Contestability content slideshow. Designed for the Economic A level qualification. Can be used in revision and in class. Subtopics: Intro to Contestability Impacts of Contestability Factors Promoting Contestability Evaluation of Contestable Markets Theory

1. Contestability
Upper 6th Micro
Market Structures

2. Intro to
Contestability
Contestability
Mr O’Grady

3. Intro to Contestability
Contestable Market: Where an entrant has access to all the production techniques
available to the incumbents, is not prohibited from wooing the incumbent’s
customers, and entry decisions can be reversed without cost
i.e. it is easy for a new firm to join the industry. Low barriers to entry.
Three Conditions of Contestable Markets:
Perfect information: All firms are aware of and have the right to use the best available
information
Equal access to technology
i.e. no IPRs restricting competition
Freedom to enter and grow: Firms are legally allowed to enter the market and it is easy for
them to grow
Firms are free to advertise and the effectiveness of this is often aided by low customer loyalty
The absence of sunk costs: There are no costs which cannot be recovered upon exiting the
industry
Firms are able to easily and cheaply leave the market
Frictionless reversible entry
Result: ‘hit and run’ competition whenever there are supernormal profits to be
made

4. Impacts of
Contestability
Contestability
Mr O’Grady

5. Impacts of Contestability
Quantity
C/R
AC
MC
D = AR
MR
qPM
pPM
cPM
p/cCon
qCon
Initial equilibrium: If the incumbent
operates at MR=MC, price is pPM P1, output
is qPM, hence SNPs are made
Contestable implication: Due to costless
entry and exit, new firms will arrive to
compete for these profits
The incumbent has an incentive to increase
output (towards qCon) and reduce price (towards
pCon), to defend its market share
Result: This promoted economic efficiency, serves consumer interests and illustrates how
even a monopoly may have an incentive to price competitively
All because of the threat of competition, even if there is no actual competition
Contestability theory: challenges the suggestion that economic efficiency is primarily
dependent upon the number of firms in the market; it suggests that is the threat of
competition that is significant i.e. the size of barriers to entry.

6. Outcomes of Contestable Markets
Quantity
C/R
AC
MC
D = AR
MR
qPM
pPM
cPM
p/cCon
qCon
Increased Allocative Efficiency: The firm lowers its price, and this is likely to be closer to
MC
Furthermore, the firm is not restricting output at MC=MR therefore lessens the DWL
Productive efficiency: Depends on the min point of AC in relation to MC=MR & AR=AC
But contestability could reduce x-inefficiency, as if the incumbent was slack it would only be able to make subnormal
profit upon the entry of a new firm. Laziness would be irrational.
Lower price & increased quantity: Market
moves towards perfectly competitive result
Firms output decision switches from MC=MR to ATC=AR
Increased CS (WTP – P): lower price causes
expansion in demand curve
Brings more customers into the market
Lowers the price paid by customers already in the market
Reduces profit: Firm goes from supernormal
profit to normal profit
Reduces dynamic efficiency

7. Factors
Promoting
Contestability
Contestability
Mr O’Grady

8. Factors Promoting Contestability
Growth of internet/e-commerce: Relatively low cost of web hosting and ability to
outsource content development
E.g. Travel agency market (Expedia vs Thomas Cook (R.I.P.))
Entrepreneurial Zeal: desire to take risks and use product innovation
E.g. Challenger banks (Metro Bank, Monzo) vs ‘High Street Banks’
Deregulation aka market liberalisation: the reduction or elimination of
government barriers in a particular industry
E.g. the 1980 transport act, making it easier for firms to enter the bus transport sector by
abolishing the requirement for bus firms to hold a road service licence
Tougher competition laws: laws to act against anticompetitive behaviour such as
predatory pricing and collusion
E.g. In the late 1990s, the OFT punished News International for using predatory pricing for
Times & Sunday Times newspapers

9. Evaluation of
Contestable
Markets Theory
Contestability
Mr O’Grady

10. Evaluation of Contestable Markets Theory
No such thing as perfect contestability: “...perfectly contestable markets do not populate
the world of reality any more than perfectly competitive markets do” Baumol
A market will never have zero sunk costs, so the theory only gives us a theoretical benchmark
The relevant question is therefore the degree of contestability and whether a particular industry is
becoming more contestable or less contestable
Firms may be reactive rather than proactive: There is an academic disagreement as to
whether the threat of hit & run entry is enough to keep prices low
They might instead make SNPs, wait for new firms to enter, then set P<AVC to drive them out,
subsidised by retained profits, before returning to SNP again
Desirability of contestability: Contestability may not be desirable in hi-tech industries,
where SNPs are needed for continued innovation and dynamic efficiency
Lower profit means less to spend on R&D and less dynamic efficiency
Note: For your exam, there are typically two styles of questions:
To what extent is ‘Market x’ contestable?
Assess the impacts of a change in the contestability of ‘Market x’.
You must identify the specific question being asked!

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