OCR A Level Economics: Contestable markets, integration, growth of firms and competition policy (H460)

This guide follows the OCR A Level Economics (H460) specification, Version 3.0 (June 2026), for first assessment in 2021. It covers the last part of the topic Market structures and their implications for the way resources are allocated and the interdependence of firms, in Component 1, Microeconomics (H460/01). The specification labels no content as AS or Extension, so everything here is A Level. All figures in worked examples are invented and illustrative.

Other market structures have their own pages. Start from the OCR Economics hub, the printable checklist and the Microeconomics overview. For the efficiency definitions used below, see economic efficiency and market failure. Then use the revision notes, the practice questions and the free diagnostics.

What this unit covers

Outcome in the specification	Section below
Characteristics of a perfectly contestable market	1
Why such a business is allocatively and productively efficient	2
Advantages and disadvantages, with a diagram	3
Contribution of contestable market theory	4
Horizontal, vertical and conglomerate integration or merger	5
Advantages and disadvantages of integration to economic agents	6
Factors which influence the growth of firms	7
Impact of regulation and ownership on the behaviour of firms	8
Impact of competition policy on the behaviour of firms	9
Extent to which firms are interdependent	10

1. Characteristics of a perfectly contestable market

A market is perfectly contestable when the threat of entry is so credible that incumbents behave as if rivals were already present. There can be just one firm.

The usual characteristics are:

• No barriers to entry or exit.
• No sunk costs. Anything an entrant spends can be recovered on leaving, for example by selling or leasing equipment.
• Entrants can reach the technology incumbents use, so their costs are similar.
• Entrants have good information about prices, costs and demand.
• Entrants can enter and leave faster than incumbents can change price. This allows hit-and-run entry: enter, take the supernormal profit, leave.

Worked example (hit-and-run). A small bakery market in Town A (illustrative) has one incumbent charging £14 a box with average cost £10, selling 600 a month. Supernormal profit is (14 − 10) × 600 = £2,400 a month. An entrant prices at £12, takes all 600 sales and earns (12 − 10) × 600 = £1,200 a month. If the incumbent needs two months to react, the entrant makes £2,400. If entering costs £3,000 that cannot be recovered, the net result is 2,400 − 3,000 = −£600, so entry is deterred. If the £3,000 is fully recoverable, the entrant keeps £2,400 and the market is contestable. Sunk costs are what turn a threat into a barrier.

2. Allocative and productive efficiency

The argument runs in two steps.

1. Any price above average cost gives supernormal profit, which invites hit-and-run entry. The incumbent must therefore price at average cost (AC), earning only normal profit.
2. Any cost above the lowest possible lets an entrant undercut. The incumbent must therefore produce at the minimum of the AC curve. That is productive efficiency.

At the minimum of AC, marginal cost (MC) equals AC. Price equals AC, so price equals MC. That is allocative efficiency.

Worked example. Total cost is TC = 200 + 4Q + 0.02Q² and market demand is P = 14 − 0.06Q (illustrative). Then AC = 200/Q + 4 + 0.02Q and MC = 4 + 0.04Q.

Case	Output	Price	AC	MC	Profit
Unthreatened monopolist (MR = MC)	62.5	£10.25	£8.45	£6.50	£112.50
Perfectly contestable	100	£8.00	£8.00	£8.00	£0

The monopolist’s MR is 14 − 0.12Q, which equals MC where 10 = 0.16Q, so Q = 62.5. In the contestable case, AC is lowest at Q = 100, where AC = 8 and MC = 8. Demand at Q = 100 is 14 − 6 = 8, so price, AC and MC coincide. The welfare triangle lost under monopoly, avoided here, is ½ × (100 − 62.5) × (10.25 − 6.50) = £70.31.

3. Advantages and disadvantages, with a diagram

Diagram in words. Draw price and cost against quantity. Draw a U-shaped AC curve with MC cutting it at its lowest point, and a downward-sloping demand (AR) curve. The monopolist produces where MR cuts MC, at a price on the AR curve above AC, and shades the supernormal profit rectangle. The contestable outcome is at the point where AR cuts AC at its minimum. The profit rectangle shrinks to nothing and price falls to the MC curve.

Advantages	Disadvantages
Prices close to cost; consumer surplus is higher	Perfect contestability needs zero sunk costs, which are rare
Pressure to keep costs low (productive efficiency)	Firms avoid sunk investment such as research or specialist capital
Efficiency without needing many firms or break-up	Hit-and-run entrants may offer unreliable service and then leave
Normal profit only, so resources are not wasted on barriers	Employment and supply may be unstable
Cheap for government to maintain	If scale economies are large, only one firm can survive and AC may exceed MC

4. Contribution of contestable market theory

Contribution.

• It shifts attention from the number of firms to barriers and sunk costs.
• It gives a benchmark: the nearer to zero sunk costs, the stronger the discipline.
• It supports policy that lowers barriers rather than breaking firms up.

Limits.

• Almost every real market has some sunk costs, such as advertising or specialist machinery.
• Incumbents can respond quickly or use strategic behaviour such as limit pricing, so the entrant may not win.
• Information is rarely perfect.
• Contestability is a matter of degree, so the theory predicts best at the extremes.

Judgement. The theory is most useful where sunk costs are low and least useful where capital is specialised. Its main contribution is the idea of potential competition.

5. Horizontal, vertical and conglomerate integration

Integration means joining firms through a merger or takeover.

