AQA A-level Economics: Dynamic competition, creative destruction and contestable markets (7136)

This guide follows the AQA AS and A-level Economics specification (version 1.3, 29 June 2022) for the A-level, first taught from September 2015. It covers two parts of the sub-section Perfect competition, imperfectly competitive markets and monopoly: the dynamics of competition and competitive market processes, and contestable and non-contestable markets. The PDF prints these as 4.1.5.8 and 4.1.5.9; the AQA website numbers them 3.1.5.8 and 3.1.5.9. Every firm, country and number below is invented for illustration.

Read it with the revision notes and the practice questions. For the wider unit, see the overview of individuals, firms, markets and market failure, the AQA A-level Economics hub and the printable checklist. To find weak spots first, use the free 10-minute diagnostics.

Outcomes at a glance

Section	What you must be able to do
4.1.5.8	Explain the short-run and long-run benefits likely to result from competition
4.1.5.8	Explain that firms compete on more than price: improving products, cutting costs, raising the quality of service
4.1.5.8	Explain creative destruction and why it is a fundamental feature of a market economy
4.1.5.9	Explain why contestability matters for the performance of an industry
4.1.5.9	Use sunk costs and hit-and-run competition to judge how contestable a market is

1. Benefits of competition: short run and long run

Competition is a process in which rival firms try to win customers. Its benefits arrive on two time scales.

Short-run benefits come from rivalry between firms using the technology they already have:

• Lower prices, because a firm that charges more than its rivals loses sales.
• Pressure to keep average costs down, because lower prices squeeze margins.
• More choice and better service as firms fight for the same customers.

Long-run benefits come from firms having time to change what they do:

• Investment in new capital and in research and development.
• New and better products, and new processes that cut unit costs.
• Gains from economies of scale as successful firms grow.
• Lower prices and higher quality that last, because costs have fallen.

The specification asks you to see both. A market can look very competitive in the short run (many sellers, low margins) but give little reward for innovation. A market with a few large firms can look less competitive on paper yet produce a steady flow of improvements.

Competition can also have costs. Rivals may duplicate research, spend heavily on advertising that only moves customers between brands, or fail, so workers lose jobs. These costs are the basis of evaluation.

Worked example: a cost-cutting investment

Firm Brightwell, in an invented market, spends 300,000 on research that lowers its unit cost by 1.50. It sells 400,000 units a year.

Annual cost saving = 400,000 x 1.50 = 600,000
Payback = 300,000 / 600,000 = 0.5 years = 6 months

If the lower cost is passed on in price, consumers gain in the long run. If Brightwell keeps it as profit, rivals have an incentive to match the saving or leave. Either way, rivalry is what makes the project worth doing: a firm with no rivals has less reason to take the risk.

2. Non-price competition

Firms do not compete on price alone. The specification lists improving products, reducing costs and improving the quality of the service provided. Other forms of non-price competition include:

• Product differentiation: features, design, durability, packaging.
• Branding and advertising.
• After-sales service, warranties, delivery speed, opening hours.
• Product innovation and process innovation.

Non-price competition matters most where price competition is weak or risky. If a firm cuts price, rivals can copy at once and everyone earns less. Improving the product is harder to copy straight away.

Worked example: is an advertising campaign worth it?

Firm Fernley sells garden chairs for 40 each. Variable cost is 25 per chair. A campaign costs 45,000.

Margin per chair = 40 - 25 = 15
Break-even extra sales = 45,000 / 15 = 3,000 chairs
If the campaign adds 3,800 chairs:
  extra margin = 3,800 x 15 = 57,000
  net gain = 57,000 - 45,000 = 12,000

The campaign pays only if it adds more than 3,000 chairs. Evaluation points: does the extra demand last after the campaign ends? Will rivals respond with their own campaigns, so market share is unchanged and both firms are worse off?

Worked example: quality can beat a lower price

Brand X chargers cost 120 and last 4 years. Brand Y chargers cost 90 and last 2 years.

Cost per year: X = 120 / 4 = 30 ; Y = 90 / 2 = 45

Brand X is cheaper per year of use by 15. A firm that can show this competes on quality without cutting its sticker price. Check whether buyers can verify durability before buying: if they cannot, claims have less force.

3. Creative destruction

The specification wants you to understand that if firms have monopoly power and are making large profits, over time there is an incentive for new firms to enter and innovate to overcome the existing barriers to entry. This process of creative destruction is a fundamental feature of the way competition operates in a market economy. The idea is associated with the economist Joseph Schumpeter.

The chain of reasoning:

1. An incumbent with market power earns large profits.
2. Those profits signal reward to anyone who can serve the market better.
3. Entrants innovate: a new product, a cheaper process, a new way to reach customers.
4. The innovation gets round or weakens the barriers to entry that protected the incumbent.
5. The incumbent loses sales, price falls or quality rises, and some old products, firms or jobs disappear. New products and markets appear. That is the “destruction” and the “creation”.
6. The entrant may itself become dominant, and the process repeats.

