Jurge The diagram doesn't show the efficiency gains, however as a result of the high level of threat of new entrants it is assumed that firms have to be as efficient as possible to wave off the threat of new firms entering the market.

If the market is perfectly contestable then there are no economies of scale (which would act as a barrier to entry). If this is true you can draw Long Run Average Cost as flat (constant returns to scale) in which case it will be equal to Long Run Marginal Costs (every time you produce a unit at the same average cost that will also be your marginal cost). So a firm undertaking limit pricing will produce where LRAC = AR to only make normal profit, and so will be producing where AR = MC. You could at this point draw a short run average cost curve with short run marginal cost cutting it at its lowest point and you would also then short run MC = AR.

easy way to understand is, "allocative efficiency" is when supply in the market meets consumer demand. P or AR are both representations of demand in an economy. MC, is a representation of a firm's supply curve. Therefore, when MC=AR (MC=P), this is equivalent to supply=demand, and so allocative efficiency

He says that it is more "likely" and the firm will have to become "more productively efficient" to place the price where AC=AR. Logically if the firm becomes more productively efficient then this means that they are getting closer to the MES (where there are constant returns to scale) as they get closer to the MES they are experiencing increasing returns to scale as they have increased their input to produce more and as they become more productive one factor of production produces double the amount or more than the initial employment of factor of production, hence increasing the "output per worker" reducing unit costs hence a rise in the profit margins. they do this to survive and attain normal profits. The conclusion is that compared to a Monopoly, a monopolist who are acting contestable are "more allocatively efficient and more productively efficient" in the side effect of trying to minimise hit and run entry by placing the price at AC=AR. (remember that no rational firm will decrease the price without trying to achieve lower unit costs because otherwise, they will lose out on profits as costs will exceed the profit)

Excellent point - perfectly valid. Hence why another characteristic of contestable markets is for entry limit pricing to be prohibited.

@John Benson How can it be contestable with the high barriers to entry

@@mohamedmahmoud7729 ikr thats what im thinking, surely monopolies won't need to worry too much about competition as the barriers to enter are so high.

This diagram is purely a representation of movement perfect contestability. It doesn't itself show the efficiency gains, but we make the assumption that existing firms have to be as efficient as possible if the threat of new entry is very high in order to detract new firms entering. This involves being both allocatively and productively efficient despite what the diagram says

What you can do is draw the AC curve as flat, after all there are no economies of scale. If AC is flat then it is equal to MC. Then , when firms produce at AR=AC in order to not send out profit signals they will also be producing at AR=MC and so will be both productively and allocatively efficient.

@@charlesben-nathan7300 Why Mc equlas Ac?The extra cost will be 0.

Neither MC nor AC will be 0. It still costs the firm money to produce, we can just say, though, that AC will be flat as (in the long run) there are no Economies of Scale (Economies of Scale would be a barrier). So, for example, whatever quantity the firm decides to produce at it will, in the long run, always cost them £10. So that means every time they produce another unit the cost will be £10 as well, so AC=MC. In order not to make supernormal profits (which would incentivise other firms to enter, the firm will price at £10 as well. So the firm is producing at AR=AC, which is also AR=MC and so is both productively and allocatively efficient.

@@charlesben-nathan7300 Thanks.Can also tell why MC of monopoly is downward sloping. It is single seller so why not to sell add unit at higher price?

ben jennings Those super normal profits existed BEFORE firms came into the market. They are the reason that other firms want to enter the market. Once they enter (or at the threat of it happening) the firm will drop the price to PL which is the LIMIT pricing, which creates an artificial barrier to entry in order to deter potential entrants.

Lucy Tong Deregulation

or legislation that forces firms to be more transparent? greater symmetry of information that way

The Flather Yes they could although this is illegal in reality. Remember the idea of contestability is low/no barriers to entry, so any barriers to entry created by firms would make the market non-contestable

limit pricing is illegal? I thought that was only predatory pricing which is below the firm's own AVC?

AC=AR is where normal profit is made indicating to external firms that theres no profit incentive of entering that market leaving the single firm as a monopoly

Zayn No difference but I've noticed most text books use abnormal profit rather than super normal profit.

Abdikadir Hassan Thanks! I've noticed my textbook (hodder) mixes between them which is really annoying, I'll be sticking to abnormal tho

Profit: Supernormal Profit: Abnormal Loss: Subnormal Break Even: Normal. Hope this helps :)