme 3 : contestable markets

6 assumptions

• number of firms in the market may vary

• both freedom to entry and exit / no barriers to entry

• firms compete - is no collusion

• perfect knowledge

• firms are short run profit maximisers

• goods are either homogenous or branded

profit as a signal for firms explanation

• when the possession of market power is profitable it should attract new entrants into the industry

• if entry is easy, then the existence of very few or even only one firm may not result in economic inefficiency

threat of potential entry explanation

• threat of potential entry may be enough competition to keep the industry operating at or closet the competitive price and output

• in this case the market is a contestable market

• however if entry is not easy because there are significant barriers to entry , the threat of competition is less

• barriers to entry exist when there are sunk costs

sunk costs explanation

• costs that cannot be recovered when you exit an industry / market

• e.g. depreciation, marketing, staff training

if sunk costs are high what does this mean

indicates that the firm is either an oligopoly or a monopoly

what does the theory of contestable markets suggest

• suggests that even if there is only one seller, the seller may be forced to act as if there were many more

• in contrast there are times when great numbers of sellers are able to organise and act as a unified seller

• this is called a cartel

• sellers have the incentive to act in this way because it will increase profits

• the key to their success is their ability to restrict sales

costless entry and exit explanation

• perfectly contestable market is one in which entry and exit are absolutely costless

• in such a market, competitive pressures supplied by the perpetual (constant) threat of entry, as well as by the presence of actual current rivals, can prevent monopoly behaviour (higher prices and restricted output)

• theory suggests that a natural monopoly who is charging a high price and is restricting output will be easing abnormal profits

• if a competitor was to enter the market then they would manage to take share of the market by cutting their prices

• original monopoly producer would retaliate by cutting their price and driving the new entrant out of the market

examples of markets that have become more contestable in recent years

• hotel industry (impact of airbnb)

• fashion retailers

• parcel delivery

• low cost domestic airlines

• grocery industry

contestable markets barriers to entry explanation

• no structural barriers to the entry of firms in the long run

• if existing businesses are enjoying high economic profits (abnormal profits), there is an incentive for new firms to enter the industry

• this increases market competition and dilutes monopoly profits for the incumbent firms (firms already in the market)

contestable markets efficiency explanation

• in the long run firms in contestable markets should make only normal profits

• this is because if a firm makes abnormal profits, there is an incentive for new firms to join

• this leads to low barriers to entry which reduces market share

• firms in a contestable market will produce at the bottom of their AC curve (productive efficiency)

• if this were not the case then new entrants would be able to establish themselves and undercut the competition

• existing firms would be forced into making the decision between either cutting prices or leaving the industry