Benefits of Contestability

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Benefits of Contestability

If a market is contestable, incumbent firms will be encouraged to innovate because the threat of new entrants mean they need to keep innovating.

Hit-and-run entry

Supernormal profits act as a signal to other firms.
If barriers to entry are low, firms will come into the market and try to compete away the supernormal profits, then leave. This is known as hit-and-run entry.

Competing on quality

As a result, incumbent firms will innovate to try maintain their market share.
Some incumbent firms may lower price temporarily, until they have market dominance.
They may try innovate their service and improve its efficiency to compete.
They will compete on a number of non-price factors.
Firms in this kind of market will strive for productive and allocative efficiency in the long run. This is because of supernormal profit being competed away.

Higher investment in R&D

Technology change can change the structure of a market.
- The efficiency of one or more factors of production may increase.
- Technology can also create or lower barriers to entry.
- Technology can also create monopoly power. First mover advantage may be possible if only one firm has a new technology.
- Technology can lead to bigger economies of scale.

Development of new technology

The introduction of a new technology to an industry can 'destroy' the old product.
- E.g Netflix and online streaming services are taking over from free-to-air television.
As a process, it is important because it highlights that large firms are still vulnerable to new technologies.
- So large firms must continue to innovate.
It was Schumpeter who called this 'gales of creative destruction'.

Benefits of Competition

The free market relies on competition to efficiently allocate resources. We can look at it through the lens of the basic economic questions – what to produce, who produces and who gets it.

Allocative efficiency

In a competitive market, firms chose what to produce based on what can generate the most profit from the resources they have.
Each firm then looks at the market prices of goods and services and compares them to the costs of production. They then produce the most profitable goods.
As price is based on the value of the goods and services, firms will be producing the most valuable goods and services to a market.

Productive efficiency

In a competitive market, firms who can produce goods and services using the fewest or cheapest resources can set the lowest price.
Consumers would choose between identical goods based on price, therefore, the cheapest producers would win the customers.

Consumer competition

Firms aren't the only agents who compete in a market, consumers do too.
When resources are scarce, consumers compete by offering more and more money for goods and services up to the amount they are willing and able to pay.
As a result, those consumers who are willing and able to pay the most of a good or service gets to consume them.