Contestable Markets (Micro and macro impact and evaluation)

Here is an example of an approach to an Edexcel paper 3 question focusing on the impact of an increase in contestability in markets.

The essay-style question was:

Evaluate the microeconomic and macroeconomic impact of increased contestability in UK industries such as telecommunications, food manufacturing and food retailing. (25)

Reminder of technique for Edexcel Paper 3 Economics

• 4 Knowledge
• 4 Application (data supported paragraphs)
• 8 Analysis (using chains of reasoning)

• Critiquing a point or offering a counter-point
• Answer must cover both micro and macro
• Refer to all aspects of the question
• Signpost when you are making a point or an evaluation

Micro point 1

One micro effect of an increase in contestability is that prices for consumers may fall as a result of greater competition between suppliers. A good example would be contestability between broadband suppliers which involves better deals offering a range of choices for consumers. Lower prices then increase the level of consumer surplus.

However a possible consequence is a fall in industry profits which might then affect how much money  broadband firms can invest in expanding network capacity & speed of service for their customers

Micro point 2

A second micro impact of competition between firms in food retailing is that firms have to become more productively efficient by controlling their unit costs. A lack of competition can lead to X-inefficiency including higher levels of waste and businesses operating with higher levels of fixed cost. This lowers profits and might lead to lower share prices.

However if there are more firms competing in a market, then the scope for each firm to utilize internal economies of scale could be limited in the long run. This can lead to higher unit costs and prices

Macro point 1

One macro effect of increased contestability in an industry such as food manufacturing might be that a rising share of the market comes from imports. If food imports rise, this will cause a deterioration in the trade deficit and the current account of the balance of payments and thus cause a fall in AD. Food imports are a leakage from the circular flow.

However competition from food imports is an incentive for domestic manufacturers to improve their dynamic and productive efficiency. Trade on the basis of comparative advantage improves welfare.

Macro point 2

An increase in contestability in industries can lead to a lower rate of consumer price inflation which helps the Bank of England meet the 2% inflation target. A lower rate of inflation then allows the MPC to keep interest rates at current historically low levels which in turn is a support to consumer and business confidence and helps maintain competitiveness.

That said, the drive to control costs in a contestable market might lead some firms to invest more in robotics/automation which might cause job losses and perhaps a rise in structural unemployment.