Edge Rewrite
translate Source code View original
Jump to content

Contestable market

From Wikipedia, the free encyclopedia
(Redirected from Contestable markets)

In economics, the theory of contestable markets, associated primarily with its 1982 proponent William J. Baumol, held that there are markets served by a small number of firms that are nevertheless characterized by competitive equilibrium, and therefore desirable welfare outcomes, because of the existence of potential short-term entrants.[1]

Theory

[edit]

A perfectly contestable market has three main features:

  1. No entry or exit barriers
  2. No sunk costs
  3. The same level of technology is available to incumbent businesses and new entrants.

A perfectly contestable market is not possible in real life. Instead, the degree of contestability can be observed within markets.[example needed] The more contestable a market is, the closer it will be to a perfectly contestable market.

Some economists argue that determining price and output is actually dependent not on the type of market structure (whether it is a monopoly or perfectly competitive market) but on the threat of competition.[2]

Thus, for example, a monopoly protected by high barriers to entry (for example, it owns all the strategic resources) will make supernormal or abnormal profits with no fear of competition. However, in the same case, if it did not own the strategic resources for production, other firms could easily enter the market, which would lead to higher competition and thus lower prices. That would make the market more contestable. Sunk costs are those costs that cannot be recovered after a firm shuts down. For example, if a new firm enters the steel industry, the entrant needs to buy new machinery. If, for any reason, the new firm cannot cope with the competition of the incumbent firm, it will plan to move out of the market. However, if the new firm cannot use or transfer the new machines that it bought for the production of steel to other uses in another industry, the fixed costs on machinery become sunk costs so if there are sunk costs in the market, they impede the first assumption of no exit barriers. That market will not be contestable, and no firms would enter the steel industry.

It is very important for firms to have access to the same level of technology as that helps determine the average cost of the product. An incumbent firm having more knowledge and access to a technology for the production of a commodity could enjoy higher economies of scale in the form of lower average cost of production. A new firm entering the market, with insufficient information or technology, could incur a higher average cost of production and so be unable to compete with the incumbent firm. That would lead to the incumbent firm enjoying monopoly power and supernormal profit in the market, as the new firm will exit the market. A solution to the problem could be governments providing equal access to knowledge and technology, as well as financial resources for the same.[3]

Its fundamental features are low barriers to entry and exit; in theory, a perfectly contestable market would have no barriers to entry or exit ("frictionless reversible entry" in economist William Brock's terms).[1] Contestable markets are characterized by "hit and run" competition; if a firm in a contestable market raises its prices so as to begin to earn excess profits, potential rivals will enter the market, hoping to exploit the high price 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 that, even a single-firm market can show highly competitive behavior.[4]

A concise theoretical statement of contestable markets with an illustrative graph is at Economics Online.[2]

Application

[edit]

The theory of contestable markets has been used to argue for weaker application of antitrust laws, as simply observing a monopoly market may not prove that a firm is exploiting its market power to control the price level.[5] Baumol himself argued based on the theory for both deregulation in certain industries and for more regulation in others.[6]

The applicability of the theory to real-world situations may be questioned, however, particularly as there are very few markets which are completely free of sunk costs and entry and exit barriers.[7] Low-cost airlines remain a commonly referenced example of a contestable market; entrants have the possibility of leasing aircraft and should be able to respond to high profits by quickly entering and exiting.[1] However, it is now generally admitted that Baumol's judgment that the US airline industry was therefore best left deregulated was incorrect since the now duly deregulated industry is "well on its way" to evolving into a concentrated oligopoly.[8] More generally, experimental evidence collected since the publication of Baumol's paper has suggested that perfectly competitive markets would, if they existed, behave in the way Baumol outlined, but the performance of imperfectly contestable markets (i.e. real-world markets) depends "on actual rather than potential competition" perhaps in part due to the range of "strategic responses" available to incumbents that were not considered by Baumol as part of his theory.[8]

Empirical evidence and criticism

[edit]

Based on empirical analysis, perfectly contestable markets have been found to be very rare since not all the requirements for perfectly contestable markets are generally met. As per Baumol et al., contestability requires no cost of entry and exit, absence of sunk costs and symmetric technology among incumbent and new firms [9]. However, studies in the field of industrial organisation indicate that there are numerous industries where entry barriers like irreversibility of investment, economies of scale, product differentiation, switching costs, and regulation make market entry costly and risky [10],[11].

Studies on market performance have further revealed that potential competition is a form of discipline that is less effective than what is suggested by contestable market theory. Some firms do not have the ability to enter quickly and successfully and discipline the incumbents through hit-and-run competition. Rather, there are some incumbents who enjoy distribution, branding, and competitive advantage that make it difficult for other firms to enter their industry [10],[12].

Furthermore, contestable market theory has been criticised by economists because it has emphasised potential competition, but it has not taken into account the importance of actual competition. Empirical evidence has shown that market concentration and barriers to entry have played a significant role in price, efficiency, and innovation when there exists potential entry [11],[12]. In addition, some actions made by incumbent firms like capacity enlargement, product development, and contracts may lead to a reduction in the level of contestability in the market due to increased risks faced by new entrants [10],[13].

