Contestable Markets

• A contestable market is a market where there is free and costless entry and exit.
• Therefore incumbent firms will always the threat of new firms entering the industry. Therefore such a market will have a competitive equilibrium, even if there are a small number of firms

 

A perfectly Contestable Market has the following three features:

• Absence of  Sunk costs
• Perfect information
• Freedom to advertise and a legal right to enter the market

 

Sunk Costs:  These are costs which are non-recoverable such as advertising

 

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 high prices,
• 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

• 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  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

 

Methods to Increase the Contestability of Markets

 

1. Remove legal barriers to entry

Royal Mail used to be a legal monopoly but now firms are allowed to enter the market for sending letters

2. 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

 

3. 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

4. OFT can legislate against abuse of Monopoly power

IF a firm abuses its monopoly power by restricting supply to certain firms the OFT can intervene to overcome this restriction on contestability.

See also:

• Essay on Contestable Markets