Contestable Markets

Alvaro Ferreira6626
Flashcards by Alvaro Ferreira6626, updated more than 1 year ago
Alvaro Ferreira6626
Created by Alvaro Ferreira6626 about 6 years ago


Contestable Markets

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Question Answer
Contestable market Incumbents This is where there is free entry and exit of other firms The existing firms in the industry
The theory of contestable markets This theory argues that the number of firms is not the most important factor and what really matters is the absence of barriers to entry and the level of sunk costs
What are the assumptions of a contestable market? Contestable markets are assumed to have free entry to new firms and free exit for both incumbents and new entrants. Firms and new entrants have access to the same technology and cost curves. New firms are not prohibited from entry by incumbents.
Sunk Costs Any form of entry is costly and these are sunk costs of entry. Free exit assumes there are no sunk costs when it leaves the industry. However this depends on whether the costs can be recovered. E.g. buying a factory for a specific good production may be a sunk cost because of the little resale value
Hit and Run entry Where new firms enter the industry, cream off some of the SNP of the incumbents and then exit. For example, the bus industry could have been seen as a contestable market because new routes could be open and by reducing fares to take some of the incumbents SNP
If the industry becomes contestable then the incumbent will lower its price to CP and increase output to 0B and strive to be productive efficient to keep new entrants away. Given ease of entry and exit, monopolies and oligopolies will act as if under perfect competition
Assumptions of contestable markets? No one firm has a significant share of the marketplace There is perfect knowledge in the market Homogeneous or heterogeneous goods Firms are short run profit maximisers Firms compete so collusion does not occur
Contestable market theory Effective? As long as there is threat of competition consumers will be protected from abuses of monopoly/oligopoly power. Potential entry can be achieved if its easily accomplished or incumbents take potential entry into account when making price and output decisions
Benefits of contestable markets Prices are low because firms will operate at AC=AR to keep new entrants away. Short run profits for new entrants (Hit and Run) There is no government intervention Focuses on the contestability rather than the number
Drawbacks of contestable market theory Limited application, sunk costs may be extremely high and make it hard for firms to pull out. Takeovers and mergers may reduce LRAC and create unachievable economies of scale for new entrants
Drawbacks of contestable market theory? Level of technical knowledge needed by the firm may be high and not freely available Incumbents protect themselves with patents and don't make their R&D results widely available. E.g. Pharmaceutical firms
Drawbacks of contestable market theory? Theory ignores the possible aggressive actions of incumbents who alert potential entrants they will resist new entrants by limit pricing. Game theory can be used to analyse the effect on a contestable market E.g. Profit vs Loss (Enter or not) (Monopoly pricing or competitive pricing)
How can markets be made more contestable? Removal of barriers to entry - Not renewing patents Privatisation Deregulation
What affects the contestability of markets? Recession De-regulation of markets Competition policy EU single market Technological change
Reality of contestable markets? There are many industries in which it will be difficult/impossible to recover sunk costs. E.g. spending on advertising is unrecoverable if the firm leaves. Firms will be at a disadvantage in the short term using the same technology
Can barriers to entry be removed? Innocent entry barriers Industry may have innocent entry barriers where they have not been created by the incumbent. This could automatically keep competition away but if there are a few innocent barriers then it can either accept competition and earn normal profits or create strategic barriers to entry to earn SNP
Strategic entry barriers Barriers created by incumbents to stop other firms from entering the market. E.g. Product differentiation, predatory pricing or branding. Bus industry has experienced takeovers to make the market less contestable
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