AQA A-level Economics: Dynamic competition and contestable markets (7136) – Revision Notes

These notes condense the AQA AS and A-level Economics specification (version 1.3, 29 June 2022), A-level content for first teaching from September 2015: the dynamics of competition and competitive market processes, and contestable and non-contestable markets. The PDF numbers them 4.1.5.8 and 4.1.5.9; the AQA website numbers them 3.1.5.8 and 3.1.5.9. All figures are invented.

Full explanations are in the study guide. Test yourself with the practice questions, then check the AQA A-level Economics hub, the printable checklist and the free 10-minute diagnostics.

Key terms

Term	Meaning in one line
Competition	Rivalry between firms for customers
Non-price competition	Competing through product, quality, service, branding or cost reduction rather than price
Creative destruction	Entrants innovate to overcome barriers, destroying old products and firms and creating new ones
Contestable market	A market in which possible entrants restrain the prices and profits of incumbents
Sunk cost	Money spent that cannot be got back when a firm exits
Hit-and-run competition	Entering to take profit and leaving quickly
Barrier to entry	Anything that makes it hard or costly for a new firm to start

4.1.5.8 Dynamics of competition

Short run versus long run

	Short-run benefits	Long-run benefits
Price	Lower, as firms undercut rivals	Lower for longer, as costs fall
Cost	Pressure to cut waste	New processes lower unit cost
Product	More choice, better service	New and better products
Firm	Rivals lose sales if they lag	Investment, research, economies of scale

Costs of competition: duplicated research, advertising that only shifts customers between brands, firm failures and job losses.

Non-price competition

Ways firms compete without changing price:

• Better product features, design and durability.
• Higher quality of service, delivery and after-sales support.
• Branding and advertising.
• Lower costs, which allow a lower price later.

Why it matters: price cuts are copied quickly. Quality gains take longer to match.

Method for a campaign decision:

1. Margin per unit = price minus variable cost.
2. Break-even extra units = campaign cost divided by margin.
3. Compare with expected extra sales.
4. Evaluate: lasting effect? rivals’ response?

Reminder: price 18, variable cost 11, campaign 28,000.

Margin = 18 - 11 = 7
Break-even = 28,000 / 7 = 4,000 extra units

Creative destruction

The chain, in order:

1. Large profit for an incumbent with market power.
2. Profit attracts entrants and encourages innovation.
3. Innovation overcomes or weakens barriers.
4. Incumbent loses sales or margin. Some products, firms and jobs disappear.
5. New products and markets appear. Cycle repeats.

The specification says the process is a fundamental feature of the way competition works in a market economy. Technological change often drives it.

Reminder numbers: an incumbent’s profit falls from 200,000 to 56,000.

Change = (56,000 - 200,000) / 200,000 = -72%

Evaluation:

• For: raises productivity, disciplines monopoly, no need for the state to pick winners.
• Against: structural unemployment, slow if barriers are high, incumbents may buy or copy entrants.
• Judgement: depends on how high barriers are and how long the transition takes.

4.1.5.9 Contestable and non-contestable markets

Perfectly contestable market

• Free entry and free exit.
• No sunk costs.
• Entrants have access to the same technology and face similar costs.
• Entrants can undercut before incumbents respond.

Result: even one firm earns only normal profit and keeps price near average cost, because high prices invite entry. Contestability is a matter of degree.

Sunk costs and hit-and-run

Sunk cost = entry cost x (1 - share recoverable)
Months to recover sunk cost = sunk cost / monthly profit

Reminder: entry cost 150,000, 20% recoverable.

Sunk = 150,000 x 0.80 = 120,000
Monthly profit = 2,500 x (7.20 - 6.00) = 3,000
Months to recover = 120,000 / 3,000 = 40

Eight months of hit-and-run earns 24,000, far short of 120,000. With only 10% sunk (15,000), eight months gives a net gain of 9,000.

Entry-deterring pricing

An incumbent in a contestable market compares two choices. At a high price it earns more per unit but invites entry. At a lower price it keeps entrants out. Entry is deterred when the price is at or below the entrant’s average cost.

Reminder: entrant’s average cost is 11.

