3.4.7 Contestability
Edexcel A-Level Economics (9EC0) | Theme 3.4.7
What Is a Contestable Market?
A contestable market is one where there is freedom of entry and low costs of exit.
The important idea is that the threat of potential competition, rather than just the number of existing firms, disciplines firm behaviour.
A key distinction is that competition refers to the number of firms in the market, whereas contestability refers to how easy it is for firms to enter and leave.
Key Characteristics of a Contestable Market
- There are no barriers to entry or exit, or barriers are very low.
- Sunk costs are minimal or zero.
- New entrants face no competitive disadvantage, for example because they can access the same technology and resources as existing firms.
- Perfect information is available, so there is no major informational advantage for incumbent firms.
- Hit-and-run competition is possible, where firms enter quickly to earn short-run supernormal profit and then leave once profits return to normal.
Implications for Firms
Even if there are only a few actual firms, the threat of hit-and-run entry can force them to behave more competitively.
Disciplined Behaviour
Incumbent firms may avoid exploiting market power because they know supernormal profits will attract new entrants.
Limit Pricing
A common strategy is limit pricing, where firms set price below the profit-maximising level so that they earn only normal profit.
In simplified form, this means price may be set around \( P = AC \), removing the profit signal that would otherwise attract entry.
Outcome
The more contestable the market, the more firm behaviour tends to resemble perfect competition, with lower prices, higher output, and greater allocative efficiency.
Types of Barriers to Entry
| Barrier | Explanation | Example |
|---|---|---|
| Economies of scale | Large existing firms may have much lower unit costs, making entry difficult for new small firms. | Large supermarket chains |
| Legal barriers | Patents, copyrights, or government licences may block entry. | 5G spectrum licences, pharmaceutical patents |
| Ownership of essential resources | An incumbent firm may control a key input needed for production. | Control of cobalt supplies |
| Anti-competitive practices | Firms may use predatory pricing, limit pricing, or aggressive takeovers to deter entrants. | Predatory or limit pricing strategies |
| Sunk costs | Costs that cannot be recovered if a firm exits reduce contestability because they make entry riskier. | Specialised machinery, heavy advertising, or R&D |
Sunk Costs and Contestability
Sunk costs are costs that cannot be recovered if a firm leaves the market.
Examples include bespoke machinery, research and development, and branding expenditure.
The lower the sunk costs, the more contestable the market is likely to be. The higher the sunk costs, the less contestable the market is, because firms are less willing to enter if exit is costly.
Exam Preparation
- Define contestability clearly and distinguish it from competition.
- Explain the four key characteristics of a contestable market, especially low barriers and low sunk costs.
- Analyse hit-and-run competition and how it can force firms to behave competitively.
- Use sunk costs as the key evaluation point when assessing how contestable a market really is.
- Identify barriers to entry and exit with examples wherever possible.