Costs that cannot be recovered after a firm shuts down. Also known as an exit barrier.
Competition:
Individuals or firms striving for a greater share of the market.
Collusion:An agreement between parties to refrain in participating in an activity that they normally would in order to reduce competition.
Assumptions:
There can be either a monopoly or and oligopoly.
Collusion is not an option for incumbent firms- the market is characterised by competition, not collusion.
There are no significant barriers to entry. Outside firms can enter the market and challenge incumbent firms for market control. If abnormal profits exist, other firms can easily enter the market by lowering price.
There are no exit barriers. Firms can freely leave as there are no sunk costs.
Theory of Contestability:
The theory suggest that incumbent firms will remove the incentive for firms to enter by setting the price and output at zero profit level, in order to avoid abnormal profit.
Diagram:
Example:
Low Cost Airlines: Entrants have the possibility of leasing aircraft and will be able to respond to high profits by quick entry and exit.
- Incumbent Firms:
Already existing firms.- Sunk Costs:
Costs that cannot be recovered after a firm shuts down. Also known as an exit barrier.- Competition:
Individuals or firms striving for a greater share of the market.Assumptions:
Theory of Contestability:
Diagram:
Example: