Contestable Markets

This section explains contestable markets. A contestable market is one where the threat of potential competition affects the behaviour of existing firms, even if there are only a few firms currently operating. It challenges traditional models of monopoly and oligopoly by emphasising the ease of market entry and exit.

Characteristics of Contestable Markets

• Low barriers to entry and exit: New firms can enter and leave the market easily without incurring significant costs.
• Access to technology and inputs: New entrants can access similar resources to incumbent firms.
• Hit-and-run entry: Firms can enter the market to take short-term profits and leave before incumbents retaliate.
• Lack of sunk costs: Minimal irrecoverable costs make markets more contestable.
• Absence of brand loyalty or exclusive contracts helps facilitate entry.

Note: A contestable market can still have a high market concentration — it’s the threat of entry, not the number of firms, that matters.

Implications of Contestable Markets for the Behaviour of Firms

• Firms act as though they are in a more competitive environment, even if they hold market power.
• May lead to lower prices, greater efficiency, and reduced supernormal profits to deter entry.
• Limit pricing may be used to discourage potential entrants.
• Incentive to innovate and reduce costs to remain ahead of possible new competitors.

Types of Barrier to Entry and Exit

Barriers to Entry:

• Legal barriers: Licences, patents, regulation.
• Capital costs: High initial investment deters new entrants.
• Brand loyalty: Strong existing consumer preference for established firms.
• Control of key inputs or distribution.

Barriers to Exit:

• Sunk costs: Costs that cannot be recovered (e.g. specialist equipment, advertising).
• Redundancy costs or contractual penalties.
• Long-term lease agreements.

Low barriers to both entry and exit increase market contestability.

Sunk Costs and the Degree of Contestability

• Sunk costs are unrecoverable once incurred (e.g. advertising, R&D, bespoke machinery).
• High sunk costs make a market less contestable by increasing the risk of entry.
• In a highly contestable market, sunk costs are minimal, allowing firms to enter and exit easily.

Example: Online retail may be more contestable than utilities due to lower sunk costs and minimal infrastructure requirements.

Summary

Contestable markets focus on potential competition rather than actual competition. Firms in such markets may behave competitively to avoid attracting new entrants, helping achieve allocative and productive efficiency even without many competitors. The key determinant is the ease of entry and exit, particularly influenced by the presence or absence of sunk costs.