Question

Identify the conditions for a contestable market, and explain the ramifications for market power and the sustainability of long-run profits.

Short answer

The hit-and-run strategy puts incumbents on the toes in terms of the price charged to the product. Potential companies are free to enter and exit the market without significant or persuasive restrictions.

Attempting to outperform not only reduces the market share of each company, but also attracts new entrants to the market and reduces profits, thus curbing the profits of existing companies. Significant Market Power (SMP) is in the pocket by existing companies in the market.

Step-by-step solution

Introduction

The Contestable theory, devised by American economist William Baumol, is based on a hit-and-run strategy. The firms enter the market when there are no barriers to entry; make a profit in the industry

Explanation for market power and the sustainability of long-run profits.

As per the Contestable theory, the market has the following main characteristics:

• There are no barriers to the entry of new companies into the market economy. This is only possible if participants have immediate access to industrial technology. Perfect and symmetrical information are available to potential market participants, and existing companies are hesitant to rivals.

• No barriers or conditions for exit from the market. This in turn is possible with the existence of: a. Zero sunk costs b. No contractual agreements which otherwise would be a barrier closing down of operations and leaving the market.

• The hit-and-run strategy puts incumbents on the toes in terms of the price charged to the product. Potential companies are free to enter and exit the market without significant or persuasive restrictions.

• Attempting to outperform not only reduces the market share of each company, but also attracts new entrants to the market and reduces profits, thus curbing the profits of existing companies. Significant Market Power (SMP) is in the pocket by existing companies in the market.

• Regulators make heartfelt business decisions, such as sharing technology with market participants and promoting healthy competition, with the aim of stopping the anti-competitive behavior of existing companies.