Contestability Theory
Contestable in economics means that a company can be challenged or contested by rival companies looking to enter the industry or market. In other words, a contestable market is a market where companies can enter and leave freely with low sunk costs.
If firms in a market have equal access to technology, and barriers to entry are weak, low, or non-existent, there is a constant threat that new competitors will enter the marketplace and challenge the existing, well-established companies. Such an environment generally keeps prices low and prevents monopolies from forming.
Contestable market theory / Contestability theory
The contestable market theory is an economic concept stating that companies with few rivals behave in a competitive manner when the market they operate in has weak barriers to entry. The theory assumes that even in a monopoly or oligopoly, incumbents will act competitively when there is a lack of barriers, such as government regulation and high entry costs, doing everything they can to prevent new entrants from one day putting them out of business.
Contestable Market Theory — Key Takeaways
- The contestable market theory states that companies with few rivals behave in a competitive manner when the market they operate in has weak barriers to entry.
- The continuous risk of new entrants emerging and stealing market share leads incumbents to focus more on maximizing sales rather than profits.
- They realize that if they are too profitable, an entrant could easily come and undercut their business
Assumptions of a contestable market
- No barriers to entry or exit barriers
- No sunk costs: costs that have already been incurred and cannot be recovered
- Entry is absolute: When the entrant lowers prices it undermines the incumbents revenues completely.
- Both incumbent companies and new entrants have access to the same level of technology
Criticism of the Assumptions above
- No entry barriers — There are more costs associated with entry than the variable costs associated with hiring labor and leasing aircraft. If incumbent firms are pricing below the entrants average costs, this is a barrier. Assuming capital markets are perfect, this would still imply greater costs. Firms with cash reserves and easy access to capital markets through networks and reputation have an absolute cost advantage.
- Absolute displacement — In the airline industry incumbents always have sufficient advanced notice of any impending entry to permit them to respond with price reductions. The cost advantages of incumbents become barriers to displacing their prices.
- Sunk costs — If some sunk costs are necessary to penetrate the market, then assumption three is false. Advertising has been identified as one of the most significant sunk costs in a market. Advertising costs cannot be recovered if the carrier is not successful.
William J. Baumol and Contestable Market Theory
The economist William J. Baumol realeased his book in 1982: Contestable Markets and the Theory of Industrial Structure. Baumol argued that contestable markets always yield competitive equilibrium due to the continuous threat of new entrants.
Limitations of Contestable Market Theory
The necessities for a perfectly contestable market are hard to come by. It is not easy for an upstart to enter another company’s turf and immediately find itself on a level playing field.
Costs to enter and exit a market are rarely minimal, while factors such as economies of scale (decreasing average costs) almost always reward companies that have been around for longer.
Special Considerations
Aspects of contestable market theory heavily influence the views and methods of government regulators. That’s because opening up a market to potential new entrants may be sufficient to encourage efficiency and discourage anti-competitive behaviour.
E.g. regulators / governments may force existing companies to open-up their infrastructure to potential entrants or to share technology. This approach of increasing contestability is common in the communications industries, where incumbents are likely to have significant power or control over the network and infrastructure.
Overall, a contestable market is one with firms facing zero entry and exit costs. This means there are no barriers to entry and no barriers to exit, such as sunk costs and contractual agreements. For a market to be perfectly contestable, relevant industry technology would be readily available to potential entrants. This is often not the case in most competitive markets.
