What is a contestable market?

In economics, the theory of contestable markets, associated primarily with its 1982 proponent William J. Baumol, holds that there exist markets served by a small number of firms, which are nevertheless characterized by competitive equilibria (and therefore desirable welfare outcomes) because of the existence of potential short-term entrants.

The theory is based on a simple and sensible idea: the threat of entry can induce incumbent firms in an industry to moderate pricing behavior even in industries with only a single firm. In this sense, contestability theory offers an alternative theory of natural monopoly and the way in which consumers' interests are best served by the way in which such a firm can respond to the pressure of threatened entry into the industry.

Contestable markets are characterized by 'hit and run' competition

If a firm in a contestable market raises its prices much beyond the average price level of the market, and thus begins to earn excess profits, potential rivals will enter the market, hoping to exploit the price level for easy profit. When the original incumbent firm(s) respond by returning prices to levels consistent with normal profits, the new firms will exit. Because of this, even a single-firm market can show highly competitive behavior.

Difference between Contestable markets and Perfect competition

Contestable markets are different from perfect competitive markets. For example, it is feasible in a contestable market for one firm to dominate the industry, have price-setting power and also for firms in a market to produce a differentiated product both of which run counter to the assumptions behind the traditional model of perfect competition.

There are three main conditions for pure market contestability:

  1. Perfect information and the ability and/or the right of all suppliers to make use of the best available production technology in the market.
  2. The freedom to market / advertise and enter a market with a competing product 
  3. The absence of sunk costs – this reduces the risks of coming into a market

Sunk costs

Sunk costs are those costs that cannot be recovered after a firm shuts down. For example a new firm enters the steel industry. For this, the entrant needs to buy new machinery. Now, if for any reason this new firm could not cope up with competition of the incumbent firm then it will plan to move out of he market. However, if the new firm cannot use or transfer the new machines that he bought for the production of steel to other uses in another industry, then these fixed costs on machinery become sunk costs. Hence if there are sunk costs present in the market it impedes the first assumption of no exit barriers. Hence this market will not be contestable and no firms would enter the steel industry.