The Theory of Contestable Markets

The Theory of Contestable Market argues that what is crucial in

determining price and output is not whether an industry is actually a
monopoly or competitive, but whether there is the real threatof
competition.
If a monopoly is protected by high barriers to entry e.g. it owns all the
raw materials, it will be able to make supernormal profits with no fear of
competition.However, if another firms could take over from it with little
difficulty, it will behave more like a competitive firm. The threat of
competition has a similar effect to actual competition.

Key Features of a Contestable Market

A contestable market has low barriers to entry and exit (see below for a
perfectly contestable market).
Therefore, if firms in the industry are making supernormal profits, there is
an incentive for a new firm to enter and take advantage of the high
profits. If the industry no longer makes supernormal profits, it is easy for
the firm to exit and leave without excessive costs.
The threat of hit and run competition*may be sufficient to keep prices
and profits low. If the market is perfectly contestable, firms might wish to
engage in some form of limit pricing to avoid the disruption of hit and run
competition.

*Hit and run competition occurs when a firm temporarily enters a market
and then leaves when supernormal profits are exhausted.

A Perfectly Contestable Market

For a perfectly contestable market, entry into and exit out must be
costless.
No barriers to entry include same access to technology and skilled labour
(or any factors of production) and no brand loyalty. In such cases, the
moment the incumbent firm earns supernormal profits, new firms will
enter, thus driving profits down to a normal level.
 The sheer threat of this happening will ensure that the firm already in the
market keep its prices down, so that it just makes normal profits and
produce as efficient as possible, taking advantage of any economies of
scale and any new technology.
So instead of charging a price at MC=MR where it maximizes profits,
it will charge a price at P or AR = LRAC earning only normal profit.
If it did not do this, rivals would enter and potential competition would
become actual competition.

The importance of costless exit

Setting up a new business usually involves large expenditures on plant

and machinery. Once this money has been spent, it becomes fixed costs.
If a potential new firm could afford the high fixed costs and they are not
higher than the existing firm, it may enter and could even win the battle.
But, there is always risk that it might lose.
To take the possibility of losing to the incumbent firm, the potential new
firm must will consider whether there are substantial costs of exit. This
will be the case if the capital equipment cannot be transferred to other
uses. E.g. a power station. The losing firm is left with capital equipment
which costs are sunk costs as they cannot be recouped transferring
assets to other uses and as such, the firm may therefore be put off
entering in the first place.
The market is not perfectly contestable and the established firm can
make supernormal profits.
If however, the capital equipment can be transferred, the exit costs will
be zero or very low and new firms will be more willing to take the risks
of entry. E.g. a rival coach company may open up a service on a route
previously operated by only one company. If the new firm loses the
resulting battle, it can use the coaches it has purchased for a different
route as such costs are not sunk costs.
Costless exit, therefore, encourages firms to enter an industry,
knowing that, if unsuccessful, they can always transfer their capital
elsewhere. E.g. studies of airlines in the USA show that entry to a
 particular route may be much easier for an established airline which can
simply transfer planes from one route to another.
The lower the exit costs, the more contestable the market.

Assessment of the Theory

The theory of contestable markets is an improvement on simple

monopoly theory, which merely focuses on the existing structure of the
industry and makes no allowance for potential competition.
Perfectly contestable markets may exist only rarely. But like perfect
competition, they provide an ideal type against which to judge the real
world.
Once criticism of the theory, however, is that it does not take sufficient
account of the possible reactions of the established form. There may be
cost barriers to entry or exit (perfectly contestable market), but the
established firm may let it be known that any firm that dares to enter
will fall all-out price war. This may act as a deterrent to entry. In the
meantime, the established firm may charge high prices and make
supernormal profits.

Contestable markets and the public interest

If a monopoly operates in a perfectly contestable market, it might bring

the best of both worlds it could achieve low costs through internal
economies of scale and the potential competition will keep profits
and hence prices down. Besides, it increases incentives for firms to
respond to consumer preferences so as to prevent them from turning
to potential competitors.
For this reason, many politicians justify the policy of non-intervention
and deregulation.
But few markets are perfectly contestable. If entry and exit are not
costless, a monopoly can still make supernormal profits in the long run.
There are other possible failings of the market beside monopoly power
such as inequality and pollution.
Nevertheless, the theory of contestable markets has highlighted the
importance of entry barriers in determining monopoly behavior. The size
 of barriers has therefore become the focus of attention of many politicians
and academics when considering anti-monopoly policy.

Potential essay question:

(a) Explain the factors that affect the contestability of a market. [10]

(b) Discuss whether a firms price and output decision is more dependent
on the threat of competition that it faces or its objectives. [15]