Contestable Markets (Cambridge (CIE) A Level Economics): Revision Note

Contestable markets

• A contestable market occurs when there is freedom of entry into a market and where costs of exit, sunk costs are low

  • A contestable market and 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

Characteristics of contestable markets

1. No barriers to entry or exit

• Barriers to entry are low or non-existent, and 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 set up and immediately compete with existing firms and have access to the same technology

3. Perfect information

• There is no proprietary knowledge that would limit competition (e.g. patents)

4. Hit-and-run competition

• Short-run supernormal profit acts as a profit signalling mechanism, and new firms easily enter the market, extract profit, then leave

Sunk costs and the degree of contestability

• 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 and difficult to resell

  • Other examples include money spent on advertising, research and development, branding etc.

• If sunk costs in an industry are high, it will limit competition and 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

Implications of contestable markets for firms

• 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-and-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