What Is a Contestable Market?

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Firms have reversible, frictionless entry, equal opportunity, and access to resources and technology. The new firms thus suffer no disadvantage in terms of production technique. However, these features make up a perfectly competitive market, and therefore, it is difficult for incumbent businesses to generate significant profits continually.

Key Takeaways

  • Contestable markets are marketplaces that give free entry and exit for firms without barriers. Characteristics in a contestable marketplace may resemble perfect competition, but unlike in perfect markets, there need not be price takers. Instead, there may be many enterprises or even just one. The market will have close-to-average prices or similar prices across the firms.The contestable market theory states that monopoly or oligopoly enterprises may conduct as if they were genuinely engaged in perfect competition if they had easy access to and exit from an industry.

Contestable Market Theory Explained

A contestable market allows the free entry and exit of firms. Potential entrants need to recognize a fleeting profit opportunity because they can enter, pocket their profits before prices change, and leave without incurring any costs if the environment turns hostile. Its susceptibility to hit-and-run entry is the essential characteristic of a contestable market.

The firms or businesses here need not be small in size, numerous, autonomous in their judgment, or able to create uniform goods. On the contrary, it’s the only characteristic of perfect competition that contestable markets may share. In other words, a completely competitive market is also necessary for being a perfectly contestable market.

The market will have close-to-average prices or similar prices across the firms. This is because entrants will enter the market if incumbents raise prices since there are no obstacles to entry. As a result, they will be able to produce just as effectively as incumbents as they have equal access to technology.

Additionally, if prices drop due to the emergence of new entries, the newcomer will be able to leave the market quickly and cheaply due to no existing barriers. This entry type is often called a “hit and run.” The contestable market theory goes like this- monopoly or oligopoly market enterprises would have conducted similarly as in perfect competition if there was an easy entry and exit option.

Characteristics

A contestable market typically satisfies the following conditions:-

#1 – Entry and exit

In a perfectly contestable market, firms are free to enter or exit at any time. They do not have any barriers and are, therefore, competitive.

#2 – Equal access to technology

All firms in the marketplace, whether old or newcomer, are provided access to the same technology for production purposes. Hence one firm does not have an unfair advantage over accessibility.

#3 – Availability of information

Contestable market economics is transparent. Information on prices is available to all consumers and firms across the markets. 

#4 – Low or no sunk costs

Sunk costs are costs that one cannot recover after they have spent them. Such costs arise due to activities requiring specialized assets that cannot be used for other purposes. And hence the opportunities for selling them are few. They are fixed costs and firm-specific. When sunk costs are present, firms find it difficult to exit and enter. It becomes a costly affair. This factor makes a contestable market and significantly contributes to the fact that existing firms do not aggressively react to the new entry of firms. The other one is economies of scale.

These characteristics may seem similar to perfect competition. However, contestable market economics may have many firms, it may have even one, and they need not be price takers. Examining contestable marketplaces is intended for situations where the presence of scale economies prevents many rivals.  

Diagram

Pricing in a contestable market model:

The diagram describes the price movement from point 1 to point 2. The price fixed is P2. This is because the chances of new firm entry increase when prices are too high in contestable markets. Hence, the prices are not exorbitant but nominal. In the contestable market model diagram, P1 and P2 are price points; Q1 and Q2 denote the output increases. MC denotes Marginal Cost, MR denotes Marginal Revenue, AC denotes Average Cost, and AR denotes Average Revenue.

In the short term, profits could be above average and below normal in the long run. In the short run, new businesses can enter and profit from the extraordinary gains. However, in actuality, only in the short term can businesses make good earnings. This is the only way businesses can prevent competition. At the same time, new firms will not be incentivized to enter without super-normal profits, even if there is free entry and exit.

Examples of Contestable Market

Here are some examples:

Example #1

The software industry can be a perfect example. Anyone can code and create an application using technology. With fewer or no barriers, it is relatively free to enter and exit the software market.

Example #2

Check out the case of the Airlines Deregulation Act in 1978. The U.S. government shifted its stance on the passenger airline sector in the late 1970s from one that was heavily regulated and had few acceptable air carriers to one that was deregulated and welcomed new competitors. This move was motivated by the idea that airlines would act in a way the market could contest.

Earlier, it was preferred to restrict and control the number of commercial passenger airlines since operating an aircraft required too much money to support more than a few businesses. Free admission and exit in the market for passenger air transport was a critical development in the 1970s. The act brought significant changes to the pricing model of airlines. It is estimated that the average price of tickets was reduced by 50%. This enabled more low-cost carriers.

This has been a guide to What is Contestable Market. Here, we explain the topic in detail, along with its characteristics, diagram, and examples. You may learn more from the following articles –

When markets are contestable, the firms in that market are seen as allocative efficient. They are also productively efficient over time as firms operate at the bottom of the average cost (AC) curve.

Two significant factors that make up contestable markets are sunken costs and economies of scale. Economies of scale are cost advantages that businesses enjoy due to efficient production. Money that has already been spent in a business and cannot be recovered is known as sunk costs.

There are quite a few benefits of being in a contestable marketplace. First, firms are free to enter and exit with no barriers. Production technology information is freely available to all firms. For costumers, they have the necessary information available and access to nominal prices.

No, both markets are different, the significant difference being products are differentiated in a monopolistic market, and prices also vary. However, in a contestable market, the prices do not vary much, and there is no product differentiation.

  • Imperfect CompetitionCompetitive AdvantageDomestic Market