ChainWhat it assumes · how to break it
Start
Barriers to entry fall, for example when deregulation opens a market or new technology lets new firms enter without large sunk costs.
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, incumbents cannot keep supernormal profit, because price is driven down towards AC and profit falls towards normal profit.
normal profit · limit pricing
normal profit · limit pricing
Best link to attack
Assumes: Incumbents have no cost advantage over entrants.
Assumes: Incumbents have no cost advantage over entrants.
But: An established firm with economies of scale has lower AC than an entrant, so it can set a price that keeps entrants out and still earn some supernormal profit.
4
In addition, any firms that do enter take market share, so incumbents' sales and revenue fall.
market share
market share
Assumes: Entrants win customers from incumbents.
But: If the market is growing, entrants may serve new customers, leaving incumbents' sales largely intact.
End
Incumbents' profits fall towards normal profit.
Evaluation chain
- E1However, how far profits fall depends on whether incumbents have cost advantages that entrants lack.
- E2Since an established firm may enjoy economies of scale and experience that a new entrant cannot match, its AC is below the entrant's.
- E3As a result, it can set a limit price just below the entrant's AC, deter entry and still earn supernormal profit.
- E4So lower barriers cut incumbents' profits most where entrants can match their costs, and much less where incumbents keep a scale advantage.
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Questions this answers
- Assess the impact of increased contestability on the profits of incumbent firms.
- Explain why firms in a perfectly contestable market earn only normal profit.
- Discuss whether deregulation reduces the profits of established firms.
Diagram
Contestable market diagram: price falls from the profit-maximising level to where AR = AC, removing the supernormal profit rectangle. For the evaluation, show a limit price set below the entrant's AC but above the incumbent's AC.
Reverse and related
Higher barriers to entry → incumbents protected, so supernormal profit persists.