Contestable Market Theory: Definition, How It Works, and Methods

What Is Contestable Market 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.

How Contestable Market Theory Works

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.

According to contestable market theory, when access to technology is equal 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.

The continuous risk of contestability weighs on the companies that already operate in the space, keeping them on their toes and influencing how they conduct business. Such an environment generally keeps prices low and prevents monopolies from forming.

Characteristics of a contestable market include:

• There are no barriers to entry or exit barriers
• There are no sunk costs: costs that have already been incurred and cannot be recovered
• Both incumbent companies and new entrants have access to the same level of technology

Contestable Market Theory Methods

In a contestable market, entrants might execute a hit-and-run strategy. The new entrants can "hit" the market, given there are no or low barriers to entry, make profits, and then "run," without incurring any exit costs.

These types of risks play on the minds of the executive management teams within the industry, leading them to adjust their business strategies and gravitate toward sales maximization rather than profit maximization. According to the theory, unlimited profits would be pushed down to normal profits in a truly contestable market.

Consequently, even a monopoly might be forced to operate competitively if barriers to entry are weak. Those operating a monopoly might conclude that if they're too profitable, a competitor could easily enter the market, contest their business, and undercut their profits.

History of Contestable Market Theory

The contestable market theory was introduced to the world by economist William J. Baumol in 1982, via his book: 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 requisites for a perfectly contestable market are hard to come by. It is seldom 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 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 behavior.

For example, regulators 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.