Cambridge International as and a level Economics Ebook

X-ineff iciency: 
where the typical costs are above those 
experienced in a more competitive market.
KEY TERM
172
Cambridge International A Level Economics

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Th
e important features of a contestable market are 
as follows:
■ 
Free entry, which implies that new and existing providers 
will have the same cost structure as in a perfectly 
competitive market.
■ 
The number and size of firms are irrelevant. If a contestable 
market has only a few large firms, any cost diff erences 
should be a reflection of a decision by a particular firm to 
charge a given price.
■ 
Only normal profits can be earned in the long run. If firms 
are making abnormal profits, then this is the signal for 
others to enter the market. This could be on a ‘hit and 
run’ basis – a firm sees an opportunity, enters the market, 
collects the gains and leaves at no cost.
■ 
The threat of potential entrants into the market is 
overriding. Oligopolists and even a monopolist are obliged 
to off er consumers the benefits that they would receive in a 
more competitive market structure. Otherwise, new firms 
will enter from the pool of potential entrants.
■ 
All firms are subject to the same regulations and 
government control irrespective of size.
■ 
Mechanisms must be in place to prevent the use of unfair 
pricing designed by established firms to stop new firms 
from entering the market.
■
Cross-subsidisation is eliminated since firms are unable 
to make normal profits if they sell any of their services 
below cost.
Th
e application of contestability to the airline market 
is particularly interesting since, prior to deregulation, 
routes were strictly regulated by governments through 
the International Air Transport Association (IATA) and 
there was little competition. Th
e ‘open skies’ policy of a 
deregulated market has led to lower fares and a greater 
choice of routes for passengers. Th
is has particularly been the 
case in the US domestic market and in Europe, where new 
low-cost airlines such as easyJet and Ryanair have entered 
the market and challenged the established national carriers. 
More recently, deregulation has had a huge impact on the 
provision of air services in southern and South East Asia.
Other examples of contestable markets include:
■
local bus services and rail services in the UK through 
deregulation and privatisation
■ 
the provision of public services such as electricity, gas and 
water supplies
■ 
telecommunications, particularly through the choice of 
network suppliers
■
personal and corporate banking and finance through 
deregulation.
Th
e extent to which markets are contestable varies from one 
country to another. In theory and in practice, any market, even 
a monopoly, can be contestable. Th
is state of aff airs will come 
about if there is a pool of potential entrants waiting to enter 
a market if they see existing fi rms making abnormal profi ts. 
Th
e cost of entry and exit is the main factor that determines 
whether a market really is contestable. Deregulation, the 
removal of barriers to entry, is the main way in which markets 
can be opened up to competition. In many cases, deregulation 
has been implemented alongside a policy of privatisation. Th
is 
twofold policy is one that has been implemented by many 
governments worldwide, oft en in markets where previously the 
state or public sector has been the only provider of a service.