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Contestable markets

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Economics

In some industries, the competition level and monopoly power of the market are not based on the number of firms but the ease or difficulty for a new firm to enter the market. We call those industries contestable markets. What are contestable markets, exactly? How do they influence the industry performance and firms' behaviour? What are the pros and cons of contestable markets? In this explanation, you will find out.

What are contestable markets?

Contestable markets occur when firms can enter and leave a market freely without any sunk costs. According to the contestable market theory, when the barriers to entry are low, there is a contest threat of new firms driving the incumbent firms out of business. Even a monopoly can suffer badly if they don't own any special technology or strategic resources that protect them from new entrants. Thus, in a contestable market, firms must behave productively to remain competitive.

Contestable markets occur when firms can enter and leave a market freely without any sunk costs and where the same technology level access is available to both new entrants as well as incumbent firms.

How does market contestability influence industry performance?

A monopoly market structure is determined by the number of firms in the market and the share of the leading companies by the concentration ratio. This poses a huge challenge for policymakers as they try to prevent the abusive behaviour of monopolies.

Market contestability may provide the answer. In a contestable market, monopoly power isn't based on the number of firms or concentration ratio but rather on how easy it is for a new firm to enter a market. To put it another way, market concentration is okay as long as the barrier of entry is low so that new firms can enter and ‘have a chance’ to compete.

In reality, the actual competition doesn't have to take place. Only the potential competition (the threat of entry by new firms) is enough to prevent existing firms from abusing their monopoly power or behaving inefficiently.

Market contestability has a significant impact on UK monopoly policy. Since the potential for competition is enough for existing firms to behave responsibly, the conventional regulatory policy is unnecessary. The governments can limit the role of monopoly policy to uncover more potentially contestable markets. In addition, deregulatory policies focus on setting the conditions for the entry and exit barriers, making sure the level of contestability is reasonable.

Key characteristics of contestable markets

The two main characteristics of a perfectly contestable market are:

  • No barriers to entry or exit.
  • No sunk costs.

No barriers to entry or exit

Barriers to entry are factors that prevent newcomers from entering the market and drive competition. Some examples include high start-up costs, government regulations, patent protection, strong brand identity, customer loyalty, or high consumer switching costs.

Barriers to exit are obstacles that prevent a company from exiting a market such as highly specialized assets, closure costs, or government regulations. In a contestable market, there are few or no barriers to entry and exit. Thus, firms are free to join and leave the market at any time, posing a huge threat to the existing businesses.

No sunk costs

Sunk costs are irrecoverable costs a firm incurs when it enters a market. This means that when the firm exits the market, it can’t recover the costs that it incurred. Sunk costs are not the same as fixed costs.

If a firm purchases machinery when entering a market, this is a fixed cost. It won't be a sunk cost if the company can sell the machinery at a good price upon its exit. On the other hand, if the firm can’t sell or give away the machinery to another firm for free, the initial investment is known as a sunk cost as the cost is not recovered. Other sunk costs include payroll and advertising expenditures.

To learn more about the different types of costs check our explanation on the Costs of Production.

Effects of contestable markets on firms’ behaviour

Without sunk costs, firms in a contestable market can have a ‘hit and run’ strategy: enter the market when the demand is high to take advantage of the abnormal profits and leave the market when the demand drops.

The threat of hit and run competition keeps prices and profits at the lowest levels possible, which increases the consumer surplus. This is shown in Figure 1 below. Instead of pricing at the monopoly price of P1, companies price at P2, thereby increasing consumer welfare due to reduced price and greater quantity.

Figure 1. Contestable market diagram - StudySmarter.

  • In a non-contestable market, a monopoly can maximise its profit by pricing where MC=MR at P1.
  • In a contestable market, the firm is forced to lower the prices to remain competitive (from P1 to P2). As a result, the supernormal profit is depleted and only normal profit is made.
  • With more firms in the market, customers also enjoy a wider range of products (Q2 compared to Q1).

Advantages and disadvantages of contestable markets

Let’s explore some of the advantages and disadvantages of contestable markets.

Advantages

  • Efficiency: contestable markets force firms to reduce costs, thus increasing allocative and productive efficiency.
  • Economies of scale: a contestable market doesn't require a large number of firms to drive prices down as it depends on the ease of entering and exiting the market. Thus, unlike perfect competition, there can be considerable economies of scale.

Disadvantages

  • Barriers to entry: it's hard to remove the barriers to entry as they may require firms to have specialised knowledge and technology.
  • Reducing monopoly power: monopoly can help the market to achieve significant economies of scale. With monopoly power reduced, the market may struggle to achieve productive efficiency.
  • Brand loyalty: customers may be resistant to switching brands when a lot of firms enter the market.

