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4.1.5.8 Contestable Markets (AQA A Level Economics Teaching Powerpoint)

Level:
A-Level
Board:
AQA

Last updated 13 Sept 2023

This editable and downloadable PowerPoint covers Contestable Markets

A contestable market is one that's easy to enter and exit, meaning new firms can quickly enter and compete with existing firms. This is the opposite of a market with high barriers to entry, like one with significant startup costs or legal requirements that make it difficult for new firms to enter. In a contestable market, existing firms know that they need to keep their prices competitive because new firms can enter and undercut them at any time. A common example is the retail industry - opening a small shop or online store is relatively easy and low-cost, so it's a very contestable market.

Some other good examples are food trucks, freelance markets (like writers, programmers, or graphic designers), and coffee shops. In each of these cases, there are relatively low barriers to entry. Starting a food truck or coffee shop is relatively low-cost and doesn't require a lot of licenses or training. And freelance markets are easy to enter because they're online and anyone with the right skills can start offering their services. The key is that in all these cases, new firms can quickly enter the market and start competing with existing firms.

William Baumol was a big proponent of contestable market theory! Baumol and his co-author, John C. Panzar, developed the idea of "Baumol-Panzar contestability" in their book "Contestable Markets and the Theory of Industry Structure". Their work showed that even if there's only one firm in a market, that market can still be competitive and efficient if new firms can enter easily. This was a big departure from the traditional view that competition requires many firms in a market.

In order for a market to be contestable, it's important that new firms don't have to make a lot of sunk costs to enter the market. Sunk costs are costs that can't be recovered, like the cost of buying equipment or a building. If these costs are too high, it makes it harder for new firms to enter the market and compete with existing firms. In a contestable market, low sunk costs mean that if a firm can't compete, it can easily exit the market without taking a major loss. This encourages new firms to enter the market and keeps existing firms from raising prices or reducing quality.

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