CONTESTABLE AND NON-CONTESTABLE MARKETS: AQA Economics Specification Topic 4.1

Topic 4.1 - Individuals, firms, markets and market failure

Snapshot of the AQA syllabus topic area we’ll be covering in this post.

CONTESTABLE AND NON-CONTESTABLE MARKETS: Perfect competition, imperfectly competitive markets and monopoly

AQA students must understand the following content [taken from the syllabus]

• The significance of market contestability for the performance of an industry.

• Concepts such as sunk costs and hit-and-run competition.

INFORMATION YOU NEED TO KNOW

[NOTE: supporting diagrams and questions at the end]

Introduction: Contestable and Non-Contestable Markets

Definition of Contestability: Contestability occurs when a market is open to a threat of competition. The more contestable a market, the more it will resemble perfect competition.

Contestable markets will have:

1. No or low barriers to entry/exit

2. Supernormal profits in the short-run

3. Lower profits in the long-run - depending on the level of contestability (the more contestable the market, the closer firms achieve normal profitability)

If a market is contestable, it means the firms within the market (the incumbent firms) will always face a threat of incoming competition from new firms. The outcome is that the incumbent firms will play it safe and keep prices at a low level to detract new firms from entering the market.

Barriers to entry: A barrier to entry is an obstacle that makes it difficult for new firms to enter a market. You need to be aware of what types of barriers to entry there are.

Examples of entry barriers:

1. Sunk costs: these are the unrecoverable costs of starting up a business.

2. Patents: legal protection to protect ideas and products being copied by other firms.

3. Required advertising expenditure: if a product needs vast amounts of advertising to be successful, barriers to entry will be higher.

4. Predatory & limit pricing: this is when firms within the market have the ability to undercut other firms as they have lower costs of production. This means they have a price advantage over existing firms or new entrants.

5. Trade restrictions: trade restrictions aim to prevent competition from firms outside of the domestic economy. These restrictions can include tariffs and quotas.

6. Technology: technology can raise or lower barriers to entry. For example, improvements in technology has allowed more people to start online business. Making an e-commerce website is cheaper and perhaps easier to maintain than multiple stores. However, certain technologies may also raise entry barriers e.g. modern manufacturing technologies have improved productivity and quality of products, but they require immense amount of capital to produce on a mass-market scale

How barriers to entry affect profit: Barriers to entry make it difficult for new firms to join the market. Higher entry barriers mean existing firms are more likely to have price making power and make supernormal profits.

Hit and run tactics: If barriers to entry are low, then the market will be more contestable. This opens up the market to hit and run tactics. New firms can easily enter the market while the market makes abnormal profits. Because there are low/no barriers to exit, the market attracts new firms who compete excess profits down to zero. Firms are free to leave when the market is no longer economically profitable due to a lack of exit barriers.

How incumbent firms act in a contestable market: Existing firms are likely to act in a way that discourages new market entrants. This could mean decreasing prices to deter new firms from entering. This means a sacrifice of short-term profits to enhance long-term profitability. This is a good strategy for the incumbent firm because new market entrants could increase the risk of business failure.

Incumbent firms may also attempt to create higher entry barriers and decrease the market’s contestability. This could mean developing better products which require a higher startup or investment outlay in order to compete. Other options could mean spending more money on advertising and applying for patents which would protect it from competition.

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SUPPORTING QUESTIONS

Question 1: What is a contestable market?

Answer:

A contestable market is a market where there is relatively easy entry and exit for firms, which creates an environment of potential competition regardless of the actual number of firms present.

Question 2: What are some of the factors contributing to market contestability?

Answer:

Market contestability is influenced by several factors:

• Low sunk costs: If firms can easily recover their investment upon exiting the market, it enhances contestability.

• Easy access to resources and technology: When firms can acquire necessary resources and technology without difficulty, it encourages competition.

• Lack of legal and regulatory barriers: Minimal government regulations or legal barriers facilitate market contestability.

Question 3: What are the advantages of contestable markets for consumers?

Answer:

Contestable markets benefit consumers in various ways:

• Increased choices: Contestable markets encourage new firms to enter, leading to a wider range of products and services for consumers to choose from.

• Competitive pricing: The threat of potential competition keeps prices fair, as existing firms aim to prevent new competitors from joining the market.

• Innovation and quality improvement: Firms may strive to innovate and improve their product lines so their businesses stay competitive on a non-price basis.

Question 4: Would you say the airline industry is contestable? Give 2 reasons.

Answer:

The airline industry could be considered contestable. Here are some reasons why.

Low barriers to entry: Starting an airline company requires significant start-up funding. However, compared to other industries the barriers are quite low because it doesn’t require specialist knowledge in order to run the service and be competitive. Planes are leased from plane manufacturers so the start-up capital wouldn’t be anywhere near as large compared to purchasing the planes outright.

On the other hand, airlines would still need a significant amount of investment capital to successfully break in to a market because leasing planes are not cheap and the company still requires well-trained employees who have a good knowledge of the industry. Thus, these create some legitimate barriers to entry.

Evidence of new entrants: In recent decades, low-cost airlines such as Ryanair and Easyjet have emerged and been successful upon entry to the market. They have quite effectively challenged existing airlines like British Airways in the market for short-haul flights, for example. These companies are often fiercely competitive on price which is evidence that the market has traits of contestability.

However, the turnover of new entrants in the airline industry is not very high compared to other industries, suggesting that the barriers to entry or exit are high relative to other industries. It’s also likely that holidaymakers have more faith when booking tickets with airlines who have an established reputation. For example, the speed and efficiency of baggage handling and the safety rating of airlines are factors people would consider before booking a holiday. New entrants would find it difficult to compete with established firms like British Airways. New firms would likely have to compete on price to attract new customers, thus decreasing profitability and the incentive to join in the first place.

Conclusion:

Overall, it’s likely that the airline industry has a significant degree of contestability due to the cutthroat nature of the business, especially when considering the proven fierce price competition within the market for short-haul flights. If prices were to increase to a level where firms made significant supernormal profits, it wouldn’t be too problematic for new firms to enter and compete prices down.