Contestable markets

Characteristics of contestable markets:

Contestable markets face actual and potential competition.

Entrants to contestable markets have free access to production techniques and technology.

There are no significant entry or exit barriers to the industry. For example, there will be no sunk costs in a contestable market. There is low consumer loyalty. The number of firms in the market varies.

  

Implications of contestable markets for the behaviour of firms:

If markets are contestable, firms are more likely to be allocatively efficient. In the long run, firms operate at the bottom of the average cost curve. This makes them productively efficient.

The threat of new entrants affects firms just as much as existing competitors. Due to the low barriers to entry which provide easy access to the market, firms are wary of new entrants entering the market, taking supernormal profits, and then leaving. This is also called hit-and-run competition.

Markets which are highly contestable are akin to a perfectly competitive market. This is because existing firms act as though there is a lot of competition. There could be supernormal profits in the short run and only normal profits in the long run. In the short run, new firms can enter and take advantage of the supernormal profits. However, in practice, firms can only earn normal profits in the short run. This is because it is the only way to prevent potential competition. Without supernormal profits, there is no incentive for new firms to enter, even if barriers to entry and exit are low.

Types of barrier to entry and exit:

Barriers to entry aim to block new entrants to the market, it increases producer surplus and reduces contestability.

The greater the economies of scale that a firm exploits, the less likely it is that a new firm will enter the market. This is because they would produce comparatively expensively, so they cannot compete.

Legal barriers can act as a barrier to entry. For example, patents and exclusive rights to production mean other firms cannot enter the market. Some industries, such as the taxi industry, gain market licences to operate. Since new firms have to gain a licence, there is a barrier to entry. Consumer loyalty and branding can make a market less contestable.

Predatory pricing involves firms setting low prices to drive out firms already in the industry. In the short run, it leads to them making losses. As firms leave, the remaining firms raise their prices slowly to regain their revenue. They price their goods and services below their average costs. This reduces contestability.

Limit pricing discourages the entry of other firms. It ensures the price of a good is below that which a new firm entering the market would be able to sustain. Potential firms are therefore unable to compete with existing firms.

Some firms might employ anti-competitive practices, such as refusing to supply retailers which stock competitors.

Vertical integration means one firm gains control of more of the market, which creates a barrier to entry.

Firms might saturate the market with their goods using brand proliferation. This disguises consumers from the actual market concentration. For example, the many brands of the laundry soap market are provided by only a few large conglomerates.

Barriers to exit prevent firms from leaving a market quickly and cheaply.

They include the cost to write off assets and pay leases. Firms have to continue paying leases and contracts, even after closure. It could make it cheaper to stay in the industry than to leave. This makes the market less contestable.

Losing a brand and consumer loyalty is hard to put a monetary value on, but is still considered a cost of leaving the market. The cost of making workers redundant might discourage firms from leaving an industry.

     By Segesela Blandina

        BAPRM 42663