Study Notes
Contestable markets are characterized by low barriers to entry and exit, allowing firms to enter and leave the market easily. This affects firm behavior, pricing, and profitability, with implications for both firms and consumers.
- Contestable Market — a market with low barriers to entry and exit. Example: A gardening business with minimal sunk costs.
- Sunk Costs — costs that cannot be recovered when a firm exits a market. Example: Advertising expenses.
- Limit Pricing — setting prices low to deter new entrants. Example: Existing firms pricing at normal profit levels to avoid attracting competitors.
- Hit-and-Run Competition — firms entering a market to earn short-term profits and exiting when profits fall. Example: A competitor entering a natural monopoly market temporarily.
Exam Tips
Key Definitions to Remember
- Contestable Market
- Sunk Costs
- Limit Pricing
- Hit-and-Run Competition
Common Confusions
- Confusing contestable markets with perfectly competitive markets
- Misunderstanding the role of sunk costs in market entry and exit
Typical Exam Questions
- What is the importance of sunk costs to the behaviour of firms? Sunk costs affect a firm's decision to enter or exit a market, influencing profitability.
- Why can a contestable market have just a few firms or many firms operating in it? Due to low entry and exit barriers, the number of firms can vary widely.
What Examiners Usually Test
- Understanding of how low barriers to entry affect market dynamics
- The impact of sunk costs on firm behavior and market structure