Contestable Markets

Contestable Markets: Overview

• A Contestable Market is one in which there may be one, few or many operators, but the key feature is the lack of barriers to entry and exit.
• This idea was developed by economists Baumol, Panzar and Willig who suggest that what matters most for competition is contestability rather than number of firms.

Characteristics

• Freedom of Entry and Exit: Easily the most defining characteristic of a contestable market, there are no barriers to entry or no barriers to exit.
• Lack of Sunk Costs: In an ideal contestable market, all investment can be recovered on leaving the industry, thus there are no sunk costs.
• Access to the same level of technology: All firms should have access to the same production technologies which enable newcomers to produce at similar costs as existing firms.
• Perfect Information: In this type of market structure, all firms must have perfect knowledge of production methods used by others.

Market Behaviour and Equilibrium

• Hit and Run Competition: This term describes the situation where, if abnormal profits were being earned in an industry, new companies will enter, compete for a short while, then leave once they’ve made a suitable profit.
• Price elasticity: In a contestable market, price tends to be elastic due to the threat of potential competition. Any attempt to increase price by an existing firm may bring in new entrants.
• Long Run: As there can be no supernormal profits in a contestable market in long run, firms will make normal profits.

Efficiency

• Contestable markets are considered to be efficient because the constant threat of competition forces existing firms to minimise their costs and to avoid increasing prices.
• The existence or threat of potential competition results in allocative efficiency as price is driven down to marginal cost.

Advantages and Disadvantages

• Advantages: High degree of competition preventing companies from increasing prices. Also, responsive to consumers due to threat of potential new entrants.
• Disadvantages: Due to the high level of market uncertainty, long term investment and planning is often discouraged. Also, there can be excessive duplication of resources if new entrants decide to compete.

Relevance to the Real World

• No market is perfectly contestable due to natural barriers. However, some sectors like digital and online services, air travel, and parcel delivery services demonstrate elements of contestability. A better understanding of contestable markets can help analyse the behaviour and strategy in such industries.