5.7 Contestable markets and barriers to entry
4 min read•august 16, 2024
Contestable markets shake up traditional thinking. Even with few firms, the threat of new competitors keeps prices low and efficiency high. It's like having a watchful rival always ready to pounce if you slack off.
Entry barriers are the bouncers of the business world. They come in economic, legal, and strategic flavors, each making it harder for new firms to crash the party. The higher the barriers, the less contestable the market becomes.
Contestable Markets and Characteristics
Definition and Key Features
Top images from around the web for Definition and Key Features
8.4 Monopolistic Competition – Principles of Microeconomics View original
Is this image relevant?
Entry, Exit, and Supply Curves: Constant Costs | Microeconomics Videos View original
Is this image relevant?
The Neoclassical School – Introduction to Macroeconomics View original
Is this image relevant?
8.4 Monopolistic Competition – Principles of Microeconomics View original
Is this image relevant?
Entry, Exit, and Supply Curves: Constant Costs | Microeconomics Videos View original
Is this image relevant?
1 of 3
Top images from around the web for Definition and Key Features
8.4 Monopolistic Competition – Principles of Microeconomics View original
Is this image relevant?
Entry, Exit, and Supply Curves: Constant Costs | Microeconomics Videos View original
Is this image relevant?
The Neoclassical School – Introduction to Macroeconomics View original
Is this image relevant?
8.4 Monopolistic Competition – Principles of Microeconomics View original
Is this image relevant?
Entry, Exit, and Supply Curves: Constant Costs | Microeconomics Videos View original
Is this image relevant?
1 of 3
- Contestable markets allow potential competitors to enter and exit with minimal costs, challenging incumbent firms
- Low characterize contestable markets, enabling firms to recover most investments upon exit
- Absence of significant barriers to entry or exit facilitates market
- Access to the same technology and information as incumbent firms levels the playing field for potential entrants
- Perfect contestability occurs when potential entrants can profitably enter the market and undercut the incumbent without incurring sunk costs ()
Impact on Competition and Market Behavior
- Threat of potential competition in contestable markets disciplines incumbent firms to behave competitively
- Competitive behavior can occur even in concentrated markets due to contestability
- Contestable markets theory challenges traditional views on the relationship between market structure and firm behavior
- Incumbent firms may adopt strategies to deter entry (, capacity expansion)
- Market outcomes in contestable markets can resemble those of perfectly competitive markets, despite concentrated structures
Barriers to Entry and Market Contestability
Types of Entry Barriers
- Economic barriers impede market entry through cost-related factors
- require large production volumes to achieve cost efficiency
- Capital requirements involve high initial investments (manufacturing plants, equipment)
- Absolute cost advantages of incumbent firms stem from proprietary technology or exclusive resource access
- Legal barriers restrict market entry through regulatory and intellectual property mechanisms
- Patents protect innovations and prevent imitation (pharmaceutical industry)
- Licenses limit the number of market participants (taxi services, broadcasting)
- Government regulations impose compliance costs and operational restrictions (environmental standards, safety requirements)
- Strategic barriers created by incumbent firms deter potential entrants
- involves temporarily setting prices below cost to drive out competitors
- Excess capacity signals the ability to flood the market if new firms enter
- Brand proliferation occupies various market segments, leaving little room for new entrants
Influence on Market Contestability
- Height of entry barriers directly affects the degree of market contestability
- Low barriers increase contestability by facilitating easy entry and exit
- High barriers reduce contestability by making market entry costly or risky
- Nature of barriers (economic, legal, strategic) shapes competitive dynamics differently
- Combination of multiple barrier types can create formidable obstacles to entry
- Dynamic nature of barriers requires ongoing assessment of market contestability
Implications of Contestable Markets
Efficiency and Pricing Behavior
- Highly contestable markets induce incumbent firms to price at or near marginal cost to deter entry
- Pricing near marginal cost leads to allocative efficiency, maximizing social welfare
- Threat of potential entry encourages incumbent firms to operate at minimum efficient scale, promoting productive efficiency
- Even monopolies or oligopolies may behave competitively if entry is sufficiently easy
- Firms have incentives to innovate and improve efficiency to maintain market position against potential entrants
Consumer Welfare and Market Performance
- Discipline imposed by potential competition leads to lower prices and increased output
