Contestable Markets

William Baumol suggested that in some markets the incumbent firms would charge such a low price to deter the entry of new firms that it would be unable to make any supernormal profits at all.

Baumol defined contestability as “an entrant has access to all production techniques available to the incumbents, is not prohibited from wooing the incumbent’s customers, and entry decisions can be reversed without cost”.

If a market is to be contestable then there must be no barriers to entry or exit (and hence no sunk costs) and entry and exit must be quick. New firms in the market must have no competitive disadvantage so they must have the same technology available to them as well as the know-how.

Due to this the incumbent firm can’t set a price higher than its average costs otherwise it will generate a supernormal profit which will encourage new firms to enter the market. Hence prices in a perfectly contestable market will be set at AR = ATC. Some firms may participate in hit-and-run entry; whereby they briefly enter a market, take the supernormal profits and then leave the market again. This is why conditions such as no sunk costs need to be met.

The result of all of this is that a monopoly firm may be forced to be efficient just by the threat of potential new entrants. If this were the case then the government would need to intervene less in contestable markets as these firms should be operating more competitively. Therefore even a single-firm industry (i.e. a monopoly) might behave as though it were competitive due to the threat of hit and run tactics by new potential entrants.

A perfectly contestable market should be productively, allocatively and X efficient even if the market is dominated by a monopoly firm. The firm is X-efficient as it has to operate on its AC curve in order to fend off competition, it must produce at the lowest point on the AC curve hence making it productively efficient. If it didn’t produce at the lowest point on the LRAC curve then new firms would enter the market and would be able to set a lower price as they would be operating at the lowest point on the LRAC curve.

Hence in the long run a perfectly contestable market will be both allocatively and productively efficient. Although this isn’t necessarily the case in the short run.

Evaluative points of this theory is that it is very rare for a market to have no sunk costs; usually advertising is undertaken in all markets to gain custom and this is an example of a sunk cost. Also incumbent firms may have advantages of asymmetric information; they know the true state of the market, this may act as a barrier to entry.

Page last updated on 20/10/13