A contestable market is determined by the threat of new entrants into the market, caused by the absence of barriers to entry and exit. As such the point at which firms within a contestable market produce at limits supernormal profits made. In turn, this disincentive new entrants into the market.
Characteristics of contestable markets
Absence of entry and exit barriers (no sunk costs)
This is the main characteristic that determines the level of contestability within a market. The absence of entry and exit barriers causes a threat of new entrants into the market. Therefore if supernormal profits are made in the short-run, they will be removed in the long run by new firms coming into the market and then exiting once they have taken some of the supernormal profits. The absence of sunk costs (costs which are incurred as a result of a firm leaving the market) is the main cause of the threat of these new entrants.
Pool of potential entrants
There are a number of firms which have the potential and willingness to enter the market. Without this, the absence of entry and exit barriers would not result in new entrants. This is key as the threat of new entrants is something which determines the contestability of a market structure.
This is another key characteristics that encourage new entrants into the market. One of the benefits of perfect information to new entrants is that they are able to gain access to the same technology as incumbent firms straight away. For example, there is no patents that would restrict a new firm from using certain technology and therefore incumbent firms have no advantage in this regard over new entrants.
Hit and run competition
The absence of barriers to entry and exit mean that incumbent firms are susceptible to hit and run competition. This is when firms enter a market that is making short run supernormal profit, take some of that supernormal profit and then leave the market without enduring any sunk costs in the process.
Implications of contestable markets for the behaviour of firms
The diagram below demonstrates contestability in a monopoly market structure. Although this is the case, contestability can occur in any market structure as contestability and competition are not the same. Competition is based upon the level of competition within the existing market, often indicated by the number of firms, whereas contestability is based upon the threat of new entrants.
A monopoly produces at the point where marginal revenue is equal to marginal cost. This creates a price level of P1 and a quantity of Q1. At this price level a supernormal profit of P1-A-B-C is made. However, due to the absence of entry and exit barriers, firms within a contestable market can’t produce at this point without new entrants taking away long run supernormal profits. Therefore, instead firms produce at what is called the entry limit price which occurs at the point where average cost is equal to average revenue. This is also the point at which normal profits are made. As supernormal profits are no longer being made, potential entrants into the market no long have the incentive of supernormal profits and therefore will not enter the market. Although this is the case in perfectly contestable markets, most markets only have a small degree of contestability which is defined by the severity of the threat of new entrants. The larger the threat, the closer the point of production will be to the entry limit price, whereas the smaller the threat, the closer the point of production will be to the profit maximization point.
Types of entry and exit barriers
Sunk costs are costs which firms cannot retrieve once leaving the market e.g. advertising. The level of sunk costs involved is also a key determinate of the level of contestability within a market. If sunk costs are high… Read more