Choice	Price	Quantity	Average cost	Profit
High price	14	8,000	9.50	(14 - 9.50) x 8,000 = 36,000
Low price	10	10,000	9.00	(10 - 9.00) x 10,000 = 10,000

At 14 an entrant with cost 11 can undercut and profit. At 10 it cannot. If sunk costs were high, the incumbent could keep 14, because entry would be too risky.

Method for a hit-and-run question

1. Work out the monthly profit: units times (price minus unit cost).
2. Work out the sunk cost: entry cost times the share not recoverable.
3. Compare the profit over the time before the incumbent responds with the sunk cost.
4. Decide, then add one evaluation point: the incumbent’s likely price cut, or whether the entrant could raise sunk costs for the next rival.

Must-know distinctions

Pair	Difference
Fixed cost and sunk cost	A fixed cost may be resold, so it is not sunk
Number of firms and contestability	Few firms can still be contestable if entry is easy
Price competition and non-price competition	One changes price, the other changes product, service or cost
Short-run and long-run benefits	Squeezed margins now versus innovation and investment later

Evaluation of contestability:

• It explains why concentrated markets can perform well.
• Few real markets have zero sunk costs, and incumbents can raise them (heavy advertising, exclusive contracts, loyalty schemes).
• So think about how contestable a market is, and about what raises or lowers sunk costs.

Quick self-test

1. Define non-price competition.
2. Give one short-run and one long-run benefit of competition.
3. A firm has margin 12 per unit and a campaign costing 36,000. How many extra units are needed to break even?
4. Product P costs 60 and lasts 5 years. Product Q costs 36 and lasts 2 years. Which is cheaper per year of use, and by how much?
5. State two features of a perfectly contestable market.
6. Entry cost is 90,000 and 30% can be recovered. Calculate the sunk cost.
7. An entrant earns 5,000 a month. How many months to recover a sunk cost of 85,000?
8. An incumbent’s profit falls from 80,000 to 60,000. Calculate the percentage change.
9. Explain why high sunk costs reduce the threat of hit-and-run competition.
10. Explain why creative destruction can reduce monopoly profit over time.
11. Give one reason a monopolist in a contestable market may keep its price low.
12. Give one reason creative destruction may be slow.

Answers

1. Competing through product, quality, service, branding or cost reduction rather than a lower price.
2. Short run: lower prices or more choice. Long run: innovation, investment or lower costs through new processes.
3. 36,000 / 12 = 3,000 units.
4. P: 60 / 5 = 12 a year. Q: 36 / 2 = 18 a year. P is cheaper by 6 a year.
5. Any two of: free entry, free exit, no sunk costs, entrants face similar costs, entrants can undercut before incumbents respond.
6. 90,000 x 0.70 = 63,000.
7. 85,000 / 5,000 = 17 months.
8. (60,000 - 80,000) / 80,000 = -25%.
9. An entrant would lose most of its outlay when it leaves, so a short raid cannot cover its costs; entry is a bigger gamble.
10. Large profits attract entrants whose innovations take sales and cut price, so the incumbent’s margin falls.
11. If it charged a high price, a rival could enter and take its profit, so it keeps price near average cost.
12. High barriers, patents held by the incumbent, or entrants unable to raise finance; the incumbent may also buy or copy a rival.

Where marks are usually lost

• Describing creative destruction as simply closing firms, with no mention of new products or entry.
• Listing non-price methods without linking them to revenue, costs or market share.
• Treating all fixed costs as sunk.
• Giving a benefit of competition with no distinction between short run and long run.
• Saying a market with one firm must be a harmful monopoly, with no reference to contestability.
• Quoting a calculation with no working, or no units, or a percentage with the wrong base.
• Leaving out a judgement: say which factor decides the answer and why.
• Writing about real firms or statistics from memory instead of using the data given.

Official syllabus

AQA AS and A-level Economics specification (7135 and 7136), version 1.3, 29 June 2022, published by AQA; A-level content for first teaching from September 2015. Sub-sections 4.1.5.8 and 4.1.5.9 in the PDF (3.1.5.8 and 3.1.5.9 on the AQA website).