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In some industries, the competition level and monopoly power of the market are not based on the number of firms but the ease or difficulty for a new firm to enter the market. We call those industries contestable markets. What are contestable markets, exactly? How do they influence the industry performance and firms' behaviour? What are the pros and cons of contestable markets? In this explanation, you will find out.
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Sign up for freeWhat are some examples of sunk costs?
What are the conditions of a contestable market?
What is not an example of barrier to entry?
What may not be an advantage of contestable markets?
Existing firms have a higher level of technology than new entrants in contestable markets.
Sunk costs are ___________ costs a firm incurs when it enters a market.
The potential competition in a contestable market is enough to prevent existing firms from abusing their monopoly power.
High start-up costs, government regulations, and patent protection are example of ___________ .
The governments can limit the role of monopoly policy to uncover more potentially contestable markets.
What are some examples of sunk costs?
What are the conditions of a contestable market?
What is not an example of barrier to entry?
What may not be an advantage of contestable markets?
Existing firms have a higher level of technology than new entrants in contestable markets.
Sunk costs are ___________ costs a firm incurs when it enters a market.
The potential competition in a contestable market is enough to prevent existing firms from abusing their monopoly power.
High start-up costs, government regulations, and patent protection are example of ___________ .
The governments can limit the role of monopoly policy to uncover more potentially contestable markets.
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Team Contestable markets Teachers
Contestable markets occur when firms can enter and leave a market freely without any sunk costs. According to the contestable market theory, when the barriers to entry are low, there is a contest threat of new firms driving the incumbent firms out of business. Even a monopoly can suffer badly if they don't own any special technology or strategic resources that protect them from new entrants. Thus, in a contestable market, firms must behave productively to remain competitive.
Contestable markets occur when firms can enter and leave a market freely without any sunk costs and where the same technology level access is available to both new entrants as well as incumbent firms.
A monopoly market structure is determined by the number of firms in the market and the share of the leading companies by the concentration ratio. This poses a huge challenge for policymakers as they try to prevent the abusive behaviour of monopolies.
Market contestability may provide the answer. In a contestable market, monopoly power isn't based on the number of firms or concentration ratio but rather on how easy it is for a new firm to enter a market. To put it another way, market concentration is okay as long as the barrier of entry is low so that new firms can enter and ‘have a chance’ to compete.
In reality, the actual competition doesn't have to take place. Only the potential competition (the threat of entry by new firms) is enough to prevent existing firms from abusing their monopoly power or behaving inefficiently.
Market contestability has a significant impact on UK monopoly policy. Since the potential for competition is enough for existing firms to behave responsibly, the conventional regulatory policy is unnecessary. The governments can limit the role of monopoly policy to uncover more potentially contestable markets. In addition, deregulatory policies focus on setting the conditions for the entry and exit barriers, making sure the level of contestability is reasonable.
The two main characteristics of a perfectly contestable market are:
Barriers to entry are factors that prevent newcomers from entering the market and drive competition. Some examples include high start-up costs, government regulations, patent protection, strong brand identity, customer loyalty, or high consumer switching costs.
Barriers to exit are obstacles that prevent a company from exiting a market such as highly specialized assets, closure costs, or government regulations. In a contestable market, there are few or no barriers to entry and exit. Thus, firms are free to join and leave the market at any time, posing a huge threat to the existing businesses.
Sunk costs are irrecoverable costs a firm incurs when it enters a market. This means that when the firm exits the market, it can’t recover the costs that it incurred. Sunk costs are not the same as fixed costs.
If a firm purchases machinery when entering a market, this is a fixed cost. It won't be a sunk cost if the company can sell the machinery at a good price upon its exit. On the other hand, if the firm can’t sell or give away the machinery to another firm for free, the initial investment is known as a sunk cost as the cost is not recovered. Other sunk costs include payroll and advertising expenditures.
To learn more about the different types of costs check our explanation on the Costs of Production.
Without sunk costs, firms in a contestable market can have a ‘hit and run’ strategy: enter the market when the demand is high to take advantage of the abnormal profits and leave the market when the demand drops.
The threat of hit and run competition keeps prices and profits at the lowest levels possible, which increases the consumer surplus. This is shown in Figure 1 below. Instead of pricing at the monopoly price of P1, companies price at P2, thereby increasing consumer welfare due to reduced price and greater quantity.
Fig. 2 - Contestable Market Diagram
Let’s explore some of the advantages and disadvantages of contestable markets.
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What is a contestable market?
A contestable market is a market that firms can enter and exit without any sunk costs.
What's the difference between contestable and competitive market?
The contestable market has no barriers to entry and exit. There can be any number of firms (even one or few firms) and these don't have to be price takers. By contrast, a perfectly competitive market can have multiple firms and all firms are price takers.
Which industries have a contestable market?
Low-cost airlines, tourism, internet service providers.
What happens in a contestable market?
Companies in a contestable market may engage in hit and run competition: they enter the market temporarily to take advantage of the supernormal profits and leave when the profit is exhausted.
In a contestable market, there is a threat of new firms entering the market, thus preventing the abuse of monopoly power by the existing firms.
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