Contestable markets
The theory of contestable markets is associated with
the American economist
William Baumol. In essence, a contestable market is one
with zero entry and exit costs. This means there are no
barriers to
entry and no barriers to exit, such as
sunk costs and contractual
agreements.
The existence, or absence, of sunk costs and economies of scale are the two most important determinants of contestability. On the basis of these two criteria, natural monopolies are the least contestable markets.
Asymmetric information is also a key barrier to
entry. Incumbents are likely to know much more about their industry than potential
entrants.
With no barriers to entry into a market, it can be argued that the threat of entry is enough to keep incumbents ‘on their toes’. This means that even if there are a few firms, or a single firm, as with oligopolistic and monopolistic markets, a market with no barriers will resemble a highly competitive one.
If we assume there are only a few firms in a market, and there are few barriers to entry and exit,
then we can state that:
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Potential entrants can freely enter and leave the market.
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Potential entrants could, if they wished, operate a hit and run strategy.
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Just the threat of entry is enough to ‘keep firms on their toes’, to the extent that existing firms behave ‘as if’ the market has a highly competitive market structure.
Evaluation
The theory of contestable markets is often seen as
an alternative to the traditional,
Neo-classical, theory of the firm. Perfectly
contestable markets can deliver the theoretical benefits of perfect
competition, but without the need for a large number of firms.
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Contestable markets Firms are forced to keep excess profits to a
minimum, and move towards sales maximisation rather than
profit
maximisation. |
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