Ch6- Contestable Markets

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What is the theory of contestable markets?
the threat of new entry might affect the conduct of incumbent firms i.e. the number of firms in a market is not the most important factor, its the absence of barriers to entry and the level of sunk costs.
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Who was the idea developed by and when? What did he argue?
W.J. Baumol in 1980s. Argued that the benefits of perfect competition could be achieved without all the conditions being met, as long as the market could be made contestable.
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What is an incumbent?
the existing firm in an industry
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What is a sunk cost?
costs that are non-recoverable on leaving the market e.g. capital equipment and advertising
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What is free entry?
assumes all firms, including incumbents and new entrants have access to the same technology and hence have the same costs curve, therefore meaning new firms aren't prohibited from entry by incumbents exploiting economies of scale
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Define free exit
No sunk costs and when it leaves the industry a firm can fully recover all of its previous investment expenditure including all money spent on advertising and building up knowledge
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What are the three features of a contestable market?
1)Low entry and exit barriers, particularly sunk costs (free entry + exit) 2)The potential for post-entry supernormal profit for new firms 3)Perfect Information- the ability and legal right to use the best production technology available
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Name 3 factors affecting contestability
1) privatisation + deregulation 2)second hand markets- where these are thriving start up costs are lowered and more of outlay can be resold if firm decides to leave market
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Give 3 ways a firm will conduct itself in an oligopolistic market
1)entry limit pricing 2)building artificial barriers to entry 3)hit and run entry
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What is entry limit pricing?
incumbent firms price at a lower level than would create maximum profits in the short-run in order to deter new entrants (they are attracted to supernormal profits)
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Why would a firm in a contestable market build artificial barriers to entry?
it would permit them to charge higher prices and make more profit without attracting new entry.
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What is hit and run entry?
When New firms can enter the industry can enter the industry and ‘cream off’ some of the supernormal profits made by the incumbent firms.
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Why would an incumbent behave as if it was in a perfectly competitive industry? (i.e. where AC=AR)
Otherwise a new entrant can step in, undercut their prices, and make a temporary profit before quitting again
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Draw the diagram for hit and run entry
Refer to notes if cannot draw it from memory
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Why would incumbents strive to be productively efficient ?
In order to deter new entrants who could reduce costs even further
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What are the outcomes of contestability (5)
1)Lower prices 2)higher output 3)incentives for firms to cut costs 4)incentives for firms to respond to consumer preferences 5)firm closer to productive and allocative efficiency
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So what does contestability protect consumers from?
the worse abuses of monopoly/oligopoly power through just the threat of competition
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Hence regulating bodies should look at?
the degree of contestability rather than the degree of concentration
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Why is the theory controversial? (4 reasons- 2 on this card)
1) ignores possible aggressive actions of incumbents such as limit pricing 2)incumbents would protect themselves by taking out patents and not making results of R&D widely available
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2 on this card...
3)in many industries it would be difficult to recover sunk costs e.g. on advertising 4)firms may have access to same technology, but the initial user’s expertise may take a new entrant time to acquire, therefore placing incumbents at an advantage
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At Nash equilibrium for the game where there are 2 players- an incumbent and a new entrant...
...The incumbent will set a price where it earns normal profit and B does not enter
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in the UK, what are the 2 main agencies for implementing policy concerning competition?
Office of Fair Trading and Competition Commission
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Who are the responsible to?
The Department of Trade and Industry
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What does the OFT do?
Discovers evidence of exploitation of a dominant market position it believes likely to be against the public interest, and refers the firms to the Competition Commission for further investigation
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What does the competition commission have the power to do? (5 things)
1) Block mergers and break up monopolies 2) Introduce price controls 3) Tax on ‘excess’ profits 4) Nationalise/Privatise 5) Deregulation- removes barriers to entry
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Has aims to?
1)Encourage business start ups 2)encourage entry into markets by removing barriers 3)take actions against anti-competitive practices 4)prevent firms from abusing monopoly power
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Give 6 benefits as a reuslt of competition policy (3 on this card)
1)Low prices for all 2)better quality- to attract customers and expand market share 3)more choice- firms will try and differentiate their products from the rest in order to compete
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(next 3...)
4)more allocatively efficient 5)better competitors in global markets 6)o Innovation: To deliver this choice, and produce better products, businesses need to be innovative – in their product concepts, design, production techniques, services etc.
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Give 3 policies and name what they target
1)UK monopoly policy- targets abuse of monopoly power 2)UK restrictive practices policy- against cartels and horizontal collusion 3)UK merger policy- prevents mergers likely to result in lessening of competition
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What is a merger?
A form of external growth i.e. a rapid way for a firm to expand
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What are the 4 main types of merger? (2 on this card)
1) Horizontal- 2 firms in same stage of production combine their operations 2)Vertical- 2 firms at diff. stages in supply chain come together 3)Conglomerate merger- firms have no obvious relationship but merge to increase market size
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2 on this card..
4)lateral merger- type of horizontal integration in that there are some similarities between businesses e.g. brewery merging with restaurant chain to increase market for their product
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What is internal growth?
Requires use of profits or loans to finance expansion over a period of time by increasing number of both fixed and variable factors within the firm.
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How does internal growth occur?
By either extending an organisations geographic reach or expanding into new products in order to increase size of its available market
