Here is a short revision video on this question "Analyse how firms might be affected by increased contestability."
A contestable market exists when there is freedom of entry and exit into an industry and there are limited or no sunk costs of production. In the absence of actual competition or threat of a rival entering a market, an unregulated firm could maximise profit where MR=MC. But if a market becomes more contestable – e.g. through a policy of liberalization, then competitive pressures will keep prices down. Instead of profit maximising, existing firms would have an incentive to cut prices perhaps to a level where normal profit is made. This is at an output where price (AR) = average cost. Firms are making enough profit to stay in the market without attracting rivals. Actual and threatened competition intensifies incentives for businesses to control their unit costs by avoiding any X-inefficiencies.
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