3.4.7 Contestability

• A contestable market occurs when there is freedom of entry into a market & where costs of exit are low
  • A contestable market & competition are different
    • Competition is based upon the number of firms competing in a market
    • A contestable market is based upon the threat of new entrants
      
      
• Contestable markets are characterised by

1. No barriers to entry or exit: barriers to entry are low or non-existent & there are no sunk costs. This allows firms to easily join or leave the market
2. No competitive disadvantages on entry: new firms are able to setup & immediately compete with existing firms & have access to the same technology
3. Perfect information: There is no proprietary knowledge that would limit competition (e.g. patents)
4. Hit & run competition: Short-run supernormal profit acts as a profit signaling mechanism & new firms easily enter the market, extract profit, then leave
   
   

• The more contestable a market, the more the behaviour of existing competitors may be modified
  • E.g. Firms making supernormal profit may change their pricing strategy from profit maximisation (MC=MR) to limit pricing
  • They are even likely to set the price = average cost (AR=AC)
    • This will reduce hit & run competition
    • It will result in normal profit
    • There will be less disruption to the market
      
      
• The more contestable a market, the more the behaviour of firms resembles that of firms in perfect competition

• Barriers to entry are conditions that make it difficult or expensive for a firm to enter a market in order to compete with the existing suppliers
  
  
• Barriers to exit are factors that either prevent a firm from leaving a market, or make it difficult to leave even if they are making a loss

Types of Barriers to Entry

• One of the main barriers to exit is the existence of sunk costs
  • E.g. To enter the industry, the firm may have acquired expensive assets that are highly specialised & difficult to resell
  • Other examples include money spent on advertising, research & development, branding etc.
    
    
• If sunk costs in an industry are high, it will limit competition & decrease contestability as firms will be more hesitant to enter
  • The lower the sunk costs the more contestable the market
  • The higher the sunk costs the less contestable the market