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Contestable Markets Theory Proposed byWilliam Baumol
What is a contestable market?
A contestable market is one in which there is always the threat of entry of potential rivals as a
result of low barriers to exit and entry.
The market usually contains one firm or a small number of firms. They provide competition for
existing firms. For a perfectly contestable market, exit and entry must be costless.
Conditions needed for a perfectly contestable market are:
- No sunk costs: sunk costs are considered a barrier to entry as they are irrecoverable if you
decide to leave a market, therefore absence of sunk costs is needed. This means there is less
risk in entering a market.
- Perfect information (firms have equal access to the best production technology)
- Freedom to market and advertise in order to compete with a rival product
Characteristics of a contestable market?
- Industry's performance: Firms' behaviour is affected by the threat of new rivals entering
the market. Just this `threat' may be enough to keep them producing at a competitive price and
output This `threat' may cause them to operate like a perfectly competitive firm.
- Hit and run: If a firm is making abnormal profits, and the market is contestable, another firm
may enter the market to take advantage of high prices. When prices fall again and are no
longer profitable, the firm will leave. This encourages firms to
be satisfied with normal profits.
- Response to sunk costs: If sunk costs are high, the
existing firm is likely to act like a monopoly as the idea of sunk
costs scares away potential rivals and they can get away with
- Predatory pricing: existing firm may try to resort to
predatory pricing, setting a very low price to knock out all other competition. This is a barrier to
Are there ever perfectly competitive markets?
There are 2 ways to look at it. In reality no market is ever perfectly contestable as there will
always be some barriers to entry, but on the other hand, it is also true that in every market
there is some degree of contestability.
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Contestability and Public Interest:
Is a market is contestable it can be said to operate competitively and so consumers benefit from
It is important to remember that the degree of contestability should be considered instead of
just market share.
Firms may deliberately limit profits to
Incentive for firms to cut costs. discourage new entrants opting away from
Incentive to consider consumer preference.
Incentive to provide low prices in order to
avoid attracting hit and run entry candidates.…read more