Contestability
Economics: Edexcel A A Level, topic 6.1.13
Contestability of Markets
The level of contestability refers to how easy it is for firms to enter and leave a market.
Barriers to entry
- The level of contestability is related to the barriers to entry.
- If there are low barriers to entry in an industry, it is more contestable and easier to enter that market.
- Sunk costs refer to the cost of leaving an industry. Sunk costs cannot be recovered. For example, if Adidas invested in specific capital machinery to build shoes, this is likely to be unrecoverable.
- If sunk costs are high, a market is not very contestable.
Examples of barriers to entry
- High levels of advertising can increase brand loyalty and act as a barrier for new firms trying to enter.
- If firms are vertically integrated, they may have a monopoly over resources.
Barriers to Entry
Barriers to entry are anything that prevents or deters a firm from starting to compete in an industry; even a very low market price could be a barrier if it simply deters a firm from entering.
Patents
- Patents prevent firms from copying protected technology and products without the patent holder's permission.
- Firms can negotiate a license fee (or royalty) for using a patented technology or product. This raises their costs.
- Patents are used to encourage innovation by guaranteeing that the firm who develop a new product or technology get the first opportunity to get a financial reward for doing so.
- Patents can lead to monopolies while they are in force.
Marketing
- In established markets, with a small number of major firms, the firms are recognisable to consumers and brand loyalty has been established.
- These firms can spend a significant amount on advertising to keep their brands popular.
- New firms would have to spend money on marketing and advertising in order to make their brand known and attract customers away from the established firms.
- For small firms or start-ups this considerable cost can be enough to put them off entering a market.
Limit pricing
- Limit pricing is a strategy whereby established firms in a market set their prices low enough to discourage new firms from entering the market.
- If a new entrant can only afford to price at the red dot to cover its variable costs, an incumbent could cut price from A to B, in order to stop a new firm entering the market. If it considered sunk costs, it would not be able to make a profit. This is called predatory pricing.
- If the market price is too low then the new entrant can't make normal profit and they will not enter.
Sunk costs
- Sunk costs are the irretrievable costs involved in entering a market. This could be in the form of licenses, research and development and capital which can't be resold.
- New firms can struggle to raise the funds required to pay these sunk costs which reduces their ability to enter the market.
- It can make it harder for firms to achieve normal profit which also discourages entry.
- An example of sunk costs are the costs of exploration for oil firms when deciding where to build their wells.
Vertical integration
- Large firms can use vertical integration to discourage new entrants.
- If a firm acquires a large proportion of the suppliers in the market they can make it difficult for new entrants to find suppliers themselves.
- The same is true for distributors. If new entrants can't easily find suppliers or distributors then they won't be able to enter the market.
Test yourself on Contestability
If sunk costs are very high, what would this say about a market?
Which of the following are examples of high barriers to entry?
Which of the following is NOT a high barrier to entry?
5 common barriers to entry
Which of these is NOT a barrier to entry?