What is contestable market theory and limit pricing and does the coffee market being more contestable help customers?

The contestable market theory is an economic theory that proposes that a market is competitive as long as it is easy for firms to enter and exit. According to this theory, even if there are only a few firms in a market, if it is easy for new firms to enter and existing firms to exit, the market will behave competitively. This is because the threat of new entrants and the possibility of existing firms exiting will provide an incentive for firms to keep prices low and quality high in order to remain competitive.

Watch this video for an explanation of contestable markets for CIE A2 and all you need to know:

Limit pricing is a common pricing strategy that involves setting prices at a level that is low enough to deter new firms from entering a market, but high enough to cover the costs of existing firms. Firms may use limit pricing in order to protect their market share and prevent new entrants from gaining a foothold in the market. Prices are set at ATC = AR when the market is perfectly contestable, either to stave off the competition from entering or in the long run, as the market will reach normal profits if economic profits are available and entry is possible.

If the coffee market were to become more contestable, it could potentially be better for customers in a number of ways. First, increased competition would likely lead to lower prices for coffee, as firms compete to attract customers by offering lower prices. Second, increased competition may also lead to higher-quality coffee, as firms seek to differentiate themselves from their competitors and attract customers through the quality of their products. Increasing the contestability in the coffee market may also lead to more innovation and product diversity, as firms seek to offer new and unique products to attract customers, such as a mocha-choca-ice-latte with marshmallows and chocolate sauce...!!

How does this look in reality?

It is difficult to generalise how contestable market theory plays out in reality, as the degree to which a market is contestable will depend on a variety of factors, such as the cost of entry, the availability of substitutes, and the extent of government regulation.

In some cases, markets may be highly contestable, with a large number of firms operating and a low barrier to entry. This can lead to intense competition and a high level of dynamism, with firms constantly seeking to attract customers through lower prices, higher quality, and innovation. In other cases, markets may be less contestable, with a smaller number of firms operating and a higher barrier to entry. This can lead to less competition and potentially higher prices, as firms have less incentive to lower prices in order to attract customers.

It is important to note that the concept of contestable market theory is a theoretical one and does not always hold true in practice. There are many examples of markets that are dominated by a few large firms, yet still, exhibit competitive behaviour due to the threat of new entrants or the possibility of existing firms exiting. Similarly, there are examples of markets that are highly contestable, yet still exhibit less than ideal levels of competition due to factors such as collusion or limit-pricing.

But what about that coffee stall set up out the back of the truck in the video?

It is possible that opening a coffee stall out the back of a truck could be considered an example of a contestable market, depending on the circumstances. In order for a market to be considered contestable, there must be low barriers to entry and exit, meaning that it should be relatively easy for new firms to enter the market and for existing firms to exit...I guess coffee meets this criteria.

For a coffee stall out the back of a truck, the barriers to entry may be low if the startup costs are relatively small and there are few regulatory hurdles to overcome. If it is easy for new firms to enter the market and set up their own coffee stalls, the market can therefore be considered contestable.

However, it is important to note that the degree of contestability in a market will depend on a variety of factors, and a market may not be considered fully contestable even if it exhibits some of the characteristics of a contestable market. For example, if the competition in the market is fierce and there are many other coffee stalls operating in the area, the market may not be considered fully contestable even if the barriers to entry are low.