However, contestable market theory has a great influence on industrial organisation and competition economics due to its focus on the importance of entry conditions and potential competition in the evaluation of market performance. Therefore, economists view contestability as a suitable indicator and not as an actual picture of the market [9],[14].

Criticisms and limitations

[edit]

Despite the fact that contestable market theory has played a critical role in the field of industrial organization and competition economics, the question of the practical existence of perfectly contestable markets is under the criticism of economists due to the presence of barriers to entry and exit in most real-world industries [15][16] In general, such barriers include sunk costs, informational disadvantages and benefits gained by existing companies. [15][16][17] The entrance costs for new firms include expenditures on the acquisition of assets, establishment of distribution channels, creation of brand and compliance with regulations. [16][18]

There are also those who believe that incumbents exhibit strategic behaviour, which makes their industry uncontestable. [16][19] Incumbent firms may lower prices, enhance production capacity, spend more on advertising, and even adopt loyalty programs in order to dissuade prospective entrants from entering their market space. These actions may discourage entry into the market and make the premise of free entry and exit through “hit-and-run” competition questionable. [18][19] Another point of view is related to the difference between potential and actual competition. The concept of contestable market theory implies that the threat of new entrants may limit the power of firms even if there are only a few of them in the market. [15] Nevertheless, empirical research shows that actual competition becomes much more important. [16][20] Firms in some concentrated markets retain their power, set high prices, and make profits regardless of the potential for entry. [16][20]

Accordingly, numerous economists view the theory of contestable markets more as an analytical tool than as a descriptive model of market behaviour. [16][18] While the theory stresses the significance of the entry situation and potential competition, it is unlikely to explain much in markets that are characterised by high entry barriers, strategic behaviour of incumbents, and ongoing market concentration. [16][19].

See also

[edit]

Notes

[edit]
  1. 1 2 3 Brock, 1983. p.1055.
  2. 1 2 Critic Capital LLC, "Contestable markets", Economics Online (at www.economicsonline.co.uk).
  3. ↑ Essentials of Economics, John Sloman (third edition) ISBN 0-273-68382-9
  4. ↑ Brock, 1983. p.1063, quoting Baumol, 1982: "This means that... an incumbent, even if he can threaten retaliation after entry, dare not offer profit-making opportunities to potential entrants because an entering firm can hit and run, gathering in the available profits and departing when the going gets rough."
  5. ↑ For example, Greenspan, 1998.
  6. ↑ Brock, 1983. p. 1064. "Baumol et al.'s plea for removal of artificial barriers to entry and exit is to be applauded.... I am more skeptical about their conclusions that occasionally it is good public policy to restrict entry and competition."
  7. ↑ Brock, 1983. p. 1057. "Some readers may feel that perfect contestability is an idealized notion of purely academic interest..."
  8. 1 2 Martin, 2000. p. 43.
  9. 1 2 Amavilah, Voxi Heinrich (2012-09-16). "Baumol, Panzar, and Willig's Theory of Contestable Markets and Industry Structure: A Summary of Reactions". Munich Personal RePEc Archive (MPRA). Retrieved 2026-08-03.
  10. 1 2 3 "The Theory of Industrial Organization". MIT Press. Archived from the original on 2025-12-27. Retrieved 2026-08-06.
  11. 1 2 Carlton, Dennis W.; Perloff, Jeffrey M. (2015-04-14). Modern Industrial Organization, Global Edition. Pearson Education. ISBN 978-1-292-08786-3.
  12. 1 2 Motta, Massimo (2004). Competition Policy: Theory and Practice. Cambridge: Cambridge University Press. pp. 121–126. ISBN 9780521816632.
  13. ↑ "Economics of Strategy, 7th Edition | Wiley". Wiley.com. Retrieved 2026-08-06.
  14. ↑ Stigler, George Joseph (1968). The Organization of Industry. R. D. Irwin.
  15. 1 2 3 Baumol, William J.; Panzar, John C.; Willig, Robert D. (1982). Contestable Markets and the Theory of Industry Structure. Harcourt Brace Jovanovich. ISBN 978-0-15-513910-7.
  16. 1 2 3 4 5 6 7 8 Carlton, Dennis W.; Perloff, Jeffrey M. (2015-04-14). Modern Industrial Organization, Global Edition. Pearson Education. ISBN 978-1-292-08786-3.
  17. ↑ Stigler, George J. The Organization of Industry. Chicago, IL: University of Chicago Press.
  18. 1 2 3 "The Theory of Industrial Organization". MIT Press. Archived from the original on 2025-12-27. Retrieved 2026-07-23.
  19. 1 2 3 "Economics of Strategy, 7th Edition | Wiley". Wiley.com. Retrieved 2026-07-23.
  20. 1 2 Khemani, R. S.; Shapiro, D. M. (1986-11-01). "The determinants of new plant entry in canada". Applied Economics. 18 (11): 1243–1257. doi:10.1080/00036848600000077. ISSN 0003-6846.

References

[edit]
Retrieved from "https://en.wikipedia.org/w/index.php?title=Contestable_market&oldid=1367932823"