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Contestable Markets


The 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 new entry.


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 neo-classical theory.


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.


Contestability in Practice

As 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):

  • The higher the profit levels available;
  • The lower the barriers to entry;
  • The 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.


A 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:

  • Undertaking 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.
  • Building 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. 


Markets 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 perfectly contestable).


This allows us to arrive at a number of generalised assumptions that are made in the theory of contestable markets:

  • There are low barriers to entry, which means that there is both freedom of entry and exit into the marketplace.
  • The 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 marketplace.
  • Firms compete with each other, therefore there is no collusion within the marketplace.
  • Firms are short run profit maximisers, producing where MC=MR.
  • Firms may produce a homogeneous or heterogeneous good.
  • There is perfect knowledge in the market.



Barriers 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 makers.


Markets That Have Become More Contestable In Recent Years

  • Internet Service Providers (including the entry of "free" ISPs - over 200 of these in September 1999
  • Online Communications (including video conferencing; virtual reality games; publishing; home shopping; travel services; information services; databases)
  • Home Banking and Financial Services
  • Electricity and Gas Supply
  • Parcel delivery
  • Opticians
  • Low cost domestic airlines
  • Road Haulage Companies


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 existing customers. 


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.



E-mail Steve Margetts