3.4.7 Contestability Quiz: Pearson Edexcel Economics A, Unit 3

The 20 questions

1. A contestable market is one with:

   • Low entry and exit barriers, so the threat of entry disciplines incumbents
   • A single government body controlling the whole market
   • High barriers to entry and no threat of new entrants
   • All firms acting as price takers in every market

2. Sunk costs are:

   • Costs that cannot be recovered if a firm leaves the market, such as advertising or specialised equipment
   • Costs that are fully recoverable on exit from the market
   • Variable costs that change directly with the level of output
   • Costs that are always zero in every market

3. In a contestable market, incumbents may:

   • Stop producing altogether to avoid all competition
   • Keep prices low to deter entry, even with few rivals in the market
   • Ignore entrants completely because competition is not a threat
   • Raise prices to the highest level possible in every period

4. Which statement about sunk costs and contestability is correct?

   • The higher the sunk costs, the more contestable the market
   • Sunk costs have no link to contestability at any level
   • The lower the sunk costs, the more contestable the market
   • Contestability depends only on the number of firms in the market

5. Which is an example of a barrier to entry in the legal category?

   • Many suppliers of inputs competing for business
   • Freely available information about the market and its prices
   • A patent that stops rivals producing the same product for a set period
   • A low start-up cost for new businesses in the market

6. Which is the most contestable market?

   • Rail networks with fixed track infrastructure that cannot be moved
   • National electricity distribution with very large sunk costs
   • Patent-protected pharmaceutical products with long exclusivity
   • Local taxi services, where vehicles can be hired and resold easily

7. Why might a monopolist in a contestable market keep its price near average cost?

   • Because demand for its product is inelastic at all prices
   • Because the law requires it to set price at average cost
   • The threat of hit-and-run entry means it cannot earn high profit without attracting rivals
   • Because its costs are zero, so price must stay low

8. Hit-and-run entry is possible when:

   • Entrants face large sunk costs that cannot be recovered on exit
   • Demand is perfectly inelastic at the market price for the product
   • Entrants can enter, earn profit and exit quickly with low sunk costs
   • Incumbents hold patents that block entry for the whole period

9. Which is an example of a barrier to exit?

   • Low fixed costs that can be cut quickly in any period
   • Large sunk costs in specialised equipment that cannot be resold
   • Free access to all markets for any firm that wishes to join
   • Easy resale of assets when a firm leaves the market

10. Why are sunk costs important in contestability?

    • They guarantee that entry always takes place in every market
    • They make entry cheaper, which strengthens the threat of entry
    • They make entry riskier, so higher sunk costs weaken the threat of potential entrants
    • They are irrelevant to any firm's decision to enter a market

11. Which is a legal barrier to entry?

    • Freely available technical information about a product
    • Many suppliers of components competing for the firm's custom
    • A patent that prevents rivals producing the same product for a fixed period
    • A low start-up cost for new firms in the industry

12. A government awards a single operator an exclusive licence to supply a service. What is the effect on contestability?

    • The market becomes perfectly contestable because one firm is licensed
    • Sunk costs fall to zero for every firm that operates in the market
    • Entry is encouraged because the licence gives every firm a right to join
    • Entry is blocked, so the market is less contestable

13. Incumbents might use limit pricing when:

    • Entry costs are not prohibitively high and a credible threat of entry remains
    • All costs are fully recoverable on exit from the market
    • No threat of entry exists at any point in the market
    • Entry is illegal under the law for all new firms

14. Which market is least contestable?

    • Hairdressing salons that can be opened with modest investment
    • Street food stalls that can be set up and removed cheaply
    • Freelance design services with few fixed costs
    • A rail network with large sunk costs and legal barriers to entry

15. Evaluate: is a contestable market always efficient?

    • Not necessarily: the threat of entry encourages efficiency, but without real rivals firms may still be X-inefficient or underinvest
    • Yes, because every firm in such a market sets price equal to marginal cost
    • No, because contestable markets contain no firms at all
    • Yes, always, because contestable markets have no inefficiency at all

16. Why does contestability matter for regulators?

    • Regulators are never needed in any market that is contestable
    • A contestable market may reduce the need for regulation, though regulators still check sunk costs and barriers
    • Contestability means regulation must always increase in every market
    • Contestability is irrelevant to the design of economic policy

17. What is the key difference between perfect contestability and perfect competition?

    • The two are identical in every aspect of market behaviour
    • Perfect competition allows entry only by government licence
    • Perfect contestability requires many firms in the market at all times
    • Contestable markets may have few firms in practice, with the threat of entry rather than the number of sellers doing the disciplining

18. An entrant needs £2 million of sunk costs and expects profit of £150,000 a year for three years, ignoring discounting. Does entry pay?

    • No, because expected profit of £450,000 is less than the £2 million sunk cost
    • Yes, because £2 million is less than £2.45 million in total
    • Yes, because annual profit of £150,000 is positive every year
    • Yes, because sunk costs are fully recoverable on exit from the market

19. Which factor reduces contestability the most?

    • Many potential suppliers of components for new entrants
    • Free access to training for all workers in the sector
    • Easy resale of assets when firms leave the market
    • Strong brand loyalty to incumbents and high advertising costs needed to enter

20. Why might an incumbent with large sunk costs still be vulnerable?

    • Sunk costs are always an advantage for incumbents in every market
    • Entrants may use cheaper technology that undermines the incumbent's cost advantage
    • Entrants always have larger sunk costs than incumbents in the market
    • Incumbents can never be undercut by any entrant at any time

Related quizzes

• Sizes and types of firms Quiz · 3.1.1 · 20 questions
• How businesses grow Quiz · 3.1.2 · 20 questions
• Demergers Quiz · 3.1.3 · 20 questions
• Business objectives Quiz · 3.2.1 · 20 questions
• Revenue Quiz · 3.3.1 · 20 questions
• Costs Quiz · 3.3.2 · 20 questions
• Economies and diseconomies of scale Quiz · 3.3.3 · 20 questions
• Normal profits, supernormal profits and losses Quiz · 3.3.4 · 20 questions
• Efficiency Quiz · 3.4.1 · 20 questions
• Perfect competition Quiz · 3.4.2 · 20 questions