Analyse the characteristics of a contestable market

by samlarlhamhotmailcom (student)

Sam Larlham F584: Transport Economics

Analyse the characteristics of a contestable market (15 marks)

A contestable market operates in a similar manner to one in perfect competition, with one of the key differences being that a contestable market can have any number of firms (as opposed to an infinite number in a perfectly competitive market). This means that, in theory, a contestable market could feature a monopoly or oligopoly, however generally these markets have a relatively large number of firms and therefore a low concentration ratio.

The key characteristic of this market that makes it contestable is that there are little or no barriers to entry and exit. In terms of low barriers to entry, this generally means that the market is not heavily regulated and therefore firms need not meet many requirements in order to join it. Low exit barriers can be characterised by low sunk costs: those initial costs that cannot be recouped by firms upon exiting the market. For example, the air travel market may be deemed not to be contestable as it has relatively high sunk costs; firms must train pilots etc.

Password

Confirm Password

I agree to the terms of service and privacy policy

This is a preview of the whole essay

These low barriers encourage ‘hit and run’ entry into a market. This is where a firm is achieving an abnormal profit in a contestable market, which is a motive for others to join the market. Therefore, there is a sudden influx of new firms, all aiming to achieve an abnormal profit. This increases the supply in the market; driving the price down until eventually, everyone is operating at a normal profit. At this point, ‘hit and run’ firms can and will exit the market, due to their low sunk costs meaning they can do so having benefitted from their entry into the market. Conversely, if a firm was operating at an abnormal loss low exit barriers would be enable it to exit the market swiftly to limit its losses (which would of course decrease market supply and cause the price to return to a level of normal profit for the remaining firms).

As such, another characteristic is that a contestable market always features potential competition; even if a firm is not being competed with by another in the market, they always perceive competition to be on the periphery. The firm knows that if they are seen to be achieving abnormal profit, there will be a high level of hit and run entry and so an increase in real competition. Because of this, firms in a contestable market always aim to be operating at normal profit. They achieve this by keeping their average costs low and capacity utilisation high, in order to be productively efficient. As well as this, firms aim to keep their prices low – ideally as close to marginal cost as possible – so that consumer welfare is maximised and they are allocatively efficient.

The reason this can theoretically occur, even if there is a market monopoly, is due to low product differentiation (some firms may offer USPs, but mostly products are homogeneous) and perfect information in the market. These characteristics mean two things. The first is that it is difficult for one firm to have an advantage in its methods of production (be that better technology, better use of labour etc.) as the perfect information allows other firms to achieve this as well. The second is that due to the combination of the two factors, there is a high consumer churn. This means that consumers can easily switch from one producer to another, as perfect information means they are aware of who is offering the best price and a low level of product differentiation means they are buying largely the same product. Therefore if a monopoly was operating at abnormal profit, a small firm could enter the market with a homogeneous product and (provided its price was lower than that of the monopoly) realistically compete and achieve at least normal profit. This explains why a contestable market could have any number of firms.