Level: AS Levels, A Level, GCSE – Exam Boards: Edexcel, AQA, OCR, WJEC, IB, Eduqas – Economics Revision Notes
Market Contestability – the ease with which firms can enter or exit a market.
A perfectly contestable market consists of zero entry or exit costs.
Characteristics of a Contestable Market
- Low barriers to entry/exit – fewer costs and obstacles involved, making it easier for other firms to move in or out of the market
- Low sunk costs – encourages firms to enter and exit the market due to lower costs, hence increasing Market Contestability
- Low levels of super-normal profit
- Low concentration ratios – less threat from other firms, making it more attractive for firms to enter the market
What are Sunk Costs?
Sunk Costs are costs a firm cannot recover if it shuts down.
Examples of Sunk Costs include: marketing costs, research, rent, and investment into new capital/equipment
If the market consisted of high barriers to entry, firms would make supernormal profits. However, if the market became contestable by the threat of competition, it would lower its prices and therefore also make fewer profits.
Barriers to Entry and Exit
Barriers to Entry are factors that prevent new firms from entering a market or an existing firm from expanding into other markets
Barriers to Exit are factors that make it more difficult for a firm to leave a market
Types of Barriers to Entry and Exit
- Limit Pricing – firms set a price below the profit maximising level to deter the entry of other firms into the market
- Predatory Pricing – selling a product below the cost of producing it to reduce competition and force rivals out of the market
- Economies of Scale – this barrier to entry exists due to the nature of the business
- Patents – this is the type of legal barrier to entry enforced by the Government, for a short-term purpose. It restricts entry rather than prevents it
- Brand Loyalty – may discourage competitors from entering the market as they need to spend heavily on marketing and promotion to build a strong relationship with their customers
- Licenses – this acts as legislation allowing firms to operate. Enforcement of licenses restricts access to the market
Implications of contestable markets for the behaviour of firms
- Allocatively and Productively Efficient – if markets are contestable, they are more likely to be allocatively and productively efficient as firms will operate at the lowest point of the average cost curve
- Profit – in the short run, firms can take advantage of supernormal profit and enter the contestable market due to low barriers. Some may choose to then leave; however firms that stay are likely to make normal profits in the long run
- Threat – firms can easily enter or exit a contestable market; this opposes threat towards firms already existing in the market as they now may face increased competition
Quick Fire Questions – Knowledge Check
1. Define ‘Market Contestability’ (2 marks)
2. Define ‘Sunk Costs’ (2 marks)
3. Using a diagram, explain how Market Contestability affects the price and profit made by a firm (4 marks)
4. Identify and explain five signs of High Levels of Contestability (10 marks)
5. Distinguish between a ‘Barrier to Entry’ and a ‘Barrier to Exit’ (4 marks)
6. Identify five types of Barriers to Entry or Exit (5 marks)
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