Alternative+Theories+of+the+firm

The Theory of Contestable Markets (note that this is not part of the formal IB syllabus for teaching beyond 2012 but it is interesting not least that it contrasts with the neoclassical theory of the firm that assumes that it is the degree of competition within an industry that influences firms' behaviour)

Introduction: Behaviour of firm is not determined by degree of competition in market, but degree of potential competition.

Definition: A contestable market is one in which there is freedom of entry to the industry and costs of exit are low. Economists have observed structures with few firms, which have low barriers to entry and it is argued that monopolies and oligopolies where there are low barriers to entry may behave not like traditional theory suggests, but that they may behave more like a perfectly competitive industry.

Key Assumptions Linked to Contestable Markets


 * No. || Assumption || Consequence ||
 * 1. || There is freedom of entry to and exit from the market. || Firms only make normal profits in the long run. Additionally, they probably only make normal profits in the short run because abnormal profits would attract competitors. ||
 * 2. || There is price competition and no collusion over prices. || This drives profits towards normal levels. This will also result in firms being productively and allocatively efficient. ||
 * 3. || <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">The number of firms may vary from one to many. || <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Perfect and monopolistic competition structures are contestable but monopoly, duopoly and oligopoly structures can also be contestable when the sunk costs of leaving an industry are relatively low. ||
 * <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">4. || <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Goods may be homogenous or branded. || <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Perfect competition or a concentrated structure. ||
 * <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">5. || <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">All participants in the market have perfect knowledge. || <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Everyone knows what’s going on. ||
 * <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">6. || <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Firms produce where MC = MR. || <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Firms behave in the same way as they do in any other market structure. ||
 * <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">6. || <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Firms produce where MC = MR. || <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Firms behave in the same way as they do in any other market structure. ||

<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">“The theory of contestable markets has been used to argue for weaker application of [|antitrust laws], as simply observing a monopoly market may not prove that a firm is exploiting its [|market power] to control the price level. The applicability of the theory to real world situations has been questioned, however, particularly as there are very few markets which are completely free of [|sunk costs] and entry and exit barriers. <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Low-cost airlines remain a commonly-referenced example of a contestable market; entrants have the possibility of leasing aircraft and should be able to respond to high profits by quickly entering and exiting. In practice, however, there may be entry/exit barriers in the form of terminal leases and availability.” <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Source Wikipedia: []

<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">
<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">In recent years has been an increase in the number of markets and industries that are genuinely contestable. Several factors explain this development:

<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">· De-regulation of markets – De-regulation involves the opening up of markets to competition by reducing some of the statutory barriers to entry that exist (Airline industry and low cost carriers) <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">· Tougher competition laws acting against predatory behaviour by existing firms in a market. This has included much tougher rules against price fixing cartels (see notes on oligopoly and collusive behaviour) <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">· The development of free trade has opened up the markets for member nations. A good example of this is home and car insurance and also the entry of Western European clothes retailers onto the UK high streets and shopping malls. <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">· The impact of new technology – which has brought down some of the entry costs in some markets (an increase in capital mobility). Examples include desktop publishing <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">· The rapid expansion of e-commerce – leading to the emergence of new players in the travel sector and online bookselling

=<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Summary: = <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Contestable Markets = = =<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Revision and extension work =
 * <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Can be monopolies or Oligopoly or any market structure
 * <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Behaviour of firm is not determined by degree of competition in market, but degree of potential competition.
 * <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Contestable markets are ones where there is a lot of potential competition, due to the lack of barriers to entry and exit.
 * <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Firms in contestable markets can only make normal profits and will be both productively and allocatively efficient- will in effect behave like a perfectly competitive firm. If they didn’t new firms would enter and abnormal profits would be competed away.

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