Concept Clarification: Contestable Markets (2)4 min read

This is a second post of a series of post discussing the concepts of contestable markets and contestability. Read the first one here.

Yesterday we examined the definition of contestable markets with an analogy and an example. Also we answered the common query of students as to why a oligopoly or monopoly could be contestable. Now let’s shift our attention to another common error of students: mixing up contestability and competition.

Contestable v.s. Competitive

Competition is a concept that is not well explained in H1 and H2 A Level Economics. This concept appears everywhere and deserves an article of its own to clarify. But I will keep things simple here: an industry is competitive when existing firms engage in behaviour that seeks to maximise their own objective (usually assumed to be SR profit) for fear of losing out to other firms in the industry. Let’s break this mouthful of a statement into two parts.

“firms engage in behaviour that seeks to maximise their own objective (usually assumed to be SR profit)”

Competition can be via pricing and output behaviour or non-price decisions as long as these decisions seek to maximise the firm’s objectives. So a profit-maximising firm in a oligopoly could seek to increase its sales revenue by spending on R&D to improve the quality of its products.

Perfectly competitive firms reduce costs through specialisation and division of labour and use of most efficient technology in order to be productive efficient and also produce at the minimum point of the Long Run Average Costs.

“for fear of losing out to other firms in the industry.”

But these behaviour would not be considered competition unless they were made with some adversary in mind. We would not call a monopoly competitive if it were innovating or lowering prices because there is no rival firm in the industry to compete against. PC firms and Monopolistically Competitive firms by this definition are competitive in terms of their pricing and output decisions. Because of the availability of close substitutes, they have a relatively price elastic demand curve, and have to try to be productive efficient so that cost savings can be passed on to consumers in the form of lower prices; failure to do so would mean a more than proportionate fall in quantity demanded to any price increase as consumers switch to their rivals that manage to be more cost-efficient.

Competition is what happens between existing firms in an industry. When McDonalds introduces their new Nasi Lemak burger to gain an edge over its rivals KFC and Pizza Hut; or when Grab launches yet another promotion in an attempt to oust its rival Uber from the market. Contestability on the other hand is what happens between existing firm and potential entrants.

Competition in the case of the street soccer example in Part 1 of this series would be having other kids come and play on the same court, sharing the court with Jesse. Because there are more players, each person enjoys a smaller court area. This does not happen in our story because the increasing contestability prompted Jesse and his friends to behave differently, more aggressively. New kids never got to play on the same court.

It is crucial to note another distinction between these two ideas. In our study of market structure, we assume that entry and exit can only take place in the long-run. That is, all factors of production must be variable. This makes contestability a long-run concept. In contrast, competition is regardless of the time frame. Firms can behave competitively in any time period of consideration.

Overlapping outcomes

So competition and contestability are different ideas altogether. But it can get confusing when we examine their implications on market outcomes and how it can be difficult to distinguish between the competitive behaviour from responses to increasing contestability in the real world. This is the topic of the next article. Till then, dream economics.

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