Type	Meaning	Example (illustrative)
Horizontal	Same stage, same industry	Two bakeries combine
Vertical backward	Firm takes over a supplier	A bakery buys its flour miller
Vertical forward	Firm takes over a distributor or retailer	A miller buys a bakery chain
Conglomerate	Unrelated industries	A bakery owner buys an umbrella maker

6. Advantages and disadvantages of integration

Worked example (horizontal). Firm X makes 40,000 units at AC £9.50 and firm Y makes 30,000 at AC £10.20. Total cost is 380,000 + 306,000 = £686,000, an average of £9.80. Merged, they make 70,000 units at AC £8.80 from bulk buying and shared overheads: total cost £616,000. The saving is £70,000, or 10.2%.

At a market price of £12, profit was £100,000 + £54,000 = £154,000. After the merger at the same price and output it is (12 − 8.80) × 70,000 = £224,000. Now suppose market power lets the firm raise price to £13 and sales fall to 62,000. Profit is (13 − 8.80) × 62,000 = £260,400. Consumers pay more per unit, so cost savings help them only if competition passes them on.

Worked example (conglomerate). Quarterly profits (£ thousand, illustrative):

Quarter	Ice cream	Umbrellas	Combined
1	2	12	14
2	14	6	20
3	18	2	20
4	4	10	14

The range of profit falls from 16 and 10 separately to 6 combined. Risk spreading is the main benefit of conglomerate integration.

Worked example (vertical backward). A bakery buys 200,000 kg of flour. The miller earns a margin of £0.15 a kg on a cost of £0.45. Taking over the miller can save up to 0.15 × 200,000 = £30,000, if it runs as efficiently under new ownership.

Evaluation by agent.

Agent	Possible gain	Possible loss
Firms and shareholders	Economies of scale, market power, security of supply, risk spreading	Integration costs, diseconomies, overpaying
Consumers	Lower costs passed on, wider range	Higher prices and less choice if competition falls
Workers	Career opportunities in a larger firm	Redundancies as duplicated roles go
Suppliers	Larger orders	Lost contracts after vertical integration

The result depends on market share, remaining rivals, contestability and whether savings are passed on.

7. Factors influencing the growth of firms

Organic growth is slower but keeps control; external growth is faster but riskier.

Worked example (decomposing growth). A firm has a 12% share of a £40m market, so revenue is £4.8m. Next year the market is £42m and the share is 15%, so revenue is £6.3m, up 31.25%. Market growth alone, at constant share, would give 42 × 0.12 = £5.04m (5%). The other £1.26m comes from winning share.

Factors that promote growth:

• Objectives such as growth or sales maximisation, and manager pay linked to size.
• Economies of scale and market power.
• Rising market demand, new technology and access to export markets.
• Finance: retained profit, shares, loans (£200,000 at 8% costs £16,000 a year in interest).

Factors that limit growth:

• Weak demand, strong rivals or regulation such as merger control.
• Limited finance, or owners who wish to keep control.
• Diseconomies of scale and management strain.

8. Regulation and ownership

Ownership shapes objectives. Private firms with shareholders usually pursue profit, with principal-agent problems. Public sector bodies may aim at social welfare or political targets but can lack cost discipline. Co-operatives and social enterprises balance profit against member or social aims. Privatisation shifts objectives towards profit and cost control; nationalisation does the reverse.

Regulation includes price caps, quality standards and restrictions on entry. Under a price cap of inflation minus X, a firm may raise prices by inflation less an efficiency factor.

Worked example. Inflation is 3.5% and X is 2.0%, so prices may rise 1.5%. A price of £40 becomes £40.60. Unit cost is £30, a £10 margin (25%). If cost falls 4% to £28.80, the margin is £11.80: the firm keeps gains above X, which rewards efficiency. If cost rises 3.5% to £31.05, the margin is £9.55.

Risks: the regulator lacks the firm’s information, may be captured by it, and a strict cap can reduce quality or investment.

9. Competition policy

Competition policy aims to protect competition rather than individual firms. Its main tools are merger control, action against cartels and abuse of market power, market investigations, and measures that lower barriers such as deregulation and liberalisation. In the UK, the Competition and Markets Authority is the competition authority.

Impact on behaviour. Credible policy deters cartels, shapes which mergers firms propose and may force remedies such as selling parts of a business.

Worked example (deterrence). A cartel expects gains of £6m a year for four years, £24m in total. The chance of detection is 30% and the fine is 10% of annual turnover of £120m, so £12m. Expected fine = 0.30 × 12 = £3.6m, leaving an expected net gain of £20.4m. To deter, the fine must be at least 24 ÷ 0.30 = £80m, which is 66.7% of turnover. A weak penalty or low detection rate leaves the incentive to collude.

10. The extent to which firms are interdependent

Firms are interdependent when one firm’s decision affects its rivals and their decisions affect it.

Structure	Interdependence
Perfect competition	Very low; price takers
Monopolistic competition	Low; many firms, differentiated products
Oligopoly	High; few firms, reactions matter
Monopoly	Low from rivals, but potential entry can still constrain it

Judgement. Interdependence is greater when firms are few, products are similar, information is shared and barriers are high. It is weaker when there are many firms or when products are differentiated. Even competitive firms are linked through suppliers, customers and labour markets, and contestability extends interdependence to firms not yet in the market. The answer depends on how the market is defined.

Common errors

• Saying a contestable market must have many firms.
• Treating low barriers as enough: the key is no sunk costs.
• Claiming cost savings always reach consumers.
• Describing competition policy without saying how firms change behaviour.

Official syllabus

OCR, A Level Economics (H460) specification, Version 3.0 (June 2026), first assessment 2021. Component 1, Microeconomics (H460/01), Area of Study Competition and market power.