The theory of contestable markets is associated with the American economist William Baumol. In essence, a contestable market is one with firms facing 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. For a market to be perfectly contestable, relevant industry technology would be readily available to potential entrants.
The existence, or absence, of sunk costs and economies of scale are two significant determinants of contestability. On the basis of these two criteria, natural monopolies are the least contestable markets.
Asymmetric information is a key barrier to entry, with incumbents likely to know much more about their industry than potential entrants, and are likely to be unwilling to share their knowledge or technology.
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.
Potential entrants can operate a hit and run strategy, which means that they can ‘hit’ the market, given there are no or low barriers to entry, make profits, and then ‘run’, given there are no or low barriers to exit.
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:
- Potential entrants can freely enter and leave the market.
- Potential entrants could, if they wished, operate a hit and run strategy.
- 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.
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.
Firms are forced to keep excess profits to a minimum, and move towards sales maximisation rather than profit maximisation. In a perfectly contestable market with an umlimited number of potential entrants, profits would be pushed down to normal profits (where AR = ATC.)
Contestability and regulation
Contestable market theory has clearly influenced the views and methods of regulators. Opening up a market to potential entrants may be sufficient to encourage efficiency, and deter anti-competitive behaviour. For example, regulators may force incumbents to open-up their infrastructure to potential entrants, or to share technology – as in the case of broadband operators being allowed to use British Telecom (BT Openreach) infrastructure. This is a common approach in the communications industries where incumbents are likely to have significant market power (SMP) in terms of control of a network.