Final answer:
In a contestable market, existing firms quickly lower their prices in response to new entries, reflecting low barriers to entry and exit. This behavior helps the market reach an equilibrium at zero-profit levels in the long run, characteristic of perfectly competitive markets.
Step-by-step explanation:
One of the characteristics of a contestable market is that existing firms respond quickly to entry by lowering their price. This type of response is crucial in a contestable market because it shows that the market conditions are such that barriers to entry and exit are low, and firms must remain competitive to retain their market share. This is different from mere consumer reaction to price changes or firms having different production technologies. Also, a characteristic of a contestable market does not involve the presence of sunk costs, although they can affect the degree of contestability of a market.
The concept of contestable markets is related to the theory of long-run adjustments in perfectly competitive markets. Firms react to profits by entering the market, and they react to losses by exiting. Continuous entry and exit drive the market toward an equilibrium where firms earn zero economic profit, as prices are pushed to the point where the marginal cost curve crosses the average cost curve at its minimum. This process facilitates a competitive environment with firms actively adjusting to market conditions.
The long-run equilibrium point demonstrates that in a perfectly competitive market, firms can only sustain zero-profit levels in the long run, regardless of short-term gains or losses. This characteristic is essential to understanding the dynamic nature of contestable markets and the conditions that lead to an efficient allocation of resources.