MarindaAsihRamadhaniah

14/372376/PEK/19486

Perfectly Constable Market

1. Definition of Constable Market
Contestable market occurs when there is freedom of entry and exit into the
market. Thus in a contestable market, there will be low sunk costs (costs that have
been committed by a business cannot be recovered once a firm has entered the
industry).
It is important to remember that contestability is not a clear cutissue, there are
degrees of contestability, some markets having more capacity for new firms to
enter. Inpractice few industries are perfectly contestable.
2. Factors Which Determine The Contestability Of A Market
When considering the contestability of markets it is important to consider the
different barriers to entry a new firm mayface :
1. Sunk Costs. If Sunk costs are high this makes it difficult for new firms to enter and
leave the market. Therefore it will be less contestable. For example, if a new
firm had to purchase raw materials, that it wouldnt be able to resell on leaving
the market, this may act as a deterrent.
2. Levels of advertising and brand loyalty. If an established firm has significant
brand loyalty such as Kentucky Fried Chicken, then it will be difficult for a new
firm to enter the market. This is because they would have to spend a lot of money
on advertising which is a sunk cost and this advertising may not be sufficient to
change customer loyalty to very strong brands. It depends on theindustry,
customer loyalty would be fairly low for a product like petrol because it is quite
homogenous. But, for fast food people have greater attachment to their brand.
3. Vertical Integration. If a firm does not have access to the supply of a good then
the market will be less contestable. For example, Oil firms could restrict the
supply of petrol to petrol stations, making it difficult for new firms to enter.
Giving access to different stages of production can make the market more
contestable.
4. Access to technology and skilled labor. For some industries like car production it
is difficult for new firms to have the right technology. Nuclear power may require
skilled labor that is difficult to get. This makes the market less contestable. If you
wished to compete with Google, you may find it hard to employ the best software

engineers because Google pays its employees a very good wage and is seen as an
attractive company to work for.
As well as looking at barriers to entry, there are other factors that might indicate the
competitiveness of a market.
The level of profit. If the market is highly profitable, this suggests the market is
less contestable. In theory, if firms are making supernormal profit, it would
attract new firms into the market. The persistence of supernormal profits
suggests that hit and run competition is not possible and there are barriers to
entry.
The number of firms. A contestable market could have a low number of firms as
long as there is the threat and possibility of new firms entering. However, if there
are only a few firms and it has been many years since any new firms have
entered, then it is likely to be less contestable. If there are recent examples of
firms entering the market, then it is likely to be more contestable.
3. Difference between Contestable Markets and Perfect Competition
Contestable markets are different from perfect competitive markets. For
example, it is feasible in a contestable market for one firm to have price-setting
power and for firms in a market to produce a differentiated product.

There are three main conditions for pure market contestability:

Perfect information and the ability and/or the right of all suppliers to make use of
the best available production technology in the market.
The freedom to market / advertise and enter a market with a competing product.
The absence of sunk costs this reduces the risks of coming into a market

4. Increasing TheConstability Market

1. Remove legal barriers to entry. Royal Mail used to be a legal monopoly but now
firms are allowed to enter the market for sending letters and parcels.
2. Force firms to allow competitors to use its network For example when BT was
privatised, OFTEL forced BT to allow other companies to use its network. This has
also occurred in the Gas and Electricity industries and has made them more
contestable. A firm can now gain access to the national network of gas /
electricity infrastructure
3. Legislation against Predatory Pricing If a firm can engage in predatory pricingit
can force new firms out of business and make it less contestable.
4. OFT can legislate against abuse of Monopoly power. If a firm abuses its monopoly
power by restricting supply to certain firms the OFT can intervene to overcome
this restriction on contestability.

5. A government firm. In the banking industry, the government has even toyed with
creating its own company to help increase competition and increase bank lending
to small firms. This could be a last resort where private firms face insurmountable
barriers to entry.
Note, there are many barriers to entry that the government cant solve. The
government cant alter the economies of scale in an industry.

5. The Effect Of The Competition Toward A Firms Behaviour

Figure 1.
In the figure 1 above a pure monopoly might price at P1 the profit maximising
equilibrium.
If a market is contestable, there is downward pressure on price, because the presence
supernormal profits signals for new firms to enter the market and if the existing
monopolist is producing at too high a price or has allowed their average total costs to
drift higher, entrants can undercut the monopolist and some of the abnormal profit will
be competed away.
Normal profit equilibrium occurs when average revenue equals average total cost (at
output Q2 and price P2). A lower price and higher output causes an increase in
consumer surplus.
When markets are contestable we expect to see lower profit margins than when a
monopoly operates without competition. The threat of competition may be just as
powerful an influence on the behaviour of the existing firms in a market than the actual
entry of new businesses.
If a market is contestable, industry structure and firm behaviour is determined by the
threat of competition - 'hit-and-run' entry. The market will resemble perfect
competition, regardless of the number of firms, since incumbents behave as if there
were intense competition

6. A Contestable Market Is Depicted In Figure 2.

Note that although only three firms are in the industry, they all produce where
price equals marginal and average cost. For the industry as a whole, price is equal to
the minimum on the long-run average total cost curve. Each firm produces one-third
(q) of total industry output (3q). Production at an efficient rate of output and
marginal cost pricing, then, does not require the atomistic markets of the perfectly
competitive model. A perfectly contestable market will do.
Figure 2. A contestable market
The market is composed of three firms, each producing output q, which minimizes
average costs. Total industry output is Q = 3q. Any attempt by the three firms to
reduce output and increase market price will lead to entry by new firms and the
dissipation of profits.

What industries might this model fit? The air travel industry is one candidate.
Many major markets are served by only two or three airlines. Yet if an airline with
a dominant position in a particular regional market attempted to set price well
above costs, entry would quickly follow. Airplanes can be shifted from one market
or use to another with ease. New entrants do not appear to be at a cost
disadvantage relative to existing firms. If the conditions for a contestable market
were indeed met, then we would expect the air travel industry to be
characterized by marginal cost pricing and zero economic profits. It is always
difficult to determine whether or not price is equal to marginal cost; one
indication that contestability characterizes the air travel industry is that prices do
not appear to be higher in markets with fewer actual competitors. The zero-profit
outcome also describes the air travel industry reasonablywell.

SOURCES :
McKenzie, Richard B. and Dwight R. Lee.Microeconomics for MBAs: The Economic Way of
Thinking for Managers, Second Edition.
http://www.cambridge.org/us/download_file/163490/(diaksestanggal 10 November
2014)
Pettinger, Tevjan R. Contestable
Market.http://www.economicshelp.org/microessays/contestablemarkets/(diaksestanggal 09 November 2014)
Riley, Geoff. Contestable Market. 23 September 2012.
http://tutor2u.net/economics/revision-notes/a2-micro-contestable-markets.html
(diaksestanggal 09 November 2014)