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Discuss How The Theory Of Contestable Markets Could Impact On The Price And Output Of A Monopoly Firm

687 words - 3 pages

Market structures are traditionally distinguished between four types i.e. perfect competition, monopoly, monopolistic competition and an oligopoly. They are determined on the basis of the number of firms in the market, the type of product, whether homogenous or differentiated and whether barriers to entry exist or not. Due to various specifications of all structures a “casual chain” is seen running from the market structure to the performance of that industry (Sloman, J. Hinde, K. pp 222)
A monopoly involves one firm producing a good without close substitutes; that coincides with the firm. Barriers to entry exist thus making it difficult for new entrants to penetrate the industry and be a ...view middle of the document...

The firm is making supernormal profits.

The theory of contestable markets does not focus on the size of the market or the number of firms present in it; instead it focuses on entry and exit conditions. Therefore the idea of market contestability rests on the absence of sunk costs. Sunk costs are costs incurred upon entry, however they are not recoverable upon exit for e.g. capital equipment. If no sunk costs are involved then a contestable market is subject to hit and run, as firms can enter the market, reap the profits for as long as possible and exit without incurring any costs. (Sloman, J. Hinde, K. 2007)
Firms therefore are forced to set a price that reflects their costs of production. Without barriers to entry and sunk costs, competition will be highly concentrated even though few large firms are present in the market. Thus the monopoly firm shall be forced to earn normal profits and output shall be at a socially efficient outcome i.e. Q*. The diagram below illustrates the situation where the monopoly firm is in a contestable market. ...

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