Contestable Markets
Questions
1.
OUTLINE the neo-classical theory of oligopoly.
2.
Define Contestable Markets.
3.
List some assumptions in the theory of Contestable markets.
4.
What is an Innocent entry barrier?
5.
OUTLINE the contestable market theory.
6.
In Contestable markets, what happens to normal/abnormal profits?
7.
OUTLINE the perfect competition theory.
8.
Is a contestable market stable?
9.
Can contestable markets be productively efficient?
10. Define allocatively efficient.
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Contestable Markets
Answers
1.
See box:
First used by English humanist Sir Thomas More (1478-1535) in Utopia (1516), and later developed by the French economist
Antoine Augustin Cournot (1801-1877), oligopoly theory is characterized by a few suppliers producing a heavily differentiated
good (differentiated through advertising, marketing and so on).
Cournot asserted that each firm set its price and output on the assumption that its rivals would not react at all. In this
situation, each firm decreases its price and increases its output to control a larger market share. The result is a market in
which prices are higher and output is lower than they would be in a more competitive market.
Source: J W Friedman, Oligopoly Theory (Cambridge, New York, 1983)
2.
3.
Contestable market is a market in which to gain entry is very easy and accessible. This provides a lot of freedom entering
and exiting the market. In order to leave costs are kept at minimum which benefits all firms/companies.
Assumptions in the Contestable market theory:

Products in this area tend to be homogeneous goods or branded goods.

All firms compete against one another.

Most firms are profit maximisers, in the short term.
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Contestable Markets
4.
See box:
Barriers to entry are designed to block potential entrants from entering a market profitably in the long run.
Entry barriers seek to protect the power of existing firms and maintain supernormal profits and thereby increase producer surplus.
These barriers have the effect of making a market less contestable and therefore affect the evolving structure of a market or an
industry over time. There are different categories or types of entry barriers:
Structural barriers (also known as natural or innocent entry barriers) arise from differences in production costs. For example a
business that has been in a market for many years and has exploited internal economies of scale can therefore produce at a lower
long run average cost. This may cause new entrants to make losses because the existing firms can cut their prices and seek to make
any entry into the market unprofitable. The diagram below helps to illustrate this.
Source: http://www.tutor2u.net/newsmanager/templates/?a=1425&z=1
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5.
See box:
In recent years the term contestable markets has been used by Baumol, Panzer and Willig. A contestable market requires barriers to
entry to be low, and a perfectly contestable market requires a total absence of barriers to entry. Barriers to entry for example being,
special licences, patents, copyrights, high fixed costs, marketing barriers (legal and illegal) constructed by incumbent firms.
A monopoly or firms in oligopoly may not behave as neo-classical economic theories of the firm predict because they may be
fearful of new entrants to the market. If super-normal profits are earned potential competitors may enter the market, so it is argued
that the existing firm(s) will keep prices and output at a level where only normal profits are made. In some cases potential
competitors may engage in hit-and-run behaviour. A hit-and-run competitor will notice when super-normal profit is being made,
enter the market and take advantage of the situation. As prices settle down once more the hit-and-run competitor exits the market
again. Thus the incumbent firms become wary of the potential competitor and set prices so that hit-and-run competitors are
discouraged.
Attention is now focused on the costs of exit from a market. For hit-and-run competition to be a threat, not only must the
costs of entry to the market be low, the costs of exit need to be low too. The costs of exit are sometimes called ‘sunk costs’. These
are costs that cannot be recovered when the firm leaves the market. For example a high street shop can be sold easily to another
retailer, its stock can be sold off at cost price, and even some of the shop fittings may be sold off. However, some things might not
be sold off, for example shop signs and changing room curtains, maybe some stock will have to be sold at less than cost price.
Nevertheless the sunk costs are not too high.
However, with some businesses the sunk costs are a large percentage of the business costs. Creating a brand name or
corporate image can be hugely expensive. Advertising costs are often a significant part of a company’s total costs for products such
as cigarettes, perfume, soap powder and the like. Leaving the market means that all the money spent creating the brand may be
lost – although even brand names can be sold. The costs of car production involve very high fixed costs in terms of machinery,
design, staff training, advertising etc. so that sunk costs are high and this will discourage companies from entering the market unless
they are planning to stay for the longer term. Thus a contestable market requires both low entry and exit barriers. But an
established company does not have to leave the market entirely; it can leave part of the market. A high street multiple can close one
shop in its chain in one town without closing the whole chain. A motor manufacturer might retreat from a country or a continent
without closing down in the rest of the world.
The theory of contestable markets has been used as a defence for companies with established monopolies. Microsoft has
argued that they might have a monopoly of supplying operating systems but because the costs of entry are so low (a PC is all that is
required!) that the software business is contestable. One result of this thinking is in anti-monopoly legislation which has undergone a
change of emphasis from ‘is there a monopoly?’ to ‘is there a harmful monopoly?’
Source: http://www.cr1.dircon.co.uk/TB/2/monopoly/contestablemarkets.htm
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6.
Abnormal prices are commonly earned in contestable markets, although they tend to be only in the short run. This is one of
the many reasons why new firms are attracted to the contestable markets. While normal profits are only achievable in the
long run, as more and more new firms come in due to short bursts in abnormal profits, it will cause the prices to drop. This
will cause most firms to only achieve normal profit.
7. See box:
The Theory of the Firm studies the profit-maximizing behaviour of a firm, and that behaviour depends in part on the demand curve
the firm faces. There are two interesting cases. Under Perfect Competition, the firm faces a horizontal demand curve. It can sell
any quantity desired at the market price, but cannot sell anything above the market price. Under Monopoly / Monopolistic
Competition, the firm faces a downward sloping demand curve. Its price does affect the quantity sold either because it is the only
firm in the market (a monopoly) or because the products in its market are not perfect substitutes (monopolistic competition).
Source: http://www.econmodel.com/classic/terms/perfectcompetition.htm
8.
Prediction in the level of output of a firm within a contestable market is not always possible. The reasons for this are simply
due to the abnormal and normal profits because they vary from short to long term.
Due to the level of output from each firm and depending on the price of the goods, equilibrium is a hard situation within a
contestable market. This is also dependant on how many firms there are and what the unit price is. An example would be 2
firms both sell there products at £15 and there is a demand of 200 units. As it’s a contestable market the firms would only be
getting normal profits, why? This is because the demand is low, and since there are already two firms new firms will not
enter. Although if the market demand was a lot higher more firms would be involved, most likely causing the opposite:
(abnormal profits). This makes the stability of a contestable market hard to judge.
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9. Firms within the contestable markets tend to be productively efficient. This is generally in the long run; the reasons for this
are because when a firm enters the market it would find itself in the low average in terms of production, costs and product
price. This of course would give them the edge over other firms due to price. The knock on affect would make other firms
reduce their prices allowing them to compete in the market. This is the reason why firms tend to be productively efficient.
10. See box:
Allocative efficiency is the market condition whereby market resources/resources are allocated in a way that maximizes the net
benefit attained through their use. Allocative efficiency refers to a situation in which the limited resources of a country are allocated
in accordance with the wishes of consumers. An allocatively efficient economy produces an "optimal mix" of commodities. A firm is
allocatively efficient when its price is equal to its marginal costs (that is, P = MC) in a perfect market.
Source: http://en.wikipedia.org/wiki/Allocative_efficiency
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