4.5 Contestable Markets

Contestable markets

When there is a threat of competition, not necessarily actual competition. This threat affects the behaviour of firms.

The characteristics of a contestable market

A market in which the existing firm makes only normal profit

(P=MC), as it cannot set a price higher than average cost

without attracting entry, owing to the absence of barriers to

entry and sunk costs

Sunk costs

Costs incurred by a firm that cannot be recovered if the firm

ceases trading

Hit-and-run entry

Where a firm enters a market to take short-run supernormal

profits knowing it can exit without incurring costs

Conditions for a Contestable Market

-A pool of new businesses who are willing and ready to enter the market – e.g. app developers

-No significant entry or exit costs – lowers the risk of market entry

-Equal access to available industry technologies

-High rates of customer switching

Efficiency in Contestable Markets

-The more contestable a market is, the more likely that an allocatively efficient outcome is achieved

-Productive efficiency is achieved as firms minimise costs in preparation for potential competition

Contestable Market curve