Study Notes: Contestable Markets (Economics 9640)

Hello! Welcome to the exciting world of market structures. You’ve probably studied Perfect Competition and Monopoly, which are two extremes. The chapter on Contestable Markets is crucial because it helps explain why sometimes, markets that look like monopolies actually behave competitively. Let's dive in and understand how the threat of competition, rather than the reality, can shape firm behaviour!

Key Takeaway from this Chapter

You will learn that the true measure of competition in a market is not always the number of firms currently operating, but the ease with which new firms can enter and leave. This concept is called market contestability.

1. Defining the Contestable Market

What is a Contestable Market?

A market is defined as contestable if there are zero or very low barriers to entry and exit for potential firms.
This means that even if the market currently only has one firm (a structural monopoly), the threat of new firms entering will force that existing firm to keep prices low and operate efficiently.

Important Distinction: Contestability vs. Actual Competition

  • A Perfectly Competitive Market: Has many firms actually competing.
  • A Contestable Market: May have few firms, but it behaves as if it were highly competitive because the barriers to entry and exit are so low.

Think of it like a game of poker: If the rules allow anyone to join the table or leave at any time without penalty, the players currently at the table will be very careful about making outrageous bets (charging high prices).

Quick Review Box: Contestable Markets

Contestability is determined by potential entry, not current entry.
If entry and exit are easy, the market is highly contestable.

2. The Crucial Role of Sunk Costs

Don't worry if this concept seems tricky at first—it's the most important piece of the puzzle!

What are Sunk Costs?

Sunk costs are those costs of production that cannot be recovered (or recouped) if a firm decides to exit the market. They act as the primary barrier to entry in contestable market theory.

Analogy: Sunk = Stuck

Imagine you buy a brand new, highly specialized machine custom-made for one type of factory (Cost: $500,000). If your business fails, you try to sell the machine, but nobody else wants it, or you can only sell it for scrap metal ($10,000).

  • Your investment was $500,000.
  • Your recoverable cost is $10,000.
  • The sunk cost is $490,000. This is the financial loss you must absorb just for trying to enter the market.

Key Rule:

The higher the level of sunk costs, the lower the market contestability. Firms are unwilling to risk a large, unrecoverable loss.

Examples of Sunk Costs (High and Low)

  • High Sunk Costs:
    (i) Highly specialised capital equipment (like a dedicated oil pipeline).
    (ii) Unrecoverable advertising expenditure (money spent on billboards that have no resale value).
    (iii) Licensing fees or R&D (Research and Development) investment unique to that product.
  • Low Sunk Costs (High Contestability):
    (i) Standard office equipment or computers (easily resold on a secondary market).
    (ii) Generic transport vehicles (like standard vans that can be used in any industry).
    (iii) Software that can be repurposed or subscription services (easy to cancel).

3. Hit-and-Run Competition

When sunk costs are low, the market is exposed to a specific type of competitive behaviour: hit-and-run competition.

The Process of Hit-and-Run

This strategy is only possible when the cost of entry and, critically, the cost of exit are negligible.

  1. The "Hit": An incumbent firm (the existing firm) starts making high supernormal profits (profits above normal profit) by setting prices high.
  2. The Entry: A potential competitor sees these high profits and enters the market quickly, offering a lower price. Because sunk costs are low, this entry is low-risk.
  3. The Threat: The entrant's presence forces the incumbent to lower its prices back down to near average cost (AC).
  4. The "Run": If the incumbent retaliates aggressively (e.g., by starting a price war) and the market becomes unprofitable, the entrant can immediately leave the market, selling off its assets and incurring almost no loss (zero sunk costs).

Did you know? This threat is often enough. The incumbent firm, knowing a "hit-and-run" is possible, will preemptively lower prices and act efficiently to discourage entry in the first place.

Key Takeaway: The Incumbent’s Dilemma

In a highly contestable market, the incumbent firm cannot enjoy high supernormal profits for long. If profit is too high, it provides an irresistible signal for entrants. To survive, the incumbent must engage in limit pricing (setting prices just low enough to deter new firms from entering).

4. Significance of Contestability for Market Performance

The theory of contestable markets argues that the threat of entry is as effective as actual competition in promoting efficiency and consumer welfare.

Impact on Price and Profit

  • Profit: Supernormal profits are eliminated in the long run. If firms are making large profits (\(P > AC\)), entry will occur. The long-run equilibrium is where price equals average cost (\(P = AC\)), meaning firms only earn normal profit.
  • Price: Prices are driven down closer to the average total cost of production, reducing potential consumer exploitation.

Impact on Efficiency

Contestability promotes various types of efficiency:

  • Productive Efficiency: Firms must produce at the lowest point on their Average Cost curve to survive the constant threat of entry. If a firm is productively inefficient, an entrant with lower costs can easily undercut its price and steal all its customers.
  • Allocative Efficiency: In a contestable market, the pressure of competition forces prices closer to marginal cost (\(P \approx MC\)) in the long run. Although not necessarily reaching the strict competitive standard of \(P = MC\), it gets very close, leading to a better allocation of resources compared to a traditional monopoly.
  • Dynamic Efficiency: The constant threat of being undercut encourages incumbent firms to invest in research and development (R&D) and innovation to maintain their cost advantage or product differentiation.

Don't confuse the two: Contestability is a spectrum. Perfect competition is fully contestable (zero barriers), but a true monopoly is non-contestable (very high barriers). Most real-world markets fall somewhere in between!

Real-World Examples of Contestability

  • Airline Industry (especially budget routes): Low-cost airlines like EasyJet or Ryanair often enter specific routes (the 'hit') when they see profits being made by incumbent carriers. Since planes can be easily moved to different routes (low sunk costs on a specific route), the market is highly contestable.
  • Online Retail and Services: Setting up an online business or app often involves relatively low fixed capital investment (servers are rented, software is generic). If a firm makes high profits, new startups can quickly enter the space (e.g., in the food delivery market), driving down prices and increasing innovation.

5. Summary and Evaluation

Evaluating the Theory of Contestable Markets

While the theory suggests that market structure might be irrelevant if barriers are low, there are limitations:

Advantages (Why Contestability is Good)
  • Promotes efficiency and innovation, benefiting consumers with lower prices and better quality goods/services.
  • Achieves outcomes similar to perfect competition even with few firms, potentially allowing existing firms to benefit from economies of scale.
  • The threat of entry acts as a powerful deterrent against monopolistic behaviour.
Disadvantages (Why Contestability May Be Limited)
  • True Sunk Costs are Rare: In reality, many industries (like telecommunications, energy, or pharmaceuticals) require massive capital investment in specialized infrastructure, resulting in high sunk costs that make true hit-and-run impossible.
  • Predatory Pricing: Incumbent firms might temporarily drop prices below cost to drive out potential entrants, knowing they can raise prices once the threat has passed. This undermines contestability.
  • Consumer Trust/Branding: New firms often struggle to overcome established brand loyalty and consumer inertia, which acts as a non-cost barrier to entry.

In conclusion, contestability is a powerful economic concept, proving that firms with monopoly power (like a single rail operator) might still be forced to act in the public interest if the barriers protecting them (the sunk costs) are low enough.