Unit 3 Micro: Revision on Contestable Markets

This blog links to an updated revision presentation on the economics of contestable markets.

Key points:

* For a contestable market to exist there must be low barriers to entry and exit so that new suppliers can come into a market to provide fresh competition.
* For a perfectly contestable market, entry into and exit out must be costless
* No market is perfectly contestable but virtually every market is contestable to some degree even when it appears that the monopoly position of a dominant seller is unassailable.
* This can have implications for the behaviour (conduct) of existing firms and then affects the performance of a market in terms of allocative, productive and dynamic efficiency.
* A contestable or competitive environment is common in most industries

Contestable markets are different from perfect competitive markets. For example, it is feasible in a contestable market for one firm to have price-setting power and for firms in a market to produce a differentiated product.

There are three main conditions for pure market contestability:

o Perfect information and the ability and/or the right of all suppliers to make use of the best available production technology in the market.
o The freedom to market / advertise and enter a market with a competing product.
o The absence of sunk costs – this reduces the risks of coming into a market.

Sunk costs – a barrier to contestability

Barriers to market contestability exist when there are sunk costs. These are costs that have been committed by a business cannot be recovered once a firm has entered the industry.