Contestable

Markets
A2 Microeconomics

What is a contestable
market?
Contestable markets are imperfectly
competitive markets in which firms
face real and potential competition
The threat of hit and run entry
from new rivals may be sufficient to
keep the industry operating at a
competitive price and output
(bringing about allocative efficiency)

Differences between Contestable

and Perfectly Competitive Markets
It is possible for one or a few firms to
dominate the industry
Each firm produces a differentiated
product
3 key conditions for market contestability
Ability / legal right to use the best available
technology
Legal freedom to enter a market
Relative absence of sunk costs / exit costs

Sunk Costs
Sunk costs are those costs which are
irrecoverable to the owners of the firm
should it decide (a) to close down or (b)
leave the market
I.e. sunk cost is a past expense or loss that
cannot be altered by current or future
actions
Sunk costs are a barrier to entry in an
industry because they may scare potential
entrants from entering

Streame
d
Movies
on
Demand
Retail
Coffee
Stores

Mail
Services

Nationa
l
Lottery

Web
Browsers
Budget
Hotels

Low Contestability (LC) or High Contestability (HC)?

Streame
d
Movies
on
Demand
L
C

Mail
Services

Web
Browsers
Budget
Hotels

Retail
Coffee
Stores

H
C

Nationa
l
Lottery

L
C

H
C

Low Contestability (LC) or High Contestability (HC)?

Pricing in a contestable
market
Price,
Cost

Profit
max
price

MC

AC

P
1

AR

MR

Q
1

Output
(Q)

Pricing in a contestable
market
Price,
Cost

Profit
max
price

MC

AC

P
1
P
2

AR

MR

Q
1

Q
2

Pricing in a contestable
market
Price,
Cost

Profit
max
price

MC

AC

P
1
P
2

AR

MR

Q
1

Q
2

Normal
profit

Hit and Run Entry

Entry to a market in
expectation of making
an immediate profit
Can only occur if the
entrant does not incur
sunk costs
Economies of scope
help here i.e.
Extending a brand
name into a new market

Strong brands can make it easier to enter

a new market!

Making markets more

contestable
De-regulation - I.e. reducing barriers to entry
to liberalise a market
Tougher competition laws acting against
predatory behaviour by existing firms / tough
rules against cartels
Changing nature of technology has
brought down entry costs and made prices more
transparent for consumers (e.g. Internet
retailing)
New business models that challenge
established players e.g. Low cost airlines

Reducing
rivals
revenues

Bundling offering some extra

products for free
Selling spare capacity at low
prices

Crosssubsidisatio
n

Using profits from one market

to cut prices in another

Vertical integration giving

control over the supply-chain
Import tariffs / protectionism

Raising
rivals costs

Barriers to Contestability

Contestability and economic welfare

Monopoly
High profit margins (P>AC)
Production inefficiencies
Price > MC (allocative
inefficiency)
Inequitable for lower income
consumers

Contestability and economic welfare

Contestable
Market
Lower prices due to
competition
Smaller profit margins
A faster pace of
innovation?
More dynamically
efficient?

Key evaluation points

Number
of firms
less
relevant
Opening
up a
market

Abnormal profits attract

new entrants driving down
prices.
Markets efficient so long
as they are genuinely
contestable
Competition policy focuses
on reducing barriers to
entry.
Potential competition
more important for
efficiency than actual
competition