- Reduced economic profits in contestable markets benefit consumers through lower prices
- Market contestability serves as a substitute for actual competition in promoting economic efficiency
- Enhanced results from competitive behavior induced by contestability
- Dynamic efficiency improves as firms continually innovate to stay ahead of potential entrants
Strategies for Barriers to Entry
Marketing and Brand-Based Strategies
- Extensive advertising creates strong brand recognition and customer loyalty (Coca-Cola, Apple)
- High advertising expenditures increase the cost of entry for potential competitors
- Product differentiation establishes unique market positions difficult for new entrants to replicate
- Brand extensions leverage existing brand equity to occupy multiple market segments (Nike apparel and footwear)
Supply Chain and Operational Strategies
- Vertical integration controls supply chains or distribution networks, limiting access for new entrants
- Exclusive contracts with suppliers or distributors create barriers for potential competitors
- Investments in proprietary technology or processes establish cost advantages (Intel's semiconductor manufacturing)
- Economies of scale in production or distribution raise the minimum efficient scale for market entry
Pricing and Capacity Strategies
- Predatory pricing temporarily sets prices below cost to drive out or deter potential entrants
- Limit pricing keeps prices low enough to make entry unattractive while still profitable for incumbents
- Excess capacity investments signal the ability to flood the market if new firms enter
- Two-part tariff pricing structures (fixed fee plus usage charge) can deter entry in certain industries (telecommunications)
Legal and Regulatory Strategies
- Strategic patenting protects innovations and prevents technological imitation (pharmaceuticals, technology sectors)
- Lobbying for government regulations or licensing requirements increases entry costs and complexity
- Regulatory capture influences policy-making to favor incumbent firms and create barriers for new entrants
- Intellectual property protection through copyrights and trademarks safeguards brand assets and creative works
Key Terms to Review (18)
Barriers to entry theory: Barriers to entry theory refers to the obstacles that prevent new competitors from easily entering an industry or market. These barriers can be structural, strategic, or legal and serve to protect established firms from potential competition. Understanding these barriers helps explain market dynamics and the degree of competition within different industries.
Bertrand Model: The Bertrand Model is an economic theory that describes how firms in an oligopoly compete on price rather than quantity. It suggests that when two or more firms produce identical products, they will undercut each other's prices to gain market share, leading to a situation where prices can drop to marginal cost, resulting in zero economic profit for the firms involved. This model highlights the intense competition present in oligopolistic markets and connects to various concepts including market power and pricing strategies.
Consumer welfare: Consumer welfare refers to the overall satisfaction and benefit that consumers derive from the consumption of goods and services. It emphasizes the importance of consumers' preferences, well-being, and their ability to access products at reasonable prices. This concept is closely linked to market structures and the impact of competition, especially in how market dynamics can enhance or hinder consumer choice and quality.
Contestability: Contestability refers to the degree to which a market can be entered and exited by new firms without significant barriers. It emphasizes the idea that even if a market is currently dominated by a few firms, the threat of potential competition can influence the behavior of existing firms, leading to more competitive pricing and innovation. This concept is closely related to the idea of barriers to entry, which are obstacles that prevent new competitors from easily entering an industry or area of business.
Cournot Model: The Cournot Model is an economic theory that describes how firms in an oligopoly compete on the quantity of output they produce, assuming that each firm's output decision influences the market price. It demonstrates how firms make decisions based on their rivals' production levels, leading to a Nash equilibrium where no firm can benefit by changing its output unilaterally.
Credible Threat: A credible threat is a commitment or action made by a firm or individual that is believable and can influence the behavior of competitors or potential entrants in a market. This concept is especially important in understanding how firms can deter entry into a market or maintain their market position by signaling to others that they are willing to take serious action if challenged. The effectiveness of a credible threat often relies on the ability of the firm to follow through on its commitments, which shapes the strategic interactions among competitors.
