Contestable Markets

Contestable Markets

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  • Created by: Clodagh
  • Created on: 24-04-14 09:19
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  • Contestable Markets
    • This theory considers how the threat of new entry might affect the conduct of incumbent firms (those already in the market)
    • Features
      • A contestable market is one that is open to new entrants
      • Low entry and exit barriers, particularly sunk costs
        • Sunk costs are costs that are not recoverable on leaving the market
          • Many sunk costs are start up costs such as capital equipment and advertising
        • A market with no entry or exit barriers is regarded as perfectly contestable
      • The potential for post-entry supernormal profit for new firms
    • Barriers to entry
      • Patents: These give a firm the legal protection to produce a patented product for a number of years
        • They are government enforced and are generally assigned for 17-20 years giving the owner the exclusive right to prevent others from using their products, ideas or inventions
      • Vertical integration: Control over supplies and distribution allow outlets to maintain their market power
      • Limit pricing: Firms may adopt predatory pricing policies by lowering prices to a level that would force new entrants to operate at a loss
      • Absolute cost advantages: Lower costs allow the existing monopolist to cut prices and win price wars
      • Advertising: High levels of advertising enable firms to establish branded products and win customer loyalty
        • New entrants must therefore spend substantial amounts on advertising to compete
      • Sunk costs: Some industries have very high start-up costs or a high ratio of fixed to variable costs
        • Some of these costs might be unrecoverable if an entrant opts to leave the market. This acts as a disincentive to enter the industry
      • International trade restrictions: Restrictions such as tariffs and quotas are considered as a barrier
        • Foreign rivals cannot compete with firms in a protected domestic market
    • Enhancing Contestability
      • Capital costs are often seen as sunk costs and reduce contestability
        • Where there is a thriving second hand market for capital equipment, start up costs are lowered and more of the outlay can be recouped if a firm decides to leave the market
      • Markets may also be contestable when there are powerful firms in related markets who are able to diversify
      • Government policy (deregulation)has made a number of industries more contestable in recent years
    • Conduct
      • The crucial assumption of the theory of contestable markets is that the conduct of incumbent firms can be influenced by the threat of new entry into their market
        • In a market with low or zero entry barriers, supernormal profit is likely to attract new entry
    • Artificial Barriers to Entry
      • Firms operating in highly contestable markets may have an interest in making their market less contestable
        • This would permit them to charge higher prices and make more profit
      • Examples include heavy advertising expenditure, product differentiation and investing in spare capacity
    • Hit and Run Competition
      • Highly contestable markets are not just easy to enter, they are also easy to leave
      • It is possible for new firms to enter for brief periods of time and make supernormal profit, even if they are then forced to leave the market quickly
    • Performance
      • The main insight of contestable markets theory is that a lack of entry barriers may force firms into concentrated markets to a price at competitive levels
      • The performance outcomes are similar to those for perefect competition


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