In our recent mock exams, some Year 13 students were confused about the concept of contestable markets. Many defined them as simply being a market with high levels of competition. They often went on to correctly explain the benefits to consumers, as a contestable market does have a similar impact on the behaviour of incumbents (firms already in the market). Contestable markets, in contrast to 'competitive' markets, are where the presence of potential entrants acts as a competitive constraint on the incumbent firms, even if these potential entrants do not actually enter the market. In this context, the concept of contestability is used to capture the degree of competition in a market, with fully contestable markets having zero barriers to entry and exit and the ability of firms to enter and exit the market quickly and easily.
I mentioned this common error to my fellow economist, Mr O'Hagan and he shared with me a brilliant analogy he uses to explain contestable markets:
Think about a classroom scenario where the teacher has temporarily left the room. The students in the class are aware that another teacher may come and check on them at any time. Let’s assume these students (being students!) prefer their classroom without a teacher...however, the students know that any noise they make may bring a nearby teacher to check on them, and possibly tell them off! So, they ‘shush’ each other, stay quiet and do not misbehave to avoid attracting any unwanted attention!
This situation is similar to contestable markets. However, instead of attracting unwanted teacher attention the potential presence of other businesses pose a threat that they may enter the market and steal profits. These potential entrants act as a constraint on the behaviour of incumbent firms, forcing them to change how they operate.
Just as students behave differently when they know a teacher is present compared to when they believe they are unobserved, firms also behave differently when they are aware of the presence of potential entrants. If a market is (or becomes) contestable, incumbent firms will have to behave in a more competitive manner and are likely to offer their goods or services at a lower (fairer?) price, since they know that new entrants can quickly and easily enter the market and take away their customers if they don't.
In contrast, in a market that is not contestable, incumbent firms have little incentive to behave competitively. They can act monopolistically and charge high prices, due to the high barriers of entry that prevent any new firms from entering the market and competing with them.
The concept of contestable markets is a useful tool for analysing the degree of competition in a market. By comparing it to a classroom scenario where the students stay quiet so as not to attract attention and have another teacher check on them, we can better understand how (and why) the potential presence of entrants acts as a constraint on the behaviour of incumbent firms and affects the degree of competition in a market, even if no firm actually enters the market.
Limit pricing is something firms in a contestable market might choose to do to prevent new entrants. This is where they lower their price and reduce their own profits to remove the incentive for firms to enter. Perfect limit pricing would see incumbents (or a monopoly) setting their price below the level that would attract entrants, and make only normal profit. This completely removes the incentive to enter the market. They may raise their prices again when the threat of new entrants goes away...
...revisiting our analogy, limit pricing is the limiting of noise, especially if the students can see a teacher approaching along the corridor. Once the teacher has passed the classroom, the noise level may lift a little as the threat of the passing teacher entering their classroom has gone!
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