David J. Teece: David J. Teece is a prominent economist known for his work on the theory of dynamic capabilities, which explains how firms can achieve competitive advantage by adapting, integrating, and reconfiguring internal and external resources. His research emphasizes the importance of innovation and knowledge management in maintaining a firm's market position, particularly in the context of contestable markets and barriers to entry.
Economies of scale: Economies of scale refer to the cost advantages that a business obtains due to the scale of its operation, with cost per unit of output generally decreasing with increasing scale as fixed costs are spread out over more units of output. This concept is crucial for understanding how firms can achieve lower production costs and potentially dominate their markets, impacting competition, pricing strategies, and market structures.
Hit-and-run entry: Hit-and-run entry refers to a strategy where a firm temporarily enters a market to gain profits and then exits quickly, taking advantage of favorable market conditions. This tactic is often employed in contestable markets where barriers to entry are low and the potential for high profits attracts new entrants who can leave as swiftly as they came if competition becomes too intense or costs rise.
Limit Pricing: Limit pricing is a strategy employed by firms to set the price of their products low enough to deter potential entrants from entering the market while still maintaining profitability. This approach is particularly relevant in markets where barriers to entry are significant, as it helps established firms protect their market share and limit competition. By setting prices at a level that is unprofitable for new entrants but sustainable for themselves, firms can create an environment that discourages competition and preserves their market dominance.
Market Efficiency: Market efficiency refers to the degree to which market prices reflect all available information. When markets are efficient, asset prices accurately represent their true value based on this information, leading to optimal resource allocation and minimizing opportunities for arbitrage. This concept is crucial in understanding how contestable markets operate and the impact of barriers to entry on competition.
Monopoly: A monopoly is a market structure where a single seller or producer dominates the entire market for a particular good or service, with significant barriers preventing other firms from entering. This leads to a lack of competition, allowing the monopolist to set prices above marginal cost and maximize profits, often resulting in reduced consumer welfare and inefficiencies in the market.
Oligopoly: An oligopoly is a market structure characterized by a small number of firms that dominate the market, leading to limited competition and interdependent decision-making. These firms have significant market power, which allows them to influence prices and output levels. The behavior of one firm in an oligopoly affects the others, making strategic decision-making crucial for success, especially when it comes to pricing, product offerings, and potential collusion.
Predatory pricing: Predatory pricing is a pricing strategy where a firm sets its prices extremely low with the intention of driving competitors out of the market or preventing new entrants. This tactic can be particularly effective in monopolistic situations, where a single firm dominates the market and can sustain short-term losses to eliminate competition. In markets with barriers to entry, predatory pricing becomes a powerful tool for maintaining monopoly power by discouraging potential entrants from even attempting to compete.
Strategic entry deterrence: Strategic entry deterrence refers to actions taken by incumbent firms to prevent potential competitors from entering the market. This can involve various tactics such as lowering prices, increasing advertising, or investing in excess capacity to signal a strong market presence. The primary goal is to create an environment where potential entrants perceive the market as unattractive due to high barriers or unprofitable conditions.
Sunk Costs: Sunk costs are expenses that have already been incurred and cannot be recovered. These costs are important in decision-making because they should not influence future choices, as they remain the same regardless of the outcome of a decision. In the context of markets, understanding sunk costs can help clarify how barriers to entry are formed, affecting competition and potential profitability for new entrants.
The theory of contestable markets: The theory of contestable markets suggests that a market can be competitive even if it is dominated by a single firm, as long as there are no significant barriers to entry or exit for potential competitors. This means that the threat of new entrants can discipline the behavior of existing firms, leading them to act competitively and keep prices at a level similar to those found in fully competitive markets.
William J. Baumol: William J. Baumol was an influential American economist known for his contributions to various fields, including contestable markets and the theory of economic growth. His work emphasized the importance of market structures and the role of competition in determining prices and efficiency, particularly in industries with high fixed costs and low marginal costs. Baumol's insights laid the groundwork for understanding how barriers to entry affect market dynamics and consumer welfare.