Analyse the characteristics of a contestable market

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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.

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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 ...

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