ChainWhat it assumes · how to break it
Start
Barriers to entry fall, for example after deregulation or because new technology lets firms enter with little sunk cost.
1
As a result, the market becomes more contestable, so incumbents face the threat of new firms undercutting them.
contestable market · threat of entry
contestable market · threat of entry
Assumes: Entry and exit costs really are low.
But: If entrants face large sunk costs, such as building a brand, the threat of entry stays weak.
2
This means incumbents must keep costs down or lower-cost entrants will take their customers, so X-inefficiency is squeezed out and productive efficiency improves.
X-inefficiency · productive efficiency
X-inefficiency · productive efficiency
Assumes: Incumbents take the threat of entry seriously.
But: Incumbents protected by brand loyalty or scale may judge entry unlikely and let organisational slack persist.
3
At the same time, price is driven down towards AC, so output rises and price moves closer to MC, improving allocative efficiency.
allocative efficiency · normal profit
allocative efficiency · normal profit
Assumes: Price ends close to marginal cost.
But: Price equals AC in a contestable market, which equals MC only at minimum AC, so allocative efficiency is only approximate.
4
Therefore, to survive on normal profit, firms invest in new processes that cut costs, so dynamic efficiency improves.
dynamic efficiency
dynamic efficiency
Best link to attack
Assumes: Firms have the funds to invest.
Assumes: Firms have the funds to invest.
But: With profit squeezed to normal levels, firms may lack the retained profit needed for long-term research.
End
Productive and allocative efficiency improve, and dynamic efficiency may improve as firms invest to stay competitive.
Evaluation chain
- E1However, the cost pressure that removes X-inefficiency also squeezes the profit that funds investment.
- E2Because profits are driven towards normal levels, firms have less retained profit to put into research and development.
- E3As a result, static efficiency may improve while dynamic efficiency, the rate at which new products and processes appear, falls.
- E4So more contestable markets improve productive and allocative efficiency, but dynamic efficiency may suffer unless the entrants themselves bring new technology.
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Questions this answers
- Assess the impact of greater contestability on economic efficiency.
- Explain how the threat of entry can reduce X-inefficiency.
- Discuss whether contestable markets are always dynamically efficient.
Diagram
Contestable market diagram: price driven down to where AR = AC, with output rising towards the level where P = MC. Show X-inefficiency removed as AC falls back to the lowest attainable cost.
Reverse and related
Higher barriers to entry → less pressure on costs, more X-inefficiency and price further above MC.