A contestable market occurs when there is freedom of entry and exit into the market.
- In a contestable market, there will be low levels of sunk costs.
- Sunk costs are costs that a firm cannot recover when it leaves the market. For example, if you spend money on advertising, you cannot get this money back, when you leave the market.
- The theory of contestable markets suggests that the number of firms is not important. But, the threat of entry is. If firms fear that new firms could easily enter, this threat of competition should be enough to keep prices competitive and profits low.
As well as low sunk costs, a contestable market will also have
- Easily available information about the state of the industry.
- Freedom to advertise.
- A legal right to enter the market.
Hit and Run Competition
- If there are low entry and exit costs then firms can engage in hit and run tactics. This means that if an industry is making supernormal profits, then a firm can enter and take advantage of the high prices and high profits.
- If prices fall and the industry is no longer profitable, then the firm will leave.
- Therefore in a contestable market a firm should be satisfied with normal profits otherwise it would encourage hit and run tactics.
Contestable Markets and the Public Interest
Contestable markets can bring the benefits of competitive markets such as:
- Lower prices
- Increased incentives for firms to cut costs.
- Increased incentives for firms to respond to consumer preferences.
- The firm will be closer to allocative and productive efficiency than in a monopoly.
- There could also be significant economies of scale because the theory of contestable markets doesn’t require there to be thousands of firms.
Therefore policy makers 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
Discuss the extent to which an industry is contestabl?
Often, at A level there are questions asking how contestable is an industr? To examine the contestability of an industry, we should look at:
Level of Sunk Costs.
If sunk costs are high this makes it difficult for new firms to enter and leave the market. Therefore it will be less contestable.
Levels of Advertising and brand loyalty.
If an established firm has significant brand loyalty such as Coca Cola, then it will be difficult for a new firm to enter the market. This is because they would have to spend a lot of money on advertising which is a sunk cost.
The level of Profit
If a firm is making very high profit, this is an indication that the market is not contestable, because hit and run competition should enable new firms to enter and reduce the profitability of the industry.
If a firm does not have access to the supply of a good then the market will be less contestable. E.g. the big oil firms could restrict the supply of petrol tonew petrol stations, making it difficult for new firms to enter. For airlines, a big issue is whether you can get a landing slot at a big airport.
Access to technology and skilled labour
For some industries like car production it is difficult for new firms to have the right technology. Nuclear power may require skilled labour that is difficult to get.
Degrees of Contestability
It is important to remember that contestability is not a clear cut issue, there are degrees of contestability, some markets having more capacity for new firms to enter.
Examples of Contestability
UK Banking industry
- There are high sunk costs in getting a network of banks set up around the country..
- Brand loyalty to existing banks is high. Customers are unwilling to switch. Therefore a new firm would have to spend a lot on advertising, which is a sunk cost, making it less contestable.
- Existing banks make very high profits, suggesting hit and run competition does not occur.
These issues suggest banking is not contestable.
- However the introduction of the internet has reduced set up costs and enabled new firms to enter the market for online banking e.g. EGG. Also there is has been a growth in non-traditional forms of banking, such as credit unions and Wonga.
Therefore the banking industry has become more contestable in recent years, although the big five banks still dominate on the high street.
Examples of Contestable Markets
- Being a tourist guide around a popular city. It is easy to be a walking guide for a tourist city. There are low sunk costs, just turn up and attract a few tourists. It is easy to leave the market. However, in cities like Venice, the job of being a tourist guide may be heavily regulated. See: example of contestable market
- Internet Blogs. It is fairly easy to set up an internet blog. If you can attract enough visitors, you could easily enter the industry. (Market contestability and the internet)
Methods to Increase the Contestability of Markets
- Remove legal barriers to entry
The Royal Mail used to be a legal monopoly but now firms are allowed to enter the market for sending letters. This has increased contestability.
- Force firms to allow competitors to use its network
For example when BT was privatised, OFTEL forced BT to allow other companies to use its network. This has also occurred in the Gas and Electricity industries and has made them more contestable.
- Legislation against Predatory Pricing
If a firm can engage in predatory pricing it can force new firms out of business and make it less contestable.
- OFT can legislate against theabuse of Monopoly power