Chapter 6
Teacher notes
Competition policy and contestable
markets
Activity, page 68.
1 Nationalisation refers to the state/government taking control of firms.
2 Arguments in favour might include:
a) prevent abuse of consumers by a dominant private sector monopoly
b) some strategic industries, for example, manufacture of defence goods, require government
oversight rather than private sector management to ensure that the outcome is in the best interest
of the country, rather than to maximise profit (the nationalisation of Northern Rock might be
seen as protection of a key strategic company)
c) potentially increased awareness of externalities
d) provision of merit goods, or those with positive externalities, that may be underprovided by the
private sector
e) provision of public goods, which would not be provided at all by the private sector
f) some companies may be natural monopolies, and so if control of them was in the hands of the
private sector, prices might be very high and output low, because they would not achieve
economies of scale
g) increased consumer surplus.
3 Arguments in favour of privatisation of former nationalised industries could be:
a) Revenue would be raised for the government.
 However, this is a one-off chance to raise revenue and cannot be repeated.
b) It would reduce the size of the public sector, which could potentially reduce the tax burden, and
improve efficiency.
 However, in the case of natural monopolies, it may be more efficient for the public sector to
run the company.
 Externalities may be ignored.
c) It would improve efficiency, as private sector firms will be motivated by profit, and will
therefore want to reduce costs (therefore possibly achieving productive efficiency) and will have
to produce the goods that consumers really want (therefore possibly being allocatively efficient).
 However, again, this would not be true for natural monopolies.
 Essential, but unprofitable, services may be underprovided, for example, rural train lines.
d) It would promote competition, since when many industries are privatised they are broken down
into a number of other companies (for example, privatisation and deregulation of the bus service
industry in the 1980s).
 However, natural monopolies cannot be broken down and so competition would not increase,
and furthermore, in the case of bus services, Stagecoach became very dominant through the
use of anti-competitive practices.
Activity, page 71.
4 A contestable market is one in which there is the potential for competition because barriers to
entry/exit are very low, but there may be any number of firms (from one to many). Furthermore,
goods may either be homogenous or differentiated. In perfect competition, however, there must be
many firms in the industry and goods are homogenous.
5 A sunk cost is one which cannot be recovered if a firm decides to leave an industry.
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Chapter 6
Teacher notes
6 A ‘hit and run’ entrant is a firm which enters a market that is contestable (that is, low sunk costs)
and that is currently making supernormal profit; the hit and run entrant appropriates some of that
supernormal profit, and then leaves the industry as sunk costs are very low.
Activity, top of page 75.
7 Contestable market theory, unlike the other theories of market structure, does not link the structure
of the market (in terms of the number of firms in the market) to the behaviour (or conduct) of those
firms. The number of firms in a contestable market is therefore irrelevant to its analysis.
8 Government competition policy has traditionally been associated with the prevention of monopoly
power, as denoted in terms of percentage market share (which can be difficult to measure as the
boundaries of markets themselves can be difficult to define in reality).
Contestable markets theory suggests that this approach may actually be wrong, as market share is not
in itself a good indicator of whether consumers are being exploited.
Instead, contestable markets theory suggests that competition policy should actually focus on removing
barriers to entry/exit, thus allowing freer entry/exit of firms into a market. This threat of
competition should encourage incumbent firms to behave more competitively, since new entrants
could engage in hit and run entry if supernormal profits are being made.
9 Examples of privatised utilities include water companies (Thames Water, United Utilities, Wessex
Water, etc.), gas companies (British Gas, EDF, EON, npower) and electricity (very much the same
companies providing gas supply).
These industries have been privatised and deregulated, in an attempt to reduce barriers to entry and
increase contestability. One way in which the government did this was to separate the network from
the actual provision of the service, so that any company could essentially ‘rent’ a gas pipeline to
provide gas to someone’s home.