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Why is it slower than external growth?
Because markets may be saturated, may be a lack of profits or could be due to strength of competition
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When considering external as opposed to internal growth, what might companies consider? (3 things)
1)time constraints- external more rapid 2)cost- cheaper to buy out other firm than undertake investment 3)asset *********- predator may be able to sell off firm's assets for more than they paid for them
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What is privatisation?
The transfer of assets or organisations from state ownership to the private sector
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What are the 4 forms of privatisation? (2 on this card)
1)Sale of nationalised firms- issuing shares e.g. Royal Mail 2)Sale of state owned assets- e.g. sale of state-owned council houses to tenants
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1 on this card...
3)Competitive tendering of services -services are 'contracted out'- i.e. state-owned services produced by private firms, such as running of leisure centres (note that this is a form of PPP)
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1 on this card...
4)Public private partnership -partnerships between private and public sectors to provide public services e.g. Private Finance Initiative (PFI)- the private sector is commissioned to pay for and build new schools, hospitals etc.
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Give 2 examples of major privatisations in the UK
1)British airways in 1987 2)BP in 1998
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How much do state-owned enterprises now contribute to GDP and employment?
Less than 2% GDP and less than 1.5% employment
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What is nationalisation? What is the most recent example?
when assents are taken back into state ownership e.g. re-nationalisation of Northern Rock and Network Rail
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Give 6 advantages of privatisation
1)promoting efficiency 2)raises gov. revenue in SR 3)promotes competition 4)improves resource allocation 5)PFI creates new facilities without immediate cost to taxpayer 6)Lack of political interference- gov. always motivated by political pressures
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When was privatisation used as a method to cut gov. spending and borrowing? What did it make possible?
in 1980s - income tax cuts
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How does it promote competition?
breaking up monopolies as many nationalised industries are legally protected from competition.
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How does it promote efficiency? (2 ways)
1)profit motives create incentives to cut costs, reducing X-inefficiency 2)if employees given shares in company, this may also contribute to higher productivity
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Give 6 disadvantages of privatisation
1)Worse allocation of resources under privately run monopolies 2)externalities 3)closure of loss-making services e.g.village stations/suburban bus routes 4)Short-termism 5)Expense of quality 6)issues with PFI
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What is short-termism
danger that under private ownership, investments that will only yield profits in the long-term won't occur
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What are the issues with PFI? (3)
1)equity- is this fair to future generations of tax payers? 2)long-term value-may eventually be more expensive than if the government government had borrowed money and paid to construct the facility itself. 3)quality- incentive to cut costs
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Why was Network rail privatised in the first place ?
due to loss making nature and heavy dependence on external subsidies for rural services, as well as the need to see safety as an overriding priority
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Give 3 advantages of privatising network rail...
1)increased efficiency through reducing costs and cutting waste 2)increased concern for consumer need 3)less subsidy from the government
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Give 3 disadvantages of privatising network rail...
1)rail=natural monopoly 2)lack of organisation 3)safety may not be prioritised 4)less profitable services at threat of being closed down 5)fares risen 6)not easy to cut subsidies, many argue gov. needs to spend MORE
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What is deregulation?
The process of removing controls to open up markets and encourage the entry of new suppliers
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What is the aim of deregulation?
Designed to improve resource allocation as it makes markets more contestable (forces incumbent firms to lower prices and increase output)
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How does it promote contestability? (3 ways)
1)Removal of artificial barriers to entry 2)Reduces unnecessary costs imposed on economic agents by red-tape 3)Prevents regulatory capture
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What deregulation has occurred in the UK in the last 3 decades? (3)
1)opening up of markets for household energy supplies 2)liberalisation of household mail services 3)financial deregulation affecting banks and building societies
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What is a natural monopoly?
Industries that can only efficiently support one firm because they have large infrastructures with very high fixed costs e.g. supply of water, gas and electricity.
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Is it possible to deregulate a natural monopoly? Give example.
Yes e.g. the national grid owns the pipe network, but has been forced by legislation to allow other providers to pay to use that network to supply gas. The price paid is set by the industry regulator.
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What is the evaluation of this?
-Subsequent merger and takeover activity has reduced the number of firms. -Consumer Inertia can reduce any downward pressure on prices (when consumers are reluctant to switch providers, as it’s too time consuming)
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What is an internal market?
a system in which goods and services are sold by the provider to a range of purchasers within the same organization, who compete to establish the price of the product
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In an internal market...
...suppliers must compete for custom: from parents choosing a school for their child/GP’s deciding where their patient is to be treated. →resources follow consumer demand
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Give 3 arguments in favour of internal markets?
1)Poorly performing services are unlikely to survive 2)Quality may be driven up as part of competitive process 3) Price competition may reduce X-inefficiency
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Give 3 arguments against internal markets used to provide public services..
1) Poorly performing services may be deprived of resources needed to improve 2)Market failure may occur in internal market e.g. poor information 3)Some services may have monopoly power if there is no other nearby service of the same kind
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Card 2


Who was the idea developed by and when? What did he argue?


W.J. Baumol in 1980s. Argued that the benefits of perfect competition could be achieved without all the conditions being met, as long as the market could be made contestable.

Card 3


What is an incumbent?


Preview of the front of card 3

Card 4


What is a sunk cost?


Preview of the front of card 4

Card 5


What is free entry?


Preview of the front of card 5
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