Steve Snider

Contestable Markets

In order for a contestable market to exist, there must be four criteria present.
1. All competitors must have access to the same technology.
2. Consumers have the ability to respond quickly to price changes.
3. Existing firms cannot respond quickly to entry by lowering their prices.
4. There are no sunk costs.

When these four criteria are present, the firms already in the market have no market power over consumers. This can happen because when existing firms charge a price in excess of what they need to cover costs, another firm could enter the market place with the same technology and product and charge a cheaper price than the existing firm's price. The existing firm is not able to quickly lower their price, and thus the new firm would take all the existing firm's business becasue it would be charging a lower price. If the market is perfectly contestable, existing firms have to set low prices because of the threat of entry by new firms.

An important aspect of constestable markets are sunk costs. Sunk costs are costs that are incurred by a firm entering the market that are not able to be recouped if the firm exits the market. For example, if an entering company pays $20,000 for computer equipment, but recieves only $10,000 for the same equipment upon exiting the market, the company has $10,000 in sunk costs. Another example of sunk costs could be the following: "Creating a brand name or corporate image can be hugely expensive. Advertising costs are often a significant part of a company’s total costs for products such as cigarettes, perfume, soap powder and the like. Leaving the market means that all the money spent creating the brand may be lost – although even brand names can be sold" (Dircon, 2007).


Sunk costs are important to account for becasue suppose a new entrant to the market believes that it could earn $100,000 by entering the market and charging a lower price than the compeition assuming the competition does not lower its price as well. In order for the new entrant to begin business, it must incur a $20,000 sunk cost. If the existing competitor lowers the price upon the entry of the new firm, the new firm could be left with no customers and be faced with the sunk cost of $20,000. In conclusion, new entrants need to believe that existing firms will lower prices upon compeition entering the market. The end result is that incumbents may not be disciplined by other entrants, and higher prices will prevail.

For further info on sunk costs, go to http://mbaecon.wikispaces.com/sunk+costs.

A perfectly contestable market is one in which entry and exit are absolutely costless. In such a market, competitive pressures supplied by the perpetual threat of entry, as well as by the presence of actual current rivals, can prevent monopoly behaviour (higher prices and restricted output)

The most common example of a constestable market is the airlines industry. Entrants have the possibility of leasing aircraft and should be able to respond to high profits by quickly entering and exiting. In practice there may be barriers to entry and exit in the market associated with terminal leases and availability and predatory pricing by incumbents, signalled through built in overcapacity (Wikipedia, 2007). For example, assume there are just two airlines flying the Omaha - Chicago route. If entry and exit were costly, the market would not be contestable and the two incumbent airlines might realize substantial economic profits from their protected market position.

However, if additional airlines can enter and leave this particular segment of the air transportation market with minimal cost. The reason is that the capital equipment, the airplanes, are highly mobile. So, if an additional airline were to enter and find the Omaha-Chicago route to be unprofitable, it could simply remove itself and move to another market by flying its equipment to some other route. The possibility of costless entry will entice the two airlines currently flying the Omaha-Chicago route to provide their transportation services efficiently and at prices which give a normal profit (Econlink, 2007).

Markets that have become more contestable in recent years

  • Online Communications (including video conferencing; virtual reality games; publishing; home shopping; travel services; information services; databases)
  • Home Banking and Financial Services
  • Electricity and Gas Supply
  • Parcel delivery
  • Opticians
  • Low cost domestic airlines
  • Road Haulage Companies


In a contestable market there are no structural barriers to the entry of firms in the long-run. If existing businesses are enjoying high economic profits, there is an incentive for new firms to enter the industry. This increases market competition and dilutes monopoly profits for the incumbent firms. Market contestability requires there are few sunk costs. A sunk cost is committed by a producer when entering an industry but cannot be recovered if a firm decides to leave a market. Examples include marketing and advertising spending and outlays on industry specific items of capital" (Tutor2u, 2007).


Sample Questions
1. True or false.
In order for a contestable market to exist, firms will face a sunk cost.

2.
Examples of contestable markets include:
A. Financial Services
B. Opticians
C. Parcel delivery
D. All of the above

3.
A sunk cost can best be defined as _.

4.
True or false.
In a contestable market, consumers have the ability to respond quickly to price changes.

5.
In a perfectly contestable market, firms will set prices because of the threat of new entrants.
A. high
B. low
C. medium





Answers:
1. False - In order for a contestable market to exist, firms must not have any sunk costs. See point 4.

2.D - All of the above are examples of contestable markets. See "Markets that have become contestable in recent years."

3. costs that a firm is unable to recoup. Sunk costs are incurred by a company entering a market. The company is not able to get these costs back, they are simply lost.

4.True - This is one of the four critera that need to be present for a contestable market. See point 2.

5.low. Existing firms will will set low prices to discourage new entrants. If the existing firm set high prices, a new entrant could easily undercut them in price with the same technology and product. The lower prices make it tough for the new entrant to compete in the market.

Works Cited

Econlink. (2007). Retrieved April 15, 2007 from http://www.econedlink.org/lessons/index.cfm?lesson=EM22&page=teacher.

Wikipedia. (2007). Contestable Markets. Retrieved April 16, 2007 from http://en.wikipedia.org/wiki/Contestable_market.

Dircon (2007). Contestable Markets. Retrieved April 16, 2007 fromhttp://www.cr1.dircon.co.uk/TB/2/monopoly/contestablemarkets.htm.

Turor2u. (2007). Contestable Markets. Retrieved April 16, 2007 from http://www.tutor2u.net/economics/content/topics/monopoly/contestable_markets.htm.