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Study Notes

3.4.7 Contestability (Edexcel)


Last updated 20 Sept 2023

This Edexcel study note covers Contestable Markets

a) Characteristics of contestable markets:

  1. Low Barriers to Entry: In a contestable market, there are low barriers to entry for new firms. This means that it is relatively easy for new companies to enter the market and compete with existing firms. Barriers to entry could include factors like high startup costs, government regulations, or control over essential resources.
  2. Low Barriers to Exit: Similarly, contestable markets have low barriers to exit. Firms can exit the market without incurring substantial costs or facing significant obstacles. This encourages firms to enter and exit the market based on changes in profit opportunities.
  3. Perfect Information: In a contestable market, both existing and potential entrants have access to perfect information about market conditions, including prices, costs, and demand. This transparency ensures that firms can make informed decisions about entering, exiting, or adjusting their production levels.
  4. No Sunk Costs: Sunk costs are costs that cannot be recovered once incurred. In contestable markets, firms are assumed not to have significant sunk costs. This means they can exit the market without suffering substantial financial losses, which makes the market more contestable.
  5. Freedom of Entry and Exit: Firms in contestable markets can enter and exit freely without facing legal or regulatory restrictions. This freedom allows for dynamic competition as firms can respond quickly to changes in market conditions.
  6. No Collusion: Collusion between firms to maintain monopoly power is less likely in contestable markets due to the ease of entry and exit. Firms know that if they try to raise prices or restrict output, new competitors can quickly enter and undercut them.

b) Implications of contestable markets for the behavior of firms:

  1. Price Competition: Firms in contestable markets tend to engage in intense price competition since they know that new entrants can easily undercut their prices if they attempt to charge excessive prices.
  2. Efficiency and Innovation: Firms have an incentive to operate efficiently and innovate to maintain a competitive edge. In a contestable market, the threat of new entrants drives firms to continually improve their products and processes.
  3. Short-Term Focus: Firms may have a short-term focus on maximizing profits since they are aware that the market conditions can change rapidly with the entry of new competitors.
  4. No Monopoly Power: Contestable markets discourage firms from attempting to establish and maintain monopoly power since any attempt to do so is likely to be short-lived.

c) Types of barriers to entry and exit:

  1. Economies of Scale: Firms that can produce at lower average costs due to economies of scale may deter new entrants, as newcomers may struggle to compete with established firms' cost advantages.
  2. Capital Requirements: High startup and capital investment costs can be a significant barrier to entry, especially in industries requiring expensive equipment or infrastructure.
  3. Government Regulation: Regulatory barriers, such as licensing requirements or safety standards, can limit entry into certain markets.
  4. Access to Distribution Channels: Difficulty in accessing distribution channels or securing shelf space can act as a barrier, particularly in industries with established distribution networks.
  5. Brand Loyalty: Established brands with strong customer loyalty can deter new entrants from gaining market share.
  6. Network Effects: In industries where the value of a product or service increases with the number of users (network effects), it can be challenging for new entrants to compete with established networks.
  7. Patents and Intellectual Property: Firms with strong patent protection or proprietary technology can create barriers to entry by preventing others from using their innovations.

d) Sunk costs and the degree of contestability:

Sunk costs are costs that have already been incurred and cannot be recovered. The presence of sunk costs can affect the degree of contestability in a market. In a contestable market:

  • Low Sunk Costs: When firms have minimal sunk costs, it becomes easier for them to exit the market if conditions become unprofitable. This enhances the contestability of the market, as firms are not financially tied to the industry.
  • High Sunk Costs: If firms have significant sunk costs, such as substantial investments in specialized equipment or infrastructure, they are less likely to exit the market quickly. High sunk costs can reduce the degree of contestability because firms may continue to operate even when they are not earning a profit, hoping to recoup their initial investments.

In summary, low sunk costs contribute to a more contestable market by allowing firms to enter and exit more easily, while high sunk costs can reduce contestability by trapping firms in the market even when they are unprofitable.

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