Technological change often drives this. A new technology can make a product obsolete (as digital imaging displaced film-based photography) and can reshape the structure of an industry.

Worked example: entry in the invented market for water purifiers

Country A, year 1. Firm Alpha is the only seller. Price 60, average cost 40, sales 10,000 units a month.

Alpha profit = (60 - 40) x 10,000 = 200,000
Consumer spending = 60 x 10,000 = 600,000

In year 2 firm Beta enters with a new process that gives an average cost of 32. Both firms now sell at 48. Alpha sells 7,000 and Beta 5,000 (the lower price expands the market to 12,000).

Alpha profit = (48 - 40) x 7,000 = 56,000
Beta profit  = (48 - 32) x 5,000 = 80,000
Price change = (48 - 60) / 60 = -20%
Output change = (12,000 - 10,000) / 10,000 = +20%
Alpha profit change = (56,000 - 200,000) / 200,000 = -72%
Consumer spending = 48 x 12,000 = 576,000

Consumers pay 20% less per unit and 20% more units are sold. Alpha’s profit falls by 72%, so it has a strong reason to innovate in turn. The profit it earned in year 1 is what drew Beta in.

Evaluating creative destruction

• In favour: it raises productivity and living standards over time, it disciplines complacent monopolies, and it works without the state choosing winners.
• Against: it can leave workers in the old industry facing structural unemployment, and it can take years, during which consumers pay high prices.
• Against: a dominant firm may buy up or copy a rival, slowing the process.
• Key judgement: the speed depends on how high the barriers to entry are and on whether patents and funding allow entrants to survive.

4. Contestable and non-contestable markets

A market is contestable when possible entrants restrain the behaviour of the firms already in it. The performance of an industry (prices, costs, profits, innovation) depends on how easily new firms can enter and leave, not only on how many firms are there now.

A perfectly contestable market has these features:

• Free entry: entrants can use the same technology and face the same costs as incumbents.
• Free exit: a firm can leave without losing the money it put in.
• No sunk costs.
• Incumbents cannot cut prices instantly after entry, before the entrant has sold anything.

In that case even a monopolist, or a market with two firms, must keep price close to average cost and earn only normal profit. If it charged more, a rival would enter, take the profit and leave. The result is that a concentrated market can still be efficient. A non-contestable market has barriers that make entry costly or exit expensive. Contestability is a matter of degree.

Sunk costs

Sunk costs are costs that cannot be recovered when a firm leaves the market. Examples are advertising to launch a brand, specialised equipment with no second-hand buyer, and staff training. Costs that can be recouped, such as general-purpose equipment that can be resold, are not sunk.

Sunk costs are the key barrier to exit. They make entry a bigger gamble, because failure means a real loss.

Hit-and-run competition

Hit-and-run competition means entering a market to take profit, then leaving once the profit has gone (for example after the incumbent cuts price). It is only a credible threat if exit is cheap, so it works when sunk costs are low.

Worked example: when is hit-and-run worth it?

In an invented regional market, the price is 10.50 and the cost of supplying each extra unit is 9.00. An entrant could win 4,000 units a month for six months before the incumbent responds. Total entry cost is 240,000.

Monthly profit = 4,000 x (10.50 - 9.00) = 6,000
Over six months = 36,000

Case A: 90% of entry cost recoverable
  sunk = 240,000 x 0.10 = 24,000
  net = 36,000 - 24,000 = +12,000   -> hit-and-run pays

Case B: 40% recoverable
  sunk = 240,000 x 0.60 = 144,000
  net = 36,000 - 144,000 = -108,000 -> does not pay
  months to cover sunk cost = 144,000 / 6,000 = 24

In case B the entrant must survive 24 months. The incumbent could cut price in that time, so the entrant stays out. High sunk costs protect the incumbent.

Contestability and the incumbent’s pricing

An incumbent in a contestable market may choose between a high price and a price low enough to deter entry. Take an invented incumbent facing a would-be entrant whose average cost is 11.

Choice	Price	Quantity	Average cost	Profit
Monopoly price	14.00	8,000	9.50	36,000
Entry-deterring price	10.00	10,000	9.00	10,000

At 14 the entrant (cost 11) can profitably undercut. At 10 the entrant would make a loss. If sunk costs were high, the incumbent could hold 14 instead because entry would be too risky.

Evaluating contestability

• Strengths: it explains good performance by concentrated markets, and it shifts attention from market share to barriers.
• Limits: few real markets have zero sunk costs. Incumbents can use advertising, loyalty schemes, exclusive contracts or capacity to raise sunk costs for entrants.
• Policy view: if a market is contestable, keeping entry open matters more than breaking up firms.

Common errors

• Writing that creative destruction only means firms close. It also means new products, firms and markets are created.
• Treating sunk costs as all fixed costs. Fixed costs that can be resold are not sunk.
• Saying a monopoly always earns supernormal profit. In a contestable market it may not.
• Describing non-price competition without saying how it affects revenue, cost or market share.
• Giving only short-run or only long-run benefits of competition.
• Forgetting a judgement: say which factor matters most and why.

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).