- Information
- AI Chat
Was this document helpful?
Contestable markets econhelp
Course: Eco (104)
96 Documents
Students shared 96 documents in this course
University: North South University
Was this document helpful?
Contestable markets
A contestable market occurs when there is freedom of entry and exit into the market.
In a contestable market, there will be low sunk costs. (Costs which can’t be recovered
when leaving the market)
Due to freedom of entry and exit – existing firms always face the threat of new firms
entering the market.
This threat of entry is sufficient to keep prices close to a competitive equilibrium and
profits low – otherwise, new firms enter.
In a contestable market, it is not the number of firms that is important, but the ease by
which new firms can enter the market.
Diagram of contestable market
If the market was a monopoly with high barriers to entry, the firm would maximise
profits at P1, Q1 (point A)
If the market became perfectly contestable – with freedom of entry and exit, then the
existing firm would have an incentive to cut prices to P2 (point B) – Otherwise, new firms
would enter the market until normal profits are made.
Therefore, contestable markets will have lower profits than monopoly.
Contestable markets and the public interest
Contestable markets can bring the benefits of competitive markets such as:
Lower prices (allocative efficiency)
Increased incentives for firms to cut costs (x-efficiency)
Increased incentives for firms to respond to consumer preferences (allocative
efficiency)
However, there could also be significant economies of scale because the theory of contestable
markets doesn’t require there to be 1000s of firms
Therefore policymakers should not just look at the degree of concentration, but also the
degree of contestability and how easy it is to enter the market.
Regulators in the privatised industries have often focused on removing barriers to
entry, rather than breaking up big firms.
Factors which determine the contestability of a market