ChainWhat it assumes · how to break it
Start
Barriers to entry fall, for example after deregulation removes a legal monopoly or new technology lets online firms enter a market at low cost.
1
As a result, new firms can enter, and leave, without large sunk costs, so the market becomes more contestable.
contestable market · sunk costs
contestable market · sunk costs
Assumes: Entry and exit costs really are low.
But: Incumbents may still have brand loyalty, economies of scale or control of distribution, so entry remains hard in practice.
2
This means if incumbents earn supernormal profit, an entrant can undercut them, take customers and leave before they can respond.
hit-and-run entry
hit-and-run entry
Assumes: Incumbents cannot respond quickly.
But: Incumbents can cut price quickly or threaten predatory pricing, which makes hit-and-run entry unprofitable.
3
Therefore, to deter entry, incumbents keep price close to average cost, earning only normal profit, even if few firms are actually in the market.
limit pricing · normal profit
limit pricing · normal profit
Best link to attack
Assumes: Incumbents believe the threat of entry is real.
Assumes: Incumbents believe the threat of entry is real.
But: If incumbents expect entry to be slow or small-scale, they may keep prices high and accept losing some market share.
4
Consequently, incumbents look for cost savings so that they can hold price down without losing profit, which pushes price lower over time.
cost efficiency
cost efficiency
Assumes: There is scope to cut costs.
But: If incumbents are already close to the lowest attainable cost, there is little room to cut price further.
End
Prices fall towards average cost, even in a market with few firms.
Evaluation chain
- E1However, the fall in price depends on incumbents believing that entry is a real threat.
- E2If entrants would face sunk costs such as advertising to build a brand, or incumbents can match any price cut at once, then hit-and-run entry is not profitable.
- E3As a result, incumbents can keep prices above AC with little fear of entry.
- E4So lower barriers bring prices down most in markets close to perfect contestability, and much less where sunk costs and incumbent advantages remain.
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Questions this answers
- Assess the likely impact of lower barriers to entry on prices in a market.
- Explain how the threat of entry can affect the behaviour of an incumbent firm.
- Discuss whether contestability matters more than the number of firms in determining prices.
Diagram
Contestable market diagram: incumbent's AR, MR, MC and AC; under the threat of entry, price is driven down from the profit-maximising level (MC = MR) to where AR = AC, with output rising and supernormal profit removed.
Reverse and related
Higher barriers to entry → incumbents are protected and can keep price above average cost.