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 RetailMail Services Coffee Stores Web National Browsers Lottery Budget Hotels Low Contestability (LC) or High Contestability (HC)?
Streamed ? Movies on Demand RetailLC Mail Services Coffee HC Stores Web National LC ? Lottery Browsers Budget Hotels HC Low Contestability (LC) or High Contestability (HC)?
Pricing in a contestable marketPrice, Cost Profit max price MC AC P1 AR MR Q1 Output (Q)
Pricing in a contestable marketPrice, Cost Profit max price MC AC P1 P2 AR MR Q1 Q2
Pricing in a contestable marketPrice, 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 controlRaising 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 cutsubsidisation 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 pointsNumber of • Abnormal profits attract new entrants driving down prices.firms less • Markets efficient so long as they are genuinely contestable relevant • Competition policy focuses onOpening up reducing barriers to entry. • Potential competition more a market important for efficiency than actual competition
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