Contestable Markets

Key Terms
Contestable Markets: Where there is free entry and free exit of other firms.

Hit and run entry: Where new firms enter the industry, cream off some of the supernormal profits of the incumbents and then exit.
Theory

What is Contestable Market Theory?


At it's core a contestable market is one with zero entry and exit costs, meaning firms can enter and leave the market at will. A purely contestable market must also fulfil the following assumptions:

Assumptions:

  • Low barriers to entry
  • Low sunk costs
  • No collusion
  • Firms are short run profit maximisers
  • Homogenous product
  • Perfect knowledge


    • Diagram

    contestable market diagram

    If an industry becomes contestable incumbents are then fearful of hit and run entry. In order to remain conpetitive firms lower prices to the lowest possible level (P1). Quantity demanded increases to Q1 creating productive efficiency.


    Criticisms of contestable market theory

  • In practise sunk costs are high
  • Technical knowledge is required to enter some markets
  • Established brands may still dominate the market
  • Incumbents may protect themselves through patents
  • Theory ignores aggressive action of incumbents


    • Methods to increase the contestability of markets

  • Remove legal entry barriers
  • Force firms to allow competitors to use network
  • Legislation against predatory pricing
  • OFT legislation of abused power


    • Advantages of Contestable Markets
    1) Efficiency

    By forcing firms to lower costs, contestability encourages allocative and productive efficiency


    2) Economies of Scale

    Unlike perfect competition there could still be significant economies of scale because a contestable market doesn’t require hundreds of firms.
    Disadvantages of Contestable Markets
    1) Entry Barriers

    The cost of removing entry barriers is high and may be difficult if entry barriers are associated with technical knowledge


    2) Breaking up of monopoly

    In some circumstances monopoly is efficient, therefore making a monopolistic market contestable would be undermining efficiency as economies of scale would be lost


    3) Consumer inertia / Brand loyalty

    Contestable market theory may not work in practise if brand loyalty and consumer inertia exists. Even if the market is openned up to more firms, consumers may feel resistance to switch brand of products. In this case monopoly power could still be exersized by firms with well established brands.









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