Contestable Markets

understand what makes a market contestable

Definition: Contestability is how open to competition a market is. The more contestable a market, the more it resembles perfect competition.

Contestable markets will have:

1. No or low barriers to entry/exit

2. This means supernormal profits can be made in the short-run

3. However, in the long-run supernormal profits will be competed away

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

You need to be aware of what types of barriers to entry there are. Barriers to entry are responsible for firms making supernormal profits.

The higher the barriers to entry, the increased likelihood of supernormal profits.

Barriers to entry could be:

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 selling online. Making an e-commerce website is cheaper and perhaps easier to maintain than multiple stores. However, certain technology can also raise barriers to entry e.g. modern manufacturing technologies have improved productivity and quality of products, however, they require immense amount of capital to produce on a mass-market scale

Overall, 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 it is making supernormal profits. However, in the long-run the market will only make normal profit. Because there are low/no barriers to exit also, firms are able to leave the market without a great deal of cost.

[Firms will choose to enter the market if they think total profit made will outweigh any costs of entry/exit]

What can the incumbent firms do in response?

If the incumbent firms are aware that the market is contestable, they will likely act to decrease the chances of new firms entering. They will likely price lower, to detract new firms for entering in the first place. They will sacrifice short-term profits, with the aim of making greater profits in the long-run and risking failure.

Another thing the incumbent firms may do is try to create barriers to entry. Developing better products with higher levels of skill, inventing and innovating, spending more on advertising, apply for new patents etc, can all be options for the incumbent firms.

In summary, we have learned:

Condition of contestable markets

Barriers to entry

Hit and run tactics

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