Airline Industry and Contestability Project What is a contestable market?

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Airline Industry and Contestability Project What is a contestable market?

In a contestable market, there are one or a number of firms which

profit maximise. In other words the number of firms is irrelevant. The

key assumption to make here is that barriers to entry to the industry

are relatively low, as is the cost to exit the industry. The existence

of potential entrants into the industry will tend to keep profits to

their normal level even in the short run, because existing firms will

want to deter new entrants from coming into the market. Contestable

markets are both productively and allocatively efficient and are

likely to be efficient in the short run as well.

The theory regarding the type of profit made in a contestable market

is this. Abnormal profit can only be made in the short run, only

normal profit will be made in the long run. The reason being is that

when firm try to profit maximises in the short run then this will

attract new entrants into the market to take some of this profit away

from the existing firm. As more competition is attracted then the new

prices will force the prices and the profit down. This is the reason

why it is only possible to make normal profit in the long run. The

threat of potential entrants into the industry means that existing

firms will behave competitively, even if the firm is a monopoly.

The key assumption of a contestable market is that it gives the firms

the ability to enter and exit the market. It is natural to assume that

a monopoly is going to have high barriers to entry, but theory

suggests that there is a large dependence on the cost to exit the

industry rather than enter it. The cost of exiting and Industry is

often termed as sunk costs. These are the costs that a firm can't

recover when they decide to exit the industry. An example of a sunk

cost would be money spent on advertising, because you cannot recover

the money you spent on advertising. If sunk costs are low or virtually

nothing then it is correct to assume that a firm is operating in a

contestable market. The lower the sunk cost the greater the

contestability of the market.

The ease at which a firm can enter and exit a market will leave it

vulnerable to 'Hit and Run' competition. If there is abnormal profit

in an industry then newcomers will enter the market, take their share

of the excess profit and exit the...

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...ity of service. In a less contestable

market firms are under less pressure to produce a service of the

highest quality. Recent mergers involving Easyjet and Ryanair have

meant that the industry is being dominated by two big firms. This is

an example of a Contestable market, because there is less competition

and these larger firms will benefit from economies of scale such as

brand loyalty and these firms will have more slots for taking off or

landing, which reduces the amount of competitors that can enter.

The reason why it may be contestable is that in the industry there are

lots of profits to be made. An increase in Ryanair profits would

attract "hit and run" competition. Another reason is that Ryanair was

able to purchase a Boeing 747 at a significant discount. This means

that there will be low sunk costs as these planes could be sold off if

you decide to exit the industry.

To conclude it can be said that the low cost airline industry is seen

as contestable, because of the east to set up, excess profits, but

recent news show that it is more becoming less and less contestable

with mergers and few firms producing at low cost and really dominating

the industry.

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