Characteristics of Contestable Markets

A contestable market is one where there is freedom of entry into and exit from the market, which is determined by the absence of significant barriers. The threat of entry from potential competitors is what disciplines the existing firms (incumbents).

Key characteristics of a perfectly contestable market:

• No Barriers to Entry or Exit (Low Sunk Costs): This is the main feature. Firms can easily enter to earn supernormal profits and exit without significant loss.

• No Competitive Disadvantages on Entry: New firms have access to the same production techniques and technology as existing firms (e.g., no proprietary knowledge like patents limiting them).

• Perfect Information: Both existing and potential firms have perfect knowledge of market conditions, costs, and profits.

• "Hit-and-Run" Competition: New firms can enter a market, attracted by short-run supernormal profits, take those profits, and then quickly exit if the incumbent firms drive the price down, all without incurring significant sunk costs.

Implications of Contestable Markets for the Behaviour of Firms

The threat of entry, rather than the number of existing firms, forces incumbent firms to behave in a more competitive manner.

• Limit Pricing: To deter the entry of new firms, incumbents are likely to adopt limit pricing. This means setting the price below the profit-maximising level MC = MR but above the average cost AR > AC initially, but potentially AR = AC for perfect contestability) to make the market appear unattractive to potential entrants.

• Reduced Supernormal Profit: In a perfectly contestable market, firms are forced to set price equal to average cost P = AC in the long run to earn only normal profit. This is the entry-limit price; any supernormal profit would immediately invite entry.

• Increased Efficiency:

  • Allocative Efficiency: The threat of entry pushes the firm's price closer to Marginal Cost P=MC, leading to greater allocative efficiency (maximising social welfare).

  • Productive Efficiency: Firms are incentivised to operate at the bottom of their long-run average cost curve to minimise costs and keep prices low, thus promoting productive efficiency.

• Incentives for Innovation: Firms may innovate to try and lower their costs or improve their product/service to maintain a competitive advantage and stave off potential entrants.

Sunk Costs and the Degree of Contestability

Sunk Costs

A sunk cost is a cost that has already been incurred and cannot be recovered if a firm decides to leave the market.

• Examples: Money spent on specialised, non-transferable machinery; unrecoverable advertising and market research expenditure; rent paid on highly specific premises.

Types of Barrier to Entry and Exit

Barriers to entry and exit reduce the degree of contestability in a market.

Economies of Scale

Existing firms may have significant cost advantages due to large-scale production, which new, smaller firms cannot match.

Legal Barriers

Government-imposed restrictions or exclusive rights.

Branding/Loyalty

Existing firms have established strong brand loyalty, making it difficult for new entrants to steal market share without significant and costly advertising/promotion.

Control of Essential Resources

Incumbents own or control a crucial input or distribution channel.

Strategic Barriers

Actions taken by incumbents to deter entry.

High Start-up Capital

The initial financial outlay required to begin operation is very high.

Sunk Costs and Contestability

• High Sunk Costs: Act as a significant barrier to entry because they increase the risk associated with entering the market. If the venture fails, the investment cannot be recovered upon exit. This reduces the degree of contestability.

  • Conclusion: Higher sunk costs = Lower contestability.

• Low Sunk Costs (or Zero): Mean that a firm can easily exit the market with minimal financial loss. This makes the risk of entry much lower, encouraging hit-and-run entry and increasing the degree of contestability.

  • Conclusion: Lower sunk costs = Higher contestability.