1.5.9 Contestable Markets — Practice Questions
Eight original multiple-choice questions on contestable and non-contestable markets, written to the style and difficulty of AQA Paper 3 Section A. Every question carries a full worked model answer.
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8 questions in this set
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1. A contestable market is best defined as one in which
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Answer: D (There is freedom of entry to and exit from the market.). Contestability is about how easily firms can get in and out, not about how many are currently trading. A market with no barriers to entry or exit and minimal sunk costs is contestable, because the mere threat of a newcomer disciplines the firms already there. Freedom of exit matters as much as entry: a firm will not enter if it cannot leave without heavy losses.
Why the other options are wrong
- A — Homogeneous products and many small buyers are characteristics of perfect competition, which is a statement about market structure rather than about ease of entry.
- B — Market share thresholds are used to identify monopoly power. A market can be highly concentrated and still be contestable.
- C — This is the definition of competition, and separating the two is the whole point of the topic. Competition counts the firms in the market; contestability asks how easily others could join them.
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2. The key distinction between competition and contestability is that competition refers to
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Answer: B (The number of firms, while contestability refers to ease of entry.). Competition describes how many firms are actually trading and how hard they compete. Contestability describes how easily other firms could join or leave. The two can come apart: a market with only three firms can behave very competitively if entry is quick and cheap, because the incumbents know that exploiting their position would invite immediate rivals.
Why the other options are wrong
- A — This reverses the terms. Barriers to entry are what determine contestability, and profit levels are a consequence rather than a definition.
- C — Competition is about the number of firms, not products, and contestability is about entry and exit rather than firm numbers.
- D — Neither concept is defined by firm size or production costs, although sunk costs do affect how contestable a market is.
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3. A sunk cost is best defined as a cost that
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Answer: A (Cannot be recovered if a firm decides to leave the market.). A sunk cost is spending that cannot be recouped on exit — bespoke advertising, industry-specific research, a licence with no resale value. Sunk costs are the single biggest obstacle to contestability, because a firm considering entry knows that if the venture fails, that money is simply gone. Equipment that could be sold on second-hand is not sunk, which is why leasing aircraft or vans makes a market far more contestable than owning them.
Why the other options are wrong
- B — Costs falling as scale increases describes economies of scale, which is a different idea, though large economies of scale can themselves act as a barrier to entry.
- C — Sunk costs are typically incurred before any trading begins — that is precisely what makes entry risky.
- D — Costs varying with output are variable costs. Sunk costs are usually fixed and, crucially, unrecoverable.
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4. A firm enters a market to capture short-run supernormal profit and leaves once profits fall back to normal. This is best described as
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Answer: C (Hit-and-run competition.). Hit-and-run competition is only possible where entry and exit are both cheap. A firm spots supernormal profit, enters quickly to take a share of it, and withdraws once the profit is competed away — losing nothing on exit because it had no sunk costs. Its importance is that the mere possibility of this behaviour restrains incumbent firms even when no entry actually occurs.
Why the other options are wrong
- A — Collusion means rival firms cooperating to keep prices high. Hit-and-run entry does the opposite: it competes profit away.
- B — Creative destruction is innovation displacing older products and firms. The entrant here is not innovating, simply capturing an existing profit.
- D — Predatory pricing is an incumbent pricing below cost to drive out a rival. This describes an entrant arriving to take a share of profit.
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5. A market contains only two firms, but entry requires no sunk costs and any new firm could begin trading immediately. All other things being equal, the two firms are most likely to
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Answer: C (Set prices close to average cost, to deter potential entrants.). This is the central insight of contestability theory. With no sunk costs, any attempt to charge a high price would attract entrants within days, so the incumbents restrain themselves and set prices close to average cost — earning little more than normal profit. The market behaves competitively despite containing only two firms, because the discipline comes from potential rather than actual competition.
Why the other options are wrong
- A — Collusion is easy to arrange with two firms but pointless here: the high price it produced would simply draw in outsiders who are not party to the agreement.
- B — Monopoly behaviour requires protection from entry. Without barriers, restricting output to raise price invites the competition that removes the profit.
- D — No rivals are present at the moment, and that is exactly the trap in this question. The threat of entry constrains behaviour even when nobody has entered.
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6. Which one of the following would make a market less contestable?
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Answer: B (Incumbent firms building strong brand loyalty over many years.). Strong brand loyalty is a barrier to entry. A newcomer must spend heavily on advertising to persuade customers to switch, and that spending is largely a sunk cost — unrecoverable if the entry attempt fails. The prospect of losing it deters entry, which weakens the threat that disciplines the incumbents and so makes the market less contestable.
Why the other options are wrong
- A — Leasing rather than buying converts what would be a sunk cost into a recoverable one, so the entrant can walk away cheaply. That makes a market more contestable.
- C — Equal access to technology means the entrant suffers no competitive disadvantage, which is one of the listed characteristics of a contestable market.
- D — Perfect information removes the informational advantage incumbents would otherwise hold, again increasing contestability.
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7. In a highly contestable market, incumbent firms are most likely to
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Answer: B (Charge lower prices and produce more than in a less contestable market.). Knowing that supernormal profit would attract entrants, incumbents in a contestable market hold back from exploiting their position. They set lower prices and produce more output than they would if entry were blocked, and earn something close to normal profit. Contestability therefore delivers many of the benefits of competition without requiring a large number of firms actually to be present.
Why the other options are wrong
- A — Restricting output to raise price is what firms do when they are protected from entry. Contestability produces the opposite behaviour.
- C — Persistent supernormal profit requires barriers to entry. In a contestable market it would be competed away, which is why incumbents avoid provoking entry in the first place.
- D — The whole theory rests on potential entrants mattering. Incumbents change their behaviour precisely because of rivals who have not yet arrived.
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8. A government wants an industry dominated by one large firm to behave more competitively, but breaking the firm up is impractical. The policy most consistent with contestability theory would be to
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Answer: C (Reduce the barriers and sunk costs facing potential entrants.). Contestability theory says behaviour is shaped by the threat of entry, not merely by how many firms exist. If the government cannot change the number of firms, it can still change how easily others could arrive — by removing licensing restrictions, requiring incumbents to share essential infrastructure, or funding common standards that cut set-up costs. The dominant firm then has to price as though rivals were about to appear, even if none does.
Why the other options are wrong
- A — A profit cap tackles the symptom directly, but it requires the regulator to know the firm's true costs and it blunts the incentive to become more efficient. It is regulation rather than contestability.
- B — Public ownership changes who owns the firm rather than the competitive pressure it faces, and it leaves the same monopoly cost structure in place.
- D — A price below average cost would force the firm into losses and eventually out of business, leaving consumers with no supplier at all.