Judging contestability and its significance

Overview

Theory 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.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Why is the theory of contestable markets significant for how competition is assessed?

   Model answer

   It shifts attention from how many firms are in a market to how easily another could join it. A high market share is no longer sufficient evidence of a competition problem, and a low one is no longer sufficient reassurance. Assessing a market therefore requires evidence on capital requirements, sunk costs, legal restrictions, access to inputs and distribution, and the resale value of the assets involved.

2. 2

   What questions would you ask to judge how contestable a particular market is?

   Model answer

   How much would a new firm have to spend before its first sale, and how much of that could it recover if it left? Are there licences, patents or regulations that restrict who may supply? Can an entrant obtain the inputs and reach the customers on the same terms as the incumbent? Is minimum efficient scale small enough that an entrant could operate at competitive cost from the outset? And how quickly and aggressively would the incumbent be expected to respond?

3. 3

   Why is the absence of recent entry weak evidence that a market is not contestable?

   Model answer

   In a genuinely contestable market the incumbent prices so that entry is not worth attempting, so no entry occurs. The same observation is also consistent with a market that is heavily protected. Since both a well-disciplined market and a closed one show no entrants, the observation cannot distinguish between them, and the entry conditions themselves must be examined instead.

4. 4

   Why is the presence of high profits stronger evidence about contestability than the presence of few firms?

   Model answer

   Persistently high profit is what a contestable market is supposed to eliminate: if the profit is there and no one has taken it, something must be stopping them. Few firms, by contrast, is consistent with either high barriers or a large minimum efficient scale in a market that would still discipline an incumbent through the threat of entry. Sustained supernormal profit therefore points more directly at the barrier than the head-count does.

5. 5

   Give three criticisms of the theory of contestable markets.

   Model answer

   First, perfect contestability requires zero sunk costs, which almost no real market satisfies, since even brand recognition and regulatory approval are sunk. Second, it assumes an entrant can appear before the incumbent responds, whereas incumbents can usually cut prices faster than a newcomer can build capacity, which destroys the profitability of a raid. Third, it assumes the entrant faces the same costs as the incumbent, ignoring the learning, reputation and scale advantages that come from years of trading.

6. 6

   Explain why the speed of the incumbent's response matters for whether hit-and-run entry works.

   Model answer

   A raid is profitable only if the entrant can earn the high price for long enough to cover its costs of entering and leaving. If the incumbent can cut its price the day the entrant opens, the window of high prices is nearly zero and the raid loses money however small the sunk cost. The theory therefore implicitly assumes some stickiness in the incumbent's price, and where prices can be changed instantly, as on many online platforms, contestability is weaker than the low capital requirement suggests.

Other ways to work this

The same content, four other ways.

What is inside Levo

Six ways to work the same material.