Barriers to entry and contestability

50 marks: 12 multiple choice questions, a data response and an essay. Answers are at the end.

AQA: Question 14 would be a 25-mark question on your papers.

Edexcel: Question 14 would be a 25-mark question on your papers.

OCR: Question 14 would be a 25-mark question on your papers.

Multiple choice online

The test

1In an industry the minimum efficient scale is about 40% of total market demand. The market structure most likely to result is:

A monopoly
B oligopoly
C perfect competition
D monopolistic competition

2An incumbent firm sets its price below the average cost a new entrant would face, but above its own average cost. This is:

A price discrimination
B predatory pricing
C limit pricing
D price leadership

3Which cost is most likely to be a sunk cost for a firm that leaves the UK grocery market?

A Money spent building its brand through advertising
B Delivery lorries that can be sold second-hand
C Unsold stock that can be returned to suppliers
D Leasehold shops that can be sublet to other retailers

4The theory of contestable markets implies that firms' prices and profits depend mainly on:

A the four-firm concentration ratio
B the number of firms in the market
C the size of the largest firm
D the threat of entry rather than the number of firms

5Which change would make a market less contestable?

A More landlords offer premises on short leases
B Second-hand equipment becomes cheaper and easier to sell
C A patent held by the incumbent expires
D Entrants must buy an operating licence that cannot be resold

6A patent acts as a barrier to entry because it:

A lowers the holder's average cost below any entrant's
B turns the product into a public good
C gives the holder the sole legal right to use an invention for a fixed period
D removes the holder's sunk costs

7A firm is less willing to enter a market where entry requires large sunk costs because:

A sunk costs raise its marginal cost above the incumbent's
B if entry fails, the money spent cannot be recovered
C sunk costs lower the price it can charge
D sunk costs must be paid again every year

8An incumbent's average cost at its current output is £20 a unit. A potential entrant, starting at a much smaller output on the same long-run average cost curve, would face an average cost of £30. The highest price at which the incumbent can be sure of deterring entry is:

A just below £30
B £25
C £20
D just above £30

9Which one of the following is a strategic barrier to entry?

A A falling long-run average cost curve across the whole market
B A licence that the law requires every firm to hold
C An incumbent's loyalty scheme that raises customers' cost of switching
D Ownership of the only deposit of a raw material

10Hit-and-run entry is possible only if a firm can:

A gain a larger market share than the incumbent
B undercut the incumbent's marginal cost
C sell a product that has no substitutes
D leave the market without losing the money it spent to enter

11The market for rail track is not contestable mainly because:

A rail fares are regulated by the government
B track is a sunk cost that cannot be moved or resold if a firm leaves
C train operating companies collude on fares
D demand for rail travel is price elastic

12High barriers to exit deter entry because:

A a firm that cannot leave cheaply risks being locked into losses
B they make rival products identical
C they increase the number of firms in the market
D they allow the incumbent to raise its price

13Flights between two cities are offered from two airports. Northgate is a large hub where every take-off and landing slot is in use; a new airline can only enter by buying slots from an airline that already holds them, at prices that have reached tens of millions of pounds for a daily pair. Westfield is a smaller airport with spare capacity, where slots are free and aircraft can be moved onto or off the route at short notice. Table 1 compares the two routes. Figures are illustrative.

Table 1: Two routes between the same cities
	From Northgate	From Westfield
Airlines on the route	2	4
Average one-way fare	£120	£75
Spare landing slots	None	Many
Cost to enter the route	Buy slots from an incumbent	None beyond the aircraft

(a)Using Table 1, calculate the percentage by which the average fare from Northgate exceeds the average fare from Westfield. [2]

(b)Explain two barriers to entry facing a new airline on the Northgate route. [4]

(c)With the aid of a diagram, explain how an incumbent airline could use limit pricing to deter a new entrant on the Northgate route. [6]

(d)Explain why the Westfield route is more contestable than the Northgate route, and the likely effect of this on fares and profits on the Westfield route. [6]

14Evaluate the view that the threat of competition matters more than the number of firms in a market. [20]

Answers

Show the answers

AO1 knowledge, AO2 application, AO3 analysis, AO4 evaluation.