Contestable Markets - Key takeaways

  • Contestable markets occur when firms can enter and leave the market freely with no sunk costs.
  • In a contestable market, monopoly power doesn't rely on the number of firms but the level of difficulty for a new firm to enter a market.
  • The potential competition (the threat of entry by new firms) in a contestable market is enough to prevent existing firms from abusing their monopoly power.
  • A perfectly contestable market is characterised by two main factors: no barriers to entry and exit and no sunk costs.
  • Sunk costs are irrecoverable costs incurred upon a firm's market entry.
  • Without sunk costs, firms in a contestable market can engage in a ‘hit and run’ competition.
  • When the market becomes contestable, existing firms must lower the prices to remain competitive. In time, the supernormal profit is replaced by the normal profit.
  • Market contestability may improve efficiency and economies of scale.
  • The disadvantages of a contestable market include low barriers to entry, decreased monopoly power, and resistance from brand loyalty.

Contestable markets

A contestable market is a market that firms can enter and exit without any sunk costs. 

The contestable market has no barriers to entry and exit. There can be any number of firms (even one or few firms) and these don't have to be price takers. By contrast, a perfectly competitive market can have multiple firms and all firms are price takers. 

Low-cost airlines, tourism, internet service providers.

Companies in a contestable market may engage in hit and run competition: they enter the market temporarily to take advantage of the supernormal profits and leave when the profit is exhausted. 


In a contestable market, there is a threat of new firms entering the market, thus preventing the abuse of monopoly power by the existing firms. 

Final Contestable markets Quiz

Question

What is a contestable market?

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Answer

Contestable markets occur when firms can enter and leave a market freely without any sunk costs. 

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What are the conditions of a contestable market?

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No barriers to entry and exit

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How many firms does a contestable market have?

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Any number of firms.

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How does contestable market differ from perfectly competitive market? 

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Answer

A contestable market can have any number of firms (even one or a very few) and these firms    don't have to be price takers.


Perfectly competitive markets have a large number of firms and all firms are price takers. 


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How does contestable market limit the abuse of monopoly power?

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Due to the low barrier to entry and exit, any number of new firms can enter the market. This forces the existing firms to behave efficiently and non-oppressively to remain in the market. 

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What does the barrier to entry mean?

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Barriers to entry are factors that prevent newcomers from entering the market and driving competition. 

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What is not an example of barrier to entry?

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High start up costs

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What does barrier to exit mean?

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Barriers to exit are obstacles that prevent a company from exiting a market

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What are some examples of barriers to exit?

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Highly specialized assets, closure costs, or government regulation.

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What does sunk cost mean?

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Sunk costs are costs a firm incurs when entering a market entry which are irrecoverable when the firm leaves the market.

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Is machinery that can be sold at a good price when a company exits the market considered a sunk cost?

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No, because the cost is recoverable. 

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What are some examples of sunk costs?

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Costs of purchasing achinery that can't be sold upon a firm's exit. 

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How do firms behave in a contestable markets?

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In the absence of sunk costs and barriers to entry & exit, firms can engage in hit and run competition. 

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What is hit and run competition?

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A firm enters the market temporarily to capture the surplus profit and exits when the profit is exhausted. 

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What may not be an advantage of contestable markets?

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Increase firm's efficiency

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Contestable markets occur when firms can enter and leave a market freely without any ___________ .   

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sunk costs 

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Existing firms have a higher level of technology than new entrants in contestable markets. 

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True

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 In a contestable market, monopoly power isn't based on the number of firms or concentration ratio but rather on  ___________ .


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how easy it is for a new firm to enter a market 

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Question

The two main characteristics of a perfectly contestable market are:

  • ___________ 
  • No sunk costs

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Answer

  • No barriers to entry or exit.

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Sunk costs are ___________ costs a firm incurs when it enters a market. 

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Answer

 irrecoverable 

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Due to little or no sunk costs, firms in a contestable market can have a hit and run strategy

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little or sunk costs 

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When a firm enters the market to take advantage of the abnormal profits and leaves when the demand drops, it is said to adopt a  ___________  

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 ‘hit and run’ strategy

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Market contestability may improve efficiency and ___________ .

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economies of scale 

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The potential competition in a contestable market is enough to prevent existing firms from abusing their monopoly power. 

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True

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High start-up costs, government regulations, and patent protection are example of  ___________ .    

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barriers to entry

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Question

The governments can limit the role of monopoly policy to uncover more potentially contestable markets. 

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True

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