The Concept of Contestable Market

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The criticism of the structure- conduct- performance approach comes from the work of W.J Baumol (1982) who introduced the concept of what he called a contestable market. They key link in the structure –conduct-performance view is link from seller concentration to market pricing behaviour of performance in terms of whether firms make profit in excess of normal. However Baumol wishes to argue that seller concentration is not significant in terms of the ability of a company to make profit above normal. Whether a firm can do that, depends not on seller concentration but on the degree of contestability of a market. Contestability is the ease with which new firms can enter the market and the ease with which firms in the market can leave if they regard their performance as inadequate. The following are the characteristics of a contestable market •Firms action are influence by the threat of new entrant to the industry •There exist no barrier to entry and exit

No sunk costs(costs that cannot be recovered when exiting the market) •Firms may intentionally limit profits made to discourage new entrants(entry limit pricing •Firms attempting to erect artificial barrier to entry, for example producing over capacity to flood the market and drive down price in the event of an entry threat, aggressive branding and marketing strategies to close up the market and also the possibility of predatory or destroyer pricing. In order to assess the idea that potential competition is an important influence on pricing behaviour, I will have to start looking at related market structures that inhabit market contestability and how they set prices due to their nature as a reaction of contestability or fear of competition. Perfect competition market structure can be viewed as some sort of theoretical construct that doesn’t exist in the real world. However the only sector in the economy that gets close to perfectly competitive markets is probably agriculture. Many farms are price takers and produce only a tiny fraction of the total supply of potatoes, milk, and egg and much more, for which they exist many buyers. Fitting in with the characteristics of contestable markets, the product sold in this form of market is often homogeneous in character and entry barriers are minimal and also almost no sunk cost. Profit maximisation would seem to be a sensible and probably necessary objective if small farms are to survive. Due to the nature of this market structure, as earlier said with the example of agricultural products where many farms are price takers, therefore they have little or no control over the price they perfect competition: •Firms have to take the price set by the market

Large number of sellers, each small market share and therefore no control over the market. Examples may include agricultural products, some type of financial product (stocks and shares).

The case for perfect competition is an ideal market structure for the entire economy giving the rise to the possibility of Pareto optimal allocation of resources in society, such an allocation is said to exist when it is impossible to make one person better off without making another worse off at the same time. To further explore the relationship between competition and price and the influence of potential competition on price, I will look at monopolistic competition; this theory was developed by Chamberlin (1933) it holds to market situation where large numbers of firms are selling similar but differentiated products. Competition would not only apply to the price charged but also to the quality of the product, advertising and sales promotion. The assumption of free entry and exit from the market as in the perfect competition still applies as compared to perfect competition each good is slightly different in composition or brand image. For instance, different brands of toothpaste or detergents are similar but identical to one another. As a result each firm does not face a...
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