	Answer	Why
1	B	A firm needs 40% of the market to reach lowest average cost, so there is room for only two or three efficient firms.
2	C	Limit pricing keeps the price just low enough that entry would not pay; predatory pricing goes below the incumbent's own cost to remove an existing rival.
3	A	Brand spending cannot be recovered on exit; vehicles, stock and leases all have a resale or sublet value.
4	D	If entry and exit are free, even a single firm must price close to average cost or invite hit-and-run entry.
5	D	A licence that cannot be resold is a sunk cost, lost if the entrant leaves; the other changes lower the cost of entering or leaving.
6	C	A patent is a legal barrier: for its term, usually 20 years, rivals may not make or sell the product without a licence.
7	B	If the venture fails, a firm with recoverable costs sells up and walks away; one with sunk costs has lost them.
8	A	At any price below £30 an entrant would make a loss at its likely output, while the incumbent still earns nearly £10 a unit.
9	C	Strategic barriers are put up deliberately by incumbents; the other three are structural or legal features of the industry.
10	D	Entering while abnormal profit is available and leaving when it is competed away only works if exit costs nothing.
11	B	Track, signalling and tunnels have no use off the route they serve, so a firm that laid them and left would lose almost everything.
12	A	A firm that fails cannot cut its losses if leaving is expensive, so it is less willing to take the risk of entering.

13 (a) Using Table 1, calculate the percentage by which the average fare from Northgate exceeds the average fare from Westfield. [2: AO2 2]

AO2 (1) (120 − 75) ÷ 75 × 100
AO2 (1) 60%

13 (b) Explain two barriers to entry facing a new airline on the Northgate route. [4: AO1 2, AO2 2]

AO1+AO2 (2) Control of a scarce resource: every slot at Northgate is held by an incumbent, so a new airline cannot fly the route without buying slots, and the price of slots is itself a cost of entry that incumbents never had to pay
AO1+AO2 (2) Economies of scale: the two incumbents spread aircraft, crew and marketing costs over many flights a day, so a newcomer starting with one or two flights would have a higher cost per seat
AO1+AO2 (2) Or: brand loyalty and frequent-flyer schemes built up by the incumbents raise the cost of switching for business travellers; or the risk that incumbents cut fares in response to entry

Maximum 4: two barriers, each identified (1) and explained in the context of the route (1).

13 (c) With the aid of a diagram, explain how an incumbent airline could use limit pricing to deter a new entrant on the Northgate route. [6: AO1 2, AO3 4]

AO1 (2) Diagram: a falling long-run average cost curve; the incumbent's large output Qi with average cost ACi; the entrant's small output Qe with a higher average cost ACe; a limit price PL drawn between ACi and ACe
AO3 (1) Because of economies of scale the incumbent's cost per seat is below any cost a small entrant could reach
AO3 (2) If the incumbent sets its fare at PL, below ACe, an entrant would make a loss on every seat at its likely output, so entry does not pay; the incumbent still covers its own cost ACi and earns a profit of PL minus ACi on each seat
AO3 (1) The incumbent gives up some profit today (it could charge more than PL) to protect its profit in the future by keeping the route to itself

Levels: 1 to 2 for a description with a partly correct diagram; 3 to 4 for a correct diagram with the two cost levels and the limit price between them; 5 to 6 for the full chain, including why the entrant would make a loss and what the incumbent gives up.