To this end, more companies now supply gas/electricity than they did previously, and so local
monopolies have been prevented. The suppliers do compete on price, but their tariff structures can
be very complicated (consumers pay different prices depending on whether they pay by meter,
direct debit or monthly cheque, and whether they get both gas and electricity supplied by the same
company, that is, dual fuel). This complicated pricing structure makes it difficult to assess the
impact of contestability on prices.
However, in the case of water, companies still have local monopoly power as there is only one
provider in each geographical area. To try to reduce exploitation of consumers in the water industry,
regulation is still quite heavy (RPI-x is used to keep prices affordable, and there are rules as to
network maintenance). Contestability has had less of an impact.
AQA Examination-style questions, bottom of page 75.
Question 1:
a) Characteristics include:
i) low sunk costs
ii) low barriers to entry/exit
iii) any number of firms (1+)
iv) prices are similar to those we would expect in very competitive markets (could draw a diagram
to illustrate this, for example, Figure 01 from Chapter 6)
v) incumbent firms consider the potential for new entrants to join the market when they make
their pricing and output decisions
vi) no collusion
vii) perfect knowledge
viii) goods can be homogenous or differentiated.
AQA Economics A2 © Nelson Thornes Ltd 2009
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Chapter 6
Teacher notes
Students could comments on which characteristics are shared with perfectly competitive markets.
b) Analysis issues that could be considered include:
i) explanation of how contestability could be increased (with possible examples from the
bus/utility/airline industries) – deregulation, privatisation, separation of network from
service, etc.
ii) contestability diagram (figure 01 from Chapter 6 of A2 student book) showing firms producing
where AC=AR, thus making normal profit, and achieving allocative and productive efficiency,
since AR=MC and AC is minimised
iii) consumers are benefited because prices are lower, therefore consumer surplus is increased, and
output is probably higher, meaning that a greater number of consumers can benefit from being
able to purchase the product.
Evaluation issues that could be considered include:
iv) removal of government regulations, or privatisation, in order to increase contestability does not
mean that barriers to entry are completely reduced; incumbent firms could use strategic barriers
to entry to maintain some degree of monopoly power, therefore continuing to exploit
consumers and maintain higher prices
v) achieving normal profits may reduce dynamic efficiency, since firms are not able to earn high
enough profits to provide funds for further investment/Reserach and Development (R&D)
vi) even if the degree of contestability is increased, hit and run entry may not benefit consumers,
particularly if the product provided requires maintenance over several years (for example, spare
parts for white goods); consumers may choose not to purchase a good at all rather than risk
buying a product that may not be supported in the future
vii) problems with the contestable markets theory itself means that the question may be irrelevant,
that is, it is usually impossible to completely remove barriers to entry/sunk costs.
Essay question 2: (AQA June 2005)
c) Define monopoly.
Draw monopoly diagram, and use it to illustrate:
i) High prices, therefore low consumer surplus
ii) Low output, therefore low consumer surplus
iii) Supernormal profits, therefore consumer exploitation
iv) Non-achievement of productive or allocative efficiency
d) Policies include:
i) Regulation – this could mean limiting price increases (e.g. RPI-x), encouraging output, setting
standards for quality of service/product
 But, expensive to run regulatory agencies, danger of regulatory capture, difficult to choose
‘x’ in RPI-x approaches
ii) Nationalisation – particularly in the case of natural monopoly
 But, government not necessarily the experts in that industry, costly for taxpayers (therefore
opportunity cost), unpopular with competitors
iii) Deregulating the industry, and reducing barriers to entry in order to increase contestability (e.g.
utility industry)
 But, difficult to remove all barriers to entry in practice, deregulation can lead to increased
monopoly power (e.g. Stagecoach in 1980s/1990s)
iv) Forcing companies to split up i.e. demerge, thus reducing market share
 But, difficult to accurately assess market share and know how to split companies up so that
they are still able to provide the good/service
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Chapter 6
Teacher notes
Students should discuss at least two policies, and come to a clear conclusion as to their preference,
with justification.
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