Advantages and Disadvantages of a Contestable Market

A contestable market is one where there are low barriers to entry and exit, allowing potential competition to threaten existing firms. In such markets, the "threat of entry" by new firms disciplines incumbent businesses, even if actual entry does not occur.

Understanding the dynamics of contestable markets is crucial for evaluating how competitive forces operate in real-world industries. This note explores their advantages and disadvantages with real-world examples, applications, and data to aid understanding.

Advantages of a Contestable Market

1. Lower Prices for Consumers

• The threat of competition pressures existing firms to keep prices low to avoid losing market share.
• Example: In the UK airline industry, low-cost carriers like Ryanair and EasyJet operate in a relatively contestable environment. The potential for entry from other budget airlines has led to competitive pricing strategies and low fares.

2. Improved Efficiency

• Allocative Efficiency: Firms produce at a price equal to marginal cost, maximizing societal welfare.
• Productive Efficiency: Firms minimize costs to remain competitive.
• Example: In broadband provision, new players such as Hyperoptic have entered the UK market, forcing incumbents like BT to invest in faster services and improve cost structures.

3. Innovation and Quality Improvements

• Firms constantly innovate to maintain their position and fend off potential entrants.
• Example: Fintech startups such as Monzo and Revolut have driven innovation in the UK banking sector, offering digital banking solutions and incentivizing traditional banks like Lloyds and Barclays to innovate.

4. Flexibility and Consumer Choice

• Contestable markets encourage the entry of niche providers who cater to specific consumer needs, enhancing choice.
• Example: In the food delivery industry, Uber Eats and Deliveroo expanded significantly by entering the market and challenging incumbents like local delivery services.

5. Dynamic Efficiency

• Over time, firms invest in new technology and processes, benefiting consumers with better products and services.
• Example: The energy market in the UK has seen an influx of renewable energy firms, such as Octopus Energy, pushing for cleaner and more sustainable options.

Disadvantages of a Contestable Market

1. Risk of "Hit and Run" Entry

• New entrants may "hit and run" by entering a market to capture short-term profits and then exit once profits decline.
• Example: In the ride-sharing market, smaller operators often enter during peak demand (e.g., during large events) but quickly exit afterward.

2. Lack of Long-Term Investment

• Firms may avoid long-term investments due to the constant threat of new entrants eroding profits.
• Example: UK energy suppliers have sometimes failed to invest sufficiently in infrastructure due to fears of losing market share to newer entrants offering lower prices.

3. Market Instability

• Frequent entry and exit can lead to volatility, affecting both businesses and consumers.
• Example: The airline industry has seen small operators entering and exiting quickly, sometimes leaving consumers stranded or facing higher fares.

4. Economies of Scale May Be Lost

• If smaller firms enter, the market may become fragmented, reducing the ability of any one firm to achieve economies of scale.

5. Risk of Lower Quality

• If firms focus solely on cost-cutting to compete, product or service quality may decline.
• Example: In the private tutoring market in the UK, some low-cost entrants may prioritize affordability over high-quality teaching.

Glossary of Key Terms

• Allocative Efficiency: A situation where resources are distributed to produce the goods and services most desired by society.
• Barriers to Entry: Obstacles that make it difficult for new firms to enter a market, such as high startup costs or regulatory hurdles.
• Contestable Market: A market with low barriers to entry and exit, allowing potential competition to discipline incumbents.
• Dynamic Efficiency: Improvements in efficiency over time, often through innovation.
• Economies of Scale: Cost advantages achieved when a firm increases production and spreads fixed costs over more units.
• Hit and Run Entry: When firms enter a market to exploit short-term opportunities before exiting.
• Incumbent: An existing firm already operating in a market.
• Marginal Cost: The cost of producing one additional unit of output.
• Productive Efficiency: Achieving the lowest cost of production for a given output level.

Possible Economics Essay Questions

1. "Evaluate the extent to which contestable markets benefit consumers."
2. "To what extent do low barriers to entry and exit always lead to lower prices and higher efficiency in markets?"
3. "Assess the view that contestable markets are inherently unstable."
4. "Using examples, evaluate the impact of contestability on innovation and long-term investment."
5. "Discuss the role of regulatory frameworks in influencing the contestability of a market."