Economics · Year 13 · Business Behavior and Market Structures · Autumn Term

Contestable Markets and Market Power

Examination of the theory of contestable markets and its implications for market power, even in concentrated industries.

• National Curriculum Attainment Targets
• A-Level: Economics - Market Structures
• A-Level: Economics - Contestable Markets

About This Topic

Contestable markets theory explains how the threat of potential entry by new firms limits market power in concentrated industries. Central to this is hit-and-run entry: competitors can enter quickly if sunk costs are low, technology is accessible, and exit is costless. Year 13 students examine how this forces incumbents to set prices near average costs and expand output to deter entrants, even without actual rivals.

In A-Level Economics market structures, this builds on oligopoly and monopoly analysis. Students address key questions: how entry threats shape pricing decisions, the difference between actual and potential competition, and policy roles for authorities like the Competition and Markets Authority (CMA). They evaluate if contestability should prioritize barriers over concentration when assessing dominance.

Active learning suits this topic well. Simulations let students role-play firm strategies under entry threats, making abstract incentives tangible. Group case studies on sectors like airlines reveal real dynamics, while debates sharpen policy critiques, boosting exam-ready analytical skills.

Key Questions

1. Analyze how the threat of entry can influence pricing and output decisions of incumbent firms.
2. Differentiate between actual competition and potential competition in shaping market outcomes.
3. Assess the policy implications of contestable market theory for competition authorities.

Learning Objectives

• Analyze how the threat of new entrants influences the pricing strategies of incumbent firms in concentrated markets.
• Differentiate between actual market competition and potential competition in determining firm behavior and market outcomes.
• Evaluate the effectiveness of competition policy interventions based on the principles of contestable markets.
• Critique the assumptions underlying the theory of contestable markets, such as zero sunk costs and costless exit.

Before You Start

Monopoly and Monopolistic Competition

Why: Students need to understand the characteristics and behaviors of firms in non-competitive market structures to appreciate how contestability offers an alternative explanation for competitive outcomes.

Oligopoly and Game Theory Basics

Why: Familiarity with strategic interdependence and the actions of a few dominant firms is helpful for understanding how incumbents react to potential threats.

Key Vocabulary

Contestable Market	A market where the threat of potential entry by new firms, even if no actual entry occurs, is sufficient to keep incumbent firms' behavior in check.
Hit-and-Run Entry	A short-term entry into a market by a new firm, aiming to make quick profits before the incumbent can respond, followed by a swift exit if necessary.
Sunk Costs	Costs that have already been incurred and cannot be recovered, such as specialized machinery or advertising campaigns, which can deter entry.
Barriers to Entry	Obstacles that make it difficult or impossible for new firms to enter a market, including high start-up costs, patents, or brand loyalty.
Potential Competition	The possibility that new firms might enter a market, influencing the decisions of existing firms even if no new firms are currently present.

Watch Out for These Misconceptions

Common Misconception

Contestable markets require many actual competitors, like perfect competition.

What to Teach Instead

Theory focuses on potential entry threat alone. Role-plays demonstrate how one credible entrant disciplines incumbents, helping students distinguish via peer comparison of strategies.

Common Misconception

High sunk costs always eliminate contestability.

What to Teach Instead

Contestability holds if sunk costs are low relative to profits. Case studies prompt groups to classify costs in real industries, revealing examples where entry occurs despite concentration.

Common Misconception

Incumbents ignore potential entrants without immediate action.

What to Teach Instead

Threat alone prompts preemptive pricing. Simulations show students testing limit-pricing tactics, correcting overconfidence in barriers through iterative feedback.

Active Learning Ideas

Role-Play: Entry Threat Simulation

Divide class into incumbent firms and potential entrants. Incumbents set initial prices and outputs; entrants announce low-cost entry, prompting incumbents to adjust. Groups report decisions and rationale in plenary. Debrief links choices to theory.

35 min·Small Groups

Case Study Analysis: Sector Analysis

Provide cases like UK energy markets. Groups identify sunk costs, entry barriers, and contestability level. They predict incumbent responses and CMA interventions. Share findings via gallery walk.

45 min·Small Groups

Formal Debate: Policy Application

Split class into teams: one argues contestability should guide CMA over structure-conduct; other defends traditional metrics. Present evidence from cases, vote, and reflect on strengths.

50 min·Whole Class

Graphing: Response Curves

Individuals plot average cost, marginal cost, and demand curves. Shade entry threat zones, adjust for low sunk costs. Pairs compare and discuss pricing shifts.

25 min·Pairs

Real-World Connections

• The airline industry, particularly routes with low barriers to entry and exit for aircraft leasing, can exhibit contestable market characteristics, forcing established carriers to compete on price and service to deter new low-cost entrants.
• The UK's Competition and Markets Authority (CMA) uses contestability analysis when investigating potential monopolies or mergers, assessing whether the ease of entry for new firms limits the market power of existing players in sectors like retail banking or digital services.

Assessment Ideas

Discussion Prompt

Present students with a scenario: 'A large tech company dominates the market for online video streaming, but the technology required to start a new service is becoming widely available and inexpensive. Discuss how the threat of new entrants might influence the dominant firm's pricing and content acquisition strategies, even if no new competitor has yet emerged.'

Quick Check

Ask students to identify two key assumptions of contestable market theory. Then, have them briefly explain one real-world industry where these assumptions might hold true and one where they are unlikely to apply, justifying their choices.

Exit Ticket

On an index card, students should write one sentence defining 'hit-and-run entry' and one sentence explaining why low sunk costs are crucial for contestable markets. They should also list one policy implication for competition authorities derived from this theory.

Frequently Asked Questions

What is contestable market theory?

Contestable market theory states that potential competition from new entrants curbs incumbent market power, even in industries with few firms. It relies on low sunk costs, easy technology access, and quick exit options, enabling hit-and-run entry. Incumbents thus price near costs to deter threats, as explored in A-Level Economics for oligopolies.

How does the threat of entry affect incumbent pricing?

Incumbents limit prices to average costs to prevent profitable entry. If they charge above, entrants undercut temporarily. Students analyze this via diagrams showing demand, costs, and entry zones, linking to output expansion for credibility.

What are policy implications of contestable markets for the CMA?

CMA should assess entry barriers over market share. Low contestability justifies intervention, like subsidies for entrants. This shifts focus from concentration to dynamics, aiding merger reviews and dominance cases in UK markets.

How can active learning help teach contestable markets?

Role-plays and simulations immerse students in firm decisions under entry threats, concretizing abstract ideas. Group debates on CMA cases build evidence-based arguments, while graphing pairs reinforce visuals. These methods address misconceptions through discussion, enhancing retention and application for A-Level exams.