contestable markets approach to competition represents an alternative to the
neo-classical theory of the firm. It
came to prominence in the early 1980s, largely through the work of the
American economist William Baumol. The
threat posed by the possibility of new firms entering the market is taken to
be a key determinant of the behaviour of existing firms. Accordingly, barriers to entry and exit play a crucial role.
Contestability is a measure of the extent to which a market is open to
At the extreme, a market with no barriers to entry or
exit is perfectly contestable. The existence of supernormal profit, no matter
how small, would trigger new entry in such a market. On the basis of the
assumption that existing firms wish to deter new entry, the logical
conclusion is that they will set prices at such a level that only normal
profits are made. They will also produce at lowest possible average cost. If
they did not, a new entrant would be able to do so and use the cost saving to
undercut the existing firm on price and capture some of the market. In a
perfectly contestable market, therefore, we expect firms to be productively
efficient (production occurs where AC is at its minimum).
Allocative efficiency is also achieved; the conditions
of normal profit (AR = AC) and least cost production (where MC = AC) combine
to give AR = MC. Since average revenue is the same as the price, we derive P
= MC, the standard criterion for allocative efficiency.
The conclusions of the previous paragraph are striking.
If firms act in the way
predicted, a market could continue as a monopoly or oligopoly even if
no barriers to entry exist to protect the position of incumbent firms. This
breaks the link between barriers to entry and market concentration assumed by
Perhaps more significantly, in the absence of actual
competition, the desirable properties of perfectly competitive markets can be
attained if there are no entry or exit barriers. The standard charge that
monopolists exploit consumers by reducing output, raising prices and earning
supernormal profits would not be relevant in a market without barriers to
entry and exit, if they did other firms would enter the market and erode the
market share of the incumbent.
This observation is important for it suggests that
competition policy should be as much concerned with the levels of barriers to
entry and exit in a market as with existing levels of competition.
Baumol himself admits “...perfectly contestable markets do not populate the
world of reality any more than perfectly competitive markets do”.
There are few, if any, markets in which no barriers to entry or
exit exist at all. In practice
then, just like perfect competition, contestability is a matter of degree:
the question “is market X contestable?” requires more than a “yes” or
“no” answer. In general, a
market will be more contestable (more open to new entry):
higher the profit levels available;
lower the barriers to entry;
lower the barriers to exit.
A major barrier to exit is sunk costs. Indeed, it was
suggested by Baumol that markets
would be contestable provided there were no sunk costs. Sunk costs will be low where the firm can sell or in other
ways dispose of its capital equipment without cost.
For example, a new airline might lease aircraft rather than purchase
them and can then leave the industry at the end of the lease period without
the costs of having to sell its aircraft.
This being so, there are a number of avenues available to incumbent
firms wishing to prevent new entry.
The first is to reduce profit levels by pricing below
the short-term profit maximising point. We would expect firms to set the
price at the highest level compatible with deterring new entry, a strategy
known as entry limit pricing. As we have already seen, in a perfectly
contestable market this would entail pricing at a level where only normal
profits are made. Where existing firms have some protection because of
barriers to entry or exit, however, they will be able to make supernormal
profits. The extent of these supernormal profits depends largely on the
height of the barriers. The link between barriers to entry and profit levels
forged by neo-classical theory is thus reinforced. Even in the short run, the
fear of triggering new entry results in firms making only that level of
profit that entry barriers will protect into the long run.
second policy is to construct artificial entry barriers. This should be
viewed as complementary to entry limit pricing: the more successful the firm
is in erecting barriers, the higher the price it will be able to charge
without inducing new entry. Advertising
and brand proliferation are possibilities, but artificial barriers can be
more subtle in nature. The possibility of existing firms adopting the
following courses of action, for example, raises doubts about whether the
discipline imposed on firms by the threat of competition is really as strong
as that imposed by actual competition:
predatory action in the event of new entry. This entails temporarily
reducing prices until the new firm is forced out of the market. By
acquiring a reputation for predatory pricing, existing firms effectively
create a new barrier to entry.
up over-capacity, so as to be able to flood the market with cheap output
in the event of new competition. This signals to potential entrants that
incumbent firms intend to resist any new challenge.
which are highly contestable are likely to be vulnerable to “hit and run
competition”. Consider a situation where incumbent firms are pricing at
above the entry-limit level. Even
in the event that existing firms react in a predatory style, new entry will
be profitable as long as there is a time lag between entry and the
implementation of such action. Having
made a profit in the intervening period, the new entrant can then leave the
industry at little cost (remember: there are no sunk costs where markets are
This allows us to arrive at a number of generalised
assumptions that are made in the theory of contestable markets:
are low barriers to entry, which means that there is both freedom of entry
and exit into the marketplace.
number of firms in the market can vary from one with complete control of
the market, to many, with each firm having no significant share of the
compete with each other, therefore there is no collusion within the
are short run profit maximisers, producing where MC=MR.
may produce a homogeneous or heterogeneous good.
is perfect knowledge in the market.
to entry are clearly crucial in determining the outcome produced by the
market. To the extent that contestable markets theory is correct in assuming
that the threat of competition is a key determinant of the behaviour of
existing firms, it reinforces the link between barriers to entry and profit,
but removes the link between barriers to entry and market concentration. The
suggestion that efficiency can be achieved in the absence of entry and exit
barriers, but without actual competition, is highly significant for policy
Markets That Have Become More Contestable In
Service Providers (including the entry of "free" ISPs - over 200
of these in September 1999
Communications (including video conferencing; virtual reality games;
publishing; home shopping; travel services; information services;
Banking and Financial Services
and Gas Supply
cost domestic airlines
Cream-Skimming In The Market
For Savings And Loans
One feature of a
contestable market is that new entrants may seek to “cream skim” the
most profitable segments of an industry. The trick is to identify which
sectors of a market offer the best returns and then successfully target
The largest UK banks
make profits of hundreds of millions of pound every year – but most of this
money comes from user-services such as foreign exchange commission and high
interest loans to a relatively small number of customers. Many accounts in high street
banks are loss-makers – particularly those held by people with tiny savings
balances who rarely use other bank services.