Revision pres

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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