13 (d) Explain why the Westfield route is more contestable than the Northgate route, and the likely effect of this on fares and profits on the Westfield route. [6: AO1 1, AO2 1, AO3 4]

AO1 (1) A contestable market is one with low barriers to entry and exit and few or no sunk costs, so firms can enter and leave freely
AO2 (1) At Westfield slots are free and spare, and aircraft can be moved onto the route and off it again, so the cost of entering is recoverable: the aircraft simply flies elsewhere if the route does not pay
AO3 (2) If fares on the route rose far enough above average cost to earn abnormal profit, another airline could enter, take some of that profit and leave when it was competed away (hit-and-run entry); the four airlines know this, so the threat of entry holds fares down
AO3 (2) Fares will therefore stay close to average cost and the airlines will earn only normal profit, which fits the lower fare of £75 in Table 1; the number of airlines matters less than the fact that a fifth could appear at any time

Levels: 1 to 2 for defining contestability or describing the data; 3 to 4 for linking free slots and movable aircraft to low sunk costs; 5 to 6 for the full chain to the threat of entry, fares near average cost and normal profit, applied to the route.

14 Evaluate the view that the threat of competition matters more than the number of firms in a market. [20: AO1 6, AO3 6, AO4 8]

Knowledge and analysis (AO1 to AO3)

Define contestability: a market in which barriers to entry and exit are low and sunk costs are small, so that firms can enter when abnormal profit appears and leave without loss when it is competed away. In a perfectly contestable market the threat of hit-and-run entry forces even a single firm to price at average cost and earn normal profit.
The case for the view: a monopolist or a few large firms in a contestable market behave like competitive firms, so market share and concentration ratios are poor guides to performance. Diagram: a monopolist that would set Pm where MC = MR instead sets price at average cost to deter entry, with higher output and no abnormal profit. Examples: routes from airports with spare slots, coach services, online retail, markets where second-hand equipment is easy to buy and sell.
The case against: in many markets sunk costs are large and the threat of entry is weak, so the number of firms and the barriers between them do decide price and profit. Natural monopolies with heavy sunk investment (track, pipes, networks), industries with patents or scarce resources (airport slots, spectrum) and markets where incumbents can use limit or predatory pricing. Here concentration does matter, which is why competition authorities still look at market shares and merger thresholds.
Incumbents can also act to make a market less contestable: advertising and loyalty schemes that create sunk costs for entrants, exclusive contracts, excess capacity held as a threat, or limit pricing. The threat of competition is something incumbents can blunt.
Diagram to use: the limit-pricing diagram with a falling LRAC, or a monopoly diagram showing price at average cost instead of the profit-maximising price when entry is free.

Evaluation (AO4)

It depends on sunk costs: where they are low (software, coach routes, many services) the threat of entry disciplines firms and the number of firms matters little; where they are high (rail track, water, aircraft manufacturing) the threat is empty and structure matters.
It depends on information and speed: hit-and-run entry needs entrants who can see the profit and move before the incumbent responds; if the incumbent can cut prices quickly, the threat is weaker than the theory assumes.
The two are not alternatives: a market with many firms and low barriers is competitive on both counts, and a market with one firm and high barriers is uncompetitive on both. The view matters most for the in-between case of few firms but free entry.
Regulators act on both: the CMA uses market shares as a starting point but asks whether entry is likely; it has blocked some mergers in concentrated markets and cleared others where entry was easy.
Perfect contestability is rare in practice because almost all entry involves some sunk cost, so the view is best read as a matter of degree rather than a replacement for looking at structure.

Judgement

A supported judgement might conclude that the threat of competition is a better guide than the number of firms where sunk costs are low and entry is quick, because there even a monopolist must behave competitively, but that in markets with large sunk costs the threat is weak and the number of firms and the height of the barriers between them still decide prices and profits. The useful question is not how many firms there are but how easily another could appear.

Marking

Bands, out of 20 (AO1 knowledge 6, AO3 analysis 6, AO4 evaluation 8, as WJEC marks a 20-mark question). Top band (16 to 20): a range of points developed in full chains of reasoning, supported by an accurate diagram and real examples, with evaluation that weighs the arguments and reaches a judgement that depends on stated conditions. Middle band (9 to 15): some developed chains, a relevant diagram, evaluation present but one-sided or asserted. Bottom band (1 to 8): points listed or described, little use of theory or examples, judgement missing or unsupported.