Contestable Markets

The Contestable Market model suggests that even if there are high costs to entering the market, this does not matter unless these cannot be recovered upon exiting the market.

The contestable markets model proposes that:

  • The number of firms is not the most important factor, instead it is the absence of barriers to entry and sunk costs
  • Contestable markets are assumed to have free entry to new firms and free exit for incumbents and new entrants
  • Free entry assumes that all firms and new entrants have access to the same technology
  • New firms are not prohibited from entry by incumbents exploiting unachievable economies of scale (This means a natural monopoly is not contestable)

Entry to a market is usually costly to the entering firm, but the firm can still be contestable if these costs can be recovered when exiting the market.

Sunk Costs

Sunk costs are the costs that you pay to enter the market, but cannot recover when exiting the market.

Capital is the biggest sunk cost. This is because of the value of capital depreciates over time, meaning that you cannot recover the same amount of money that you paid for the capital when selling it.

However this can be avoided by renting the capital instead of purchasing it. This means that you do not have to pay the cost of the depreciation.

For example, in the Airline market, if you purchase a new plane, it will lose value rapidly first, and you will not be able to sell it for as much as you paid for it. However, if you rent the plane, you do not have to resell, and the cost of rent will be a part of your costs of production, and factored into your price.

So, by renting, markets become more contestable.

Hit and Run

A contestable market allows hit and run, allowing new firms to enter, compete away SNP then leave the market. Barriers to exit prevent hit and run.

If the industry becomes contestable, then the incumbent(s) fearing new firms will reduce their prices. This means that firms don't even have to enter the market to eliminate SNP, unlike in the other models.

Incumbents also strive to be productively efficient in order to deter new entrants - the lower they costs are, the harder it is to compete with them.

Contestable markets diagram

Point A

Point of profit maximisation, without contestability

Point B

  • Fear of entry drives firms to increase output
  • This causes a reduction in prices and the firm becoming more efficient as well as more supply
  • This benefits consumers