3.4.7 Contestability – Edexcel Economics A notes

Contents

The characteristics of a contestable market

Contestability measures the extent of barriers to entry and exit in the market.

What are the features of a contestable market?

• Freedom to enter and exit the market.
• Low barriers to entry
  • Barriers to entry include:
    • Economies of scale.
    • Advertising and brand loyalty.
    • Predatory pricing occurs when a firm lowers prices temporarily to force competing firms out of the market.
    • Intellectual property, for example patents that provide the owner with legal protection for an invention.
    • Vertical integration that prevents other firms from accessing suppliers.
  • Barriers to entry and exit include sunk costs
    • Sunk costs are costs that cannot be recovered.
    • Sunk costs make it harder to enter the market, decreasing contestability.
    • Examples of sunk costs include spending on advertising, research and development or specialised capital equipment that cannot be sold after exiting the market.
• As a result of free entry and exit, firms face a threat of other firms entering the market. This forces firms already in the market to keep profits low.
• Potential entrants to the market have information about available production techniques.
  • This allows potential entrants to enter the market, copy existing production techniques, while undercutting the firm already in the market.
  • This eliminates supernormal profit in the market over time.

Note markets can be contestable, whether they contain one firm or many firms.

The difference between perfect competition and contestable markets, briefly, is that in a contestable market the threat of competition (“potential competition”) keeps firms from making supernormal profits. This occurs even if there is only one firm. 

Implications of contestable markets for firm behaviour

How do contestable markets influence firm behaviour?

• Limit pricing
  • Limit pricing is where firms in the market set prices so low that they make normal profit.
  • In a contestable market, firms may use limit pricing to prevent other firms entering.
• Normal profit (or zero supernormal profit)
  • This results from low barriers to entry. 
  • So either firms engage in limit pricing leading to normal profits, or if firms try to make supernormal profits, other firms enter the market in the long run and undercut on price, lowering profits.
  • Note it is possible for firms to earn supernormal profits in the short run. However in the long run other firms would enter the market.
  • This means there is less need for regulators to intervene to prevent abuse of market power.
• Benefits for consumers include lower prices and increased consumer surplus.
• Firms have incentives to cut costs, otherwise other firms will enter and undercut them on price. This means firms will produce on their lowest average total cost curve (X-efficiency).
• Dynamic inefficiency
  • Firms do not earn supernormal profit in the long run, so lack the funds to reinvest into innovation to lower costs over time.
• Lack of stability for firms and workers
  • Firms may be more likely to shut down in a contestable market. This is because new entrants can enter the market and undercut other firms on price. Also firms cannot build up high reserves of supernormal profits to sustain future losses. This uncertainty about whether a firm will survive may reduce investment. 
  • This may also lead to less job security for workers, as firms are more likely to go out of business.

Extra evaluation points for contestable markets

The consequences of contestable markets and the extent to which markets are contestable depend on:

• The extent of economies of scale.
  • In practice industries may exhibit economies of scale, making it more difficult to contest the market. 
  • Larger firms who benefit from economies of scale are able to produce at lower long-run average costs, so new entrants cannot compete on cost and hence price.
• The level of information.
  • If potential entrants lack information about the opportunities to make profit in different industries, they may be less likely to enter the market. This would make the market less contestable
• The level of regulation.
  • Regulation may be needed to prevent firms forming exclusive contracts with suppliers for example. 
  • Regulation may also be needed to ensure stability, for instance to reduce disorder that may be associated with frequent firm entry and exit.

Factors that influence the level of contestability

• Technological progress.
  • New technology can lower barriers to entry. For instance the cost of advertising as firms can advertise online and there is no longer a requirement for an in person shop to do business. 
  • Technology may make consumers more knowledgeable, reducing brand loyalty.
  • However as technology improves and becomes more sophisticated, the costs of technology may rise, increasing barriers to entry.
• Mergers or collusion could encourage predatory pricing.
• Action from the competition regulators.
  • This could include breaking up or blocking a merger, as well as investigating and punishing firms for collusion. There could also be legal sanctions, such as fines, for predatory pricing.
  • This would prevent firms from achieving economies of scale or engaging in predatory pricing.
• How easy it is to access loans.
  • Suppose it becomes easier for small firms to access funding. This would give new firms the funding to enter the market, allowing them to overcome barriers to entry more easily.
• The level of intellectual property protection can create barriers to entry, as firms without patents cannot use a new technology for production that other firms can use.

Edexcel style practice question on contestability

This is a practice question written in the style of Edexcel Economics A. Specifically there is a short extract, followed by a practice question.

The banking and energy markets in the UK have seen several new entrants. This includes Monzo and Starling in banking, as well as OVO Energy and Octopus Energy in the market for energy. These markets have become more contestable. This is in part because the UK Government has made it easier for consumers to switch providers in these markets but this is also due to technological change.  

Discuss the microeconomic consequences of markets becoming more contestable. (25 marks)

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