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Contestable
 Markets
 A2 Microeconomics
What is a contestable market?
• Contestable markets are imperfectly
  competitive markets in which firms face real
  and potential competition
• The threat of “hit and run entry” from new
  rivals may be sufficient to keep the industry
  operating at a competitive price and output
  (bringing about allocative efficiency)
Differences between Contestable and
    Perfectly Competitive Markets
• It is possible for one or a few firms to
  dominate the industry
• Each firm produces a differentiated product
• 3 key conditions for market contestability
  – Ability / legal right to use the best available
    technology
  – Legal freedom to enter a market
  – Relative absence of sunk costs / exit costs
Sunk Costs
• Sunk costs are those costs which are
  irrecoverable to the owners of the firm should
  it decide (a) to close down or (b) leave the
  market
• I.e. sunk cost is a past expense or loss that
  cannot be altered by current or future actions
• Sunk costs are a barrier to entry in an industry
  because they may scare potential entrants
  from entering
Streamed
                    Movies on
                     Demand

                                            Retail
Mail Services                               Coffee
                                            Stores



     Web                                   National
   Browsers                                Lottery

                      Budget
                      Hotels

      Low Contestability (LC) or High Contestability (HC)?
Streamed
                                               ?
                         Movies on
                          Demand

                                                   Retail
LC   Mail Services                                 Coffee         HC
                                                   Stores



          Web                                   National          LC
 ?                                              Lottery
        Browsers

                           Budget
                           Hotels            HC

           Low Contestability (LC) or High Contestability (HC)?
Pricing in a contestable market
Price, Cost

                     Profit max
                       price        MC



                                               AC
              P1


                                               AR




                                  MR


                        Q1        Output (Q)
Pricing in a contestable market
Price, Cost

                     Profit max
                       price       MC



                                             AC
              P1


              P2                             AR




                                  MR


                        Q1              Q2
Pricing in a contestable market
Price, Cost

                     Profit max
                       price       MC



                                             AC
              P1                                  Normal
                                                   profit
              P2                             AR




                                  MR


                        Q1              Q2
Hit and Run Entry
• Entry to a market in
  expectation of making an
  immediate profit
• Can only occur if the
  entrant does not incur
  sunk costs
• Economies of scope help
  here – i.e. Extending a
  brand name into a new
  market
Strong brands can make it easier to enter a new market!
Making markets more contestable
• De-regulation - I.e. reducing barriers to entry to
  liberalise a market
• Tougher competition laws acting against
  predatory behaviour by existing firms / tough
  rules against cartels
• Changing nature of technology – has brought
  down entry costs and made prices more
  transparent for consumers (e.g. Internet retailing)
• New business models that challenge established
  players e.g. Low cost airlines
Barriers to Contestability
                  • Vertical integration giving control
Raising rivals’     over the supply-chain
    costs         • Import tariffs / protectionism


  Reducing        • Bundling – offering some extra
    rival’s         products for free
  revenues        • Selling spare capacity at low prices


   Cross-         • Using profits from one market to cut
subsidisation       prices in another
Contestability and economic welfare

           Monopoly
           High profit margins (P>AC)

            Production inefficiencies

       Price > MC (allocative inefficiency)

     Inequitable for lower income consumers
Contestability and economic welfare

   Contestable Market
     Lower prices due to competition
         Smaller profit margins
       A faster pace of innovation?
       More dynamically efficient?
Key evaluation points
Number of    • Abnormal profits attract new
               entrants driving down prices.
firms less   • Markets efficient so long as they
               are genuinely contestable
 relevant

             • Competition policy focuses on
Opening up     reducing barriers to entry.
             • Potential competition more
 a market      important for efficiency than
               actual competition
Tutor2u

 Keep up-to-date with economics,
resources, quizzes and worksheets
    for your economics course.

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Contestable Markets

  • 1. Contestable Markets A2 Microeconomics
  • 2. What is a contestable market? • Contestable markets are imperfectly competitive markets in which firms face real and potential competition • The threat of “hit and run entry” from new rivals may be sufficient to keep the industry operating at a competitive price and output (bringing about allocative efficiency)
  • 3. Differences between Contestable and Perfectly Competitive Markets • It is possible for one or a few firms to dominate the industry • Each firm produces a differentiated product • 3 key conditions for market contestability – Ability / legal right to use the best available technology – Legal freedom to enter a market – Relative absence of sunk costs / exit costs
  • 4. Sunk Costs • Sunk costs are those costs which are irrecoverable to the owners of the firm should it decide (a) to close down or (b) leave the market • I.e. sunk cost is a past expense or loss that cannot be altered by current or future actions • Sunk costs are a barrier to entry in an industry because they may scare potential entrants from entering
  • 5. Streamed Movies on Demand Retail Mail Services Coffee Stores Web National Browsers Lottery Budget Hotels Low Contestability (LC) or High Contestability (HC)?
  • 6. Streamed ? Movies on Demand Retail LC Mail Services Coffee HC Stores Web National LC ? Lottery Browsers Budget Hotels HC Low Contestability (LC) or High Contestability (HC)?
  • 7. Pricing in a contestable market Price, Cost Profit max price MC AC P1 AR MR Q1 Output (Q)
  • 8. Pricing in a contestable market Price, Cost Profit max price MC AC P1 P2 AR MR Q1 Q2
  • 9. Pricing in a contestable market Price, Cost Profit max price MC AC P1 Normal profit P2 AR MR Q1 Q2
  • 10. Hit and Run Entry • Entry to a market in expectation of making an immediate profit • Can only occur if the entrant does not incur sunk costs • Economies of scope help here – i.e. Extending a brand name into a new market
  • 11. Strong brands can make it easier to enter a new market!
  • 12. Making markets more contestable • De-regulation - I.e. reducing barriers to entry to liberalise a market • Tougher competition laws acting against predatory behaviour by existing firms / tough rules against cartels • Changing nature of technology – has brought down entry costs and made prices more transparent for consumers (e.g. Internet retailing) • New business models that challenge established players e.g. Low cost airlines
  • 13. Barriers to Contestability • Vertical integration giving control Raising rivals’ over the supply-chain costs • Import tariffs / protectionism Reducing • Bundling – offering some extra rival’s products for free revenues • Selling spare capacity at low prices Cross- • Using profits from one market to cut subsidisation prices in another
  • 14. Contestability and economic welfare Monopoly High profit margins (P>AC) Production inefficiencies Price > MC (allocative inefficiency) Inequitable for lower income consumers
  • 15. Contestability and economic welfare Contestable Market Lower prices due to competition Smaller profit margins A faster pace of innovation? More dynamically efficient?
  • 16. Key evaluation points Number of • Abnormal profits attract new entrants driving down prices. firms less • Markets efficient so long as they are genuinely contestable relevant • Competition policy focuses on Opening up reducing barriers to entry. • Potential competition more a market important for efficiency than actual competition
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