Contestable Markets Lecture Notes

Introduction to Contestable Markets

• Definition: A contestable market is one where there is a threat of competition, not necessarily actual competition.
• Impact: The threat alone can influence firms' behavior within the market.

Characteristics of Contestable Markets

1. Low Barriers to Entry and Exit: Essential for a strong threat of competition.
2. Large Pool of Potential Entrants: Helps sustain the threat of competition.
3. Good Information on Market Conditions: Entrants need to know about costs and technology to compete.
4. Hit-and-Run Competition: Due to low entry/exit barriers, new firms can quickly enter, capture profits, and exit.
5. Impact of Technology:
   • Reduces barriers to entry (e.g., lower startup and sunk costs).
   • Increases pool of potential entrants through innovation and cost reduction.
   • Improves information availability via the internet and communication.

Market Behavior in Contestable Markets

• Monopolistic Markets:
  • Despite high entry barriers, can be contestable if there is a threat of entry.
  • Monopolists may lower prices to the limit price (where average cost equals average revenue) to deter new entrants.

Outcomes of Contestability

• Competitive Outcomes: Lower prices and higher quantities even without actual competition.

Pros and Cons of Contestable Markets

Pros

• Movement Towards Competitive Outcomes:
  • Allocative Efficiency: More choice, higher quality, lower prices.
  • Productive Efficiency: Economies of scale lead to lower costs and prices.
  • X Efficiency: Minimizes waste, lowers costs, and prices.
  • Potential Job Creation: Higher quantities might lead to more jobs.

Cons

• Lack of Dynamic Efficiency: Lower profit margins may reduce long-term progress.
• Cost Cutting in Dangerous Areas: Could affect safety standards and wages.
• Creative Destruction: Innovation may lead to job losses in existing firms.
• Anti-Competitive Strategies: Limit pricing and predatory pricing may reduce long-term contestability.

Evaluation Points

1. Length of Contestability: Patents and anti-competitive strategies can reduce contestability.
2. Role of Technology:
   • Can both increase and reduce contestability (e.g., through patents).
   • May enable price discrimination, affecting efficiency.
3. Regulation:
   • Can mitigate dangerous cost-cutting and anti-competitive strategies.
   • Potential role in maintaining contestability.

Conclusion

• The study of contestable markets reveals how the mere threat of entry can significantly affect market outcomes and efficiencies.
• Emphasizes the importance of understanding how technology and regulation play roles in shaping market contestability.