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.
What are contestable markets?
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.
How does market contestability influence industry performance?
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.
Key characteristics of contestable markets
The two main characteristics of a perfectly contestable market are:
- No barriers to entry or exit.
- No sunk costs.
No barriers to entry or exit
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.
No sunk costs
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.
Effects of contestable markets on firms’ behaviour
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
- In a non-contestable market, a monopoly can maximise its profit by pricing where MC=MR at P1.
- In a contestable market, the firm is forced to lower the prices to remain competitive (from P1 to P2). As a result, the supernormal profit is depleted and only normal profit is made.
- With more firms in the market, customers also enjoy a wider range of products (Q2 compared to Q1).
Advantages and disadvantages of contestable markets
Let’s explore some of the advantages and disadvantages of contestable markets.
Advantages
- Efficiency: contestable markets force firms to reduce costs, thus increasing allocative and productive efficiency.
- Economies of scale: a contestable market doesn't require a large number of firms to drive prices down as it depends on the ease of entering and exiting the market. Thus, unlike perfect competition, there can be considerable economies of scale.
Disadvantages
- Barriers to entry: it's hard to remove the barriers to entry as they may require firms to have specialised knowledge and technology.
- Reducing monopoly power: monopoly can help the market to achieve significant economies of scale. With monopoly power reduced, the market may struggle to achieve productive efficiency.
- Brand loyalty: customers may be resistant to switching brands when a lot of firms enter the market.
Contestable Markets - Key takeaways
- Contestable markets occur when firms can enter and leave the market freely with no sunk costs.
- In a contestable market, monopoly power doesn't rely on the number of firms but the level of difficulty for a new firm to enter a market.
- The potential competition (the threat of entry by new firms) in a contestable market is enough to prevent existing firms from abusing their monopoly power.
- A perfectly contestable market is characterised by two main factors: no barriers to entry and exit and no sunk costs.
- Sunk costs are irrecoverable costs incurred upon a firm's market entry.
- Without sunk costs, firms in a contestable market can engage in a ‘hit and run’ competition.
- When the market becomes contestable, existing firms must lower the prices to remain competitive. In time, the supernormal profit is replaced by the normal profit.
- Market contestability may improve efficiency and economies of scale.
- The disadvantages of a contestable market include low barriers to entry, decreased monopoly power, and resistance from brand loyalty.
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