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Study notes

Contestable Markets

  • Levels: A Level
  • Exam boards: AQA, Edexcel, OCR, IB

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 to established businesses

Introduction to contestable markets
Examples of contestable markets
  • For a perfectly contestable market, entry into and exit out must be costless
  • 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 even when there appears to be one or more dominant businesses with significant market power

Key conditions for a contestable market

  • Absence of sunk costs
  • Access to technology
  • Low consumer loyalty
  • Size of entry barriers
Barriers to Entry - revision video

Are there Differences between Contestable Markets and Perfect Competition?

Yes! It is important to realise that 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:

  1. Perfect information and the ability and/or the right of all suppliers to make use of the best available production technology in the market
  2. The freedom to market / advertise and enter a market with a competing product
  3. 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 i.e. costs that have been committed by a business and cannot be recovered once a firm has entered the industry.

Increasing Contestability of Markets

In recent years a growing number of markets and industries have become genuinely contestable.

Several factors explain this development:

  1. Entrepreneurial zeal: It is often the case that markets become more competitive because of the persistence of entrepreneurs who do not accept that the existing market structure is a given or fixed. A new supplier may have the advantage of product innovation or a more competitive business model based on different pricing strategies. An example of this is the battle that King of Shaves is having as the challenger brand to companies such as Gillette and Wilkinson Sword. Metro Bank has recently opened in the UK in a bid to break the stranglehold of the existing UK high street retail banks, retailers such as Tesco are trying to follow suit.
  2. The recession – an economic downturn can have the effect of opening up markets to new businesses. For example, the recession and subsequent slow recovery has also led to an increase in market share for a number of discount food retailers such as Aldi and Lidl – taking away some of the market share of the dominant food retailers.
  3. De-regulation of markets – De-regulation involves the opening up of markets to competition by reducing some of the statutory barriers to entry that exist. Good examples of recent deregulation include the liberalisation of telecommunications and postal services as part of the European Union competition initiatives. And also the Open Skies initiative in aviation that is aimed at opening up trans-Atlantic air travel.
  4. Competition Policy: Tougher competition laws acting against predatory behaviour by existing firms are designed to make markets more contestable. In both the UK and the EU this has included tougher rules against price fixing cartels.
  5. The EU Single Market: The development of the Single European Market has opened up the markets for member nations. A good example of this is home and car insurance and also the entry of Western European clothes retailers onto the UK high streets and shopping malls.
  6. Technological Change: New technology has brought down some of the entry costs in some markets leading to an increase in capital mobility. A huge investment in open source software is changing the contestability of the market for web browsers; there is no fierce competition between Microsoft's Internet Explorer, Chrome and Android (Google), Firefox (Mozilla) and Safari (Apple).
  7. Technological spill-over can see the emergence of products that imitate the characteristics of the products of the incumbent firms. Just a few years after the launch of Viagra, the anti-impotence drug, Levitra, the first market rival to the hugely profitable Viagra, is now being manufactured by the German firm, Bayer AG, and marketed by British firm GlaxoSmithKline. Pfizer's patent for Viagra expired in June 2013, allowing other pharmaceutical companies to produce their own version and sending prices plummeting from £21.27 for a pack of four to £1.45

UK pubs group JD Wetherspoon announced plans to triple sales of coffee and breakfasts over the next 18 months, as it seeks new sources of growth as pubs come under increased competition from cheap supermarket deals

Deloitte Monday Briefing (March 2015)
What are some of the main barriers to contestable markets?

The contestable market for parcel services

A good example of an increasingly contestable industry is the market for parcel services in the UK. For many years Royal Mail has dominated the sector. But now the part-privatised post service also faces stiff competition in its main UK parcels market from rivals including UPS, TNT and Yodel.

Amazon has recently expanded it's own delivery network to add competitive pressure to existing players and there are many smaller operators such as Shutl (recently bought by eBay) which offers same day delivery for parcels to household and business customers.

Contestable market for e-fit devices

In 2015, Microsoft announced the launch of the Band, a rival product to the Moto 360 and other fitness trackers such as Nike's FuelBand

Key evaluation points

  1. The threat of new competition is often a powerful an influence on the behaviour of existing established firms
  2. A highly contestable market may resemble perfect competition, regardless of the number of firms, since incumbents behave as if there were intense competition!
  3. Competition policies that help to open up the market to new suppliers or persuade consumers to switch in greater numbers help to increase contestability

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