Welcome to the World of Contestable Markets!
In our previous look at market structures, we focused a lot on how many firms are in a market (like Monopolies or Oligopolies). But what if the number of firms doesn't actually matter as much as the threat of new firms joining? That is the heart of Contestable Market Theory.
In this chapter, we are going to explore why a single giant company might behave like a small, friendly business just because they are afraid of someone else moving into their "neighborhood." Don't worry if this seems a bit backwards at first—by the end of these notes, you’ll see why the "threat" of competition is just as powerful as competition itself!
1. What is a Contestable Market?
A contestable market is a market where there is freedom of entry and exit. Unlike a Monopoly where high walls (barriers) keep others out, a contestable market has "low walls."
The most important thing to remember: Contestability is about the ease with which a firm can enter or leave an industry. It is not about how many firms are currently there. A market could have just one firm (a monopoly) but still be highly contestable if a rival could easily pop up tomorrow.
Key Characteristics of a Perfectly Contestable Market
For a market to be perfectly contestable, it needs to follow these "rules":
1. No Sunk Costs: This is the big one! A sunk cost is money you spend to enter a market that you cannot get back when you leave (like a massive advertising campaign or a custom-built factory). In a contestable market, there are no (or very low) sunk costs.
2. Low Barriers to Entry and Exit: It’s easy to start the business and easy to shut it down without losing money.
3. Access to Technology: New firms have the same access to the "recipe" for production as the big, established firms.
4. Perfect Information: Everyone knows where the profits are being made and how to make the product.
The "Pop-Up Shop" Analogy:
Think of a local park. If you see someone making a huge profit selling expensive lemonade, you can bring your own table and lemons tomorrow. If sales drop, you just take your table home. You haven't lost any "sunk costs" because you can use the table and lemons for something else. That lemonade market is highly contestable!
Quick Review: A market is contestable if there is "freedom of entry and exit" and no "sunk costs."
2. The "Hit-and-Run" Strategy
In a contestable market, new firms can practice something called hit-and-run competition.
If an established firm is making supernormal profits (extra high profits), a new firm will "hit" the market, enter easily, "run" away with those profits, and then exit the market as soon as the prices fall or the profits disappear. They can do this because it costs them almost nothing to enter or leave.
Common Mistake to Avoid:
Students often think "contestable" means there are many firms. Remember: A market with only one firm can be perfectly contestable if that firm is constantly looking over its shoulder, worried about a "hit-and-run" rival!
3. Efficiency in Contestable Markets
Because big firms are scared of "hit-and-run" rivals, they change how they behave. Even if they are the only firm in the market, they will act as if they are in perfect competition.
Productive Efficiency
Firms must produce at the lowest possible cost. If they are wasteful and their costs rise, a new, more efficient firm will enter and undercut their prices. Therefore, they aim for the bottom of the Average Cost (AC) curve.
Allocative Efficiency
To keep rivals away, the firm will often set prices where \(Price = Marginal Cost\) (or \(P = MC\)). If they charge a price that is too high, it signals to other firms that there is "easy money" to be made, inviting competition. By keeping prices low and output high, they "limit" the entry of others.
Key Takeaway: The threat of entry forces firms to be efficient. This means consumers get lower prices and better quality, even without hundreds of companies competing.
4. Advantages and Disadvantages
Is a contestable market always a good thing? Let's evaluate.
Advantages
1. Lower Prices: Consumers benefit from prices being pushed down toward the cost of production (\(P = AC\)).
2. Incentives for Innovation: Firms may innovate to keep their costs so low that no one else can compete.
3. Better Quality: Firms must keep customers happy so they don't look for alternatives.
Disadvantages
1. Lack of Dynamic Efficiency: Because firms are forced to keep prices low (often only making normal profit), they might not have enough "spare cash" to invest in long-term Research and Development (R&D).
2. "Cream-Skimming": New firms might enter only the most profitable part of a business (like only delivering parcels in a big city) and leave the unprofitable parts (like rural deliveries) to the old firm, which can make the old firm go bust.
3. Cost of Constant Change: Frequent entry and exit of firms can sometimes be disruptive for workers and consumers.
Did you know?
The airline industry is often used as an example. If a route between London and Paris becomes very profitable, an airline can simply move a plane from another route to that one. The plane is a mobile asset—not a sunk cost!
5. Summary Table for Quick Revision
Characteristic: Barriers to Entry/Exit
Contestable Market: Very Low / Zero
Characteristic: Sunk Costs
Contestable Market: Zero
Characteristic: Type of Profit (Long Run)
Contestable Market: Normal Profit (due to threat of entry)
Characteristic: Efficiency
Contestable Market: High (Productive and Allocative)
Final Tip for the Exam:
When writing about this, always mention Sunk Costs. It is the "golden key" to explaining contestability. If a firm can leave the market and sell all its equipment for the price they paid (minus depreciation), the market is contestable!