Contestable Markets

What Contestable Markets covers

Contestable markets is examined in Unit A2 1, Business Economics. It covers what makes a market contestable, sunk costs and hit-and-run entry, how ease of entry changes the behaviour of firms and judging contestability and its significance.

The 4 subtopics

Each one has its own page.

• What makes a market contestableContestable market, barrier to entry and barrier to exit.Open →
• Sunk costs and hit-and-run entrySunk cost, hit-and-run entry and asset specificity matter for contestability.Open →
• How ease of entry changes the behaviour of firmsLimit pricing, effect of increased contestability on efficiency in a market and predatory pricing.Open →
• Judging contestability and its significanceTheory of contestable markets significant for how competition is assessed, three criticisms of the theory of contestable markets and usefulness of contestability as a guide for competition policy.Open →

What you need to know

Answer each one before you reveal it.

Take Contestable Markets further

The same content, four other ways.

Commonly confused

Pairs that lose marks when they are blurred together.

• A contestable market vs A competitive market

  A contestable market: one where the threat of entry alone disciplines the firms already in it. A competitive market: one where many rivals are actually operating side by side.

• A sunk cost vs A fixed cost

  A sunk cost: spending that cannot be recovered on leaving. A fixed cost: spending that does not vary with output but may still be recovered.

• Hit-and-run entry vs Sunk costs

  Hit-and-run entry: coming in to take a temporary profit and leaving before conditions change. Sunk costs: spending that cannot be recovered, which is what deters that behaviour.

Questions from this topic

Each one with the model answer underneath.

1. 1

   What is a contestable market?

   Model answer

   A contestable market is one in which firms can enter and leave freely, so that any supernormal profit earned by an incumbent invites entry and the threat of that entry disciplines the incumbent's behaviour. Contestability is a property of the entry and exit conditions, not of the number of firms already trading.

2. 2

   What is a perfectly contestable market?

   Model answer

   A perfectly contestable market is the limiting case in which there are no barriers to entry or exit at all, entrants have access to the same technology and costs as the incumbent, and there are no sunk costs, so a firm can enter, trade and leave without losing anything it cannot recover. In this case the incumbent must price at the level that yields only normal profit, because any margin above it would be taken by an entrant.

3. 3

   Why is contestability not determined by the number of firms in a market?

   Model answer

   Because what constrains an incumbent's price is not who is currently selling but who could sell tomorrow. A single firm facing costless entry cannot raise price above the normal-profit level without being undercut by an arrival, whereas twenty firms sheltered behind heavy sunk costs and licensing restrictions can hold prices high indefinitely. The head-count describes the market's structure; contestability describes the pressure on it.

4. 4

   Give an example of a market with very few firms that is nevertheless reasonably contestable, and explain why.

   Model answer

   A route flown by only one or two airlines can still be contestable, because an aircraft is a mobile asset: a rival can move a plane onto the route, lease a slot and start selling seats within a season, and if the route proves unprofitable it can move the aircraft to another route and sell it on a deep second-hand market. Little of the capital committed is lost on exit, so the sitting airline cannot safely price far above cost.

5. 5

   Give an example of a market with many firms that is nevertheless not very contestable, and explain why.

   Model answer

   Community pharmacy in the UK has many separate outlets but is not easily contested, because opening a new dispensing pharmacy requires a licence that is granted only where a need is shown. A would-be entrant that has spotted a profitable location cannot simply open there, so the number of existing firms gives a misleading impression of how much competitive pressure any one of them faces.

6. 6

   What is a barrier to entry?

   Model answer

   A barrier to entry is anything that raises the cost or reduces the expected return of a new firm starting to supply a market, relative to the position of firms already there. Examples include large capital requirements, economies of scale that the entrant cannot immediately match, patents, established brand loyalty, control of an essential input or distribution channel, and legal restrictions such as licences.

What is inside Levo

Six ways to work the same material.

Contestable Markets revision questions

What does Contestable Markets cover in CCEA A-Level Economics?

4 subtopics: what makes a market contestable, sunk costs and hit-and-run entry, how ease of entry changes the behaviour of firms and judging contestability and its significance. Each one has its own page with questions and model answers.

How is Contestable Markets organised?

By the CCEA 4410 specification, subtopic by subtopic, so it matches the order you are taught it in.