Contestable market
Encyclopedia
In economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

, the theory of contestable markets, associated primarily with its 1982 proponent William J. Baumol
William Baumol
William Jack Baumol is an American economist. He is a professor of economics at New York University and is also affiliated with Princeton University. Baumol has written extensively about labor market and other economic factors that affect the economy. He also made valuable contributions to the...

, holds that there exist market
Market
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...

s served by a small number of firms, which are nevertheless characterized by competitive equilibria (and therefore desirable welfare outcomes
Welfare economics
Welfare economics is a branch of economics that uses microeconomic techniques to evaluate economic well-being, especially relative to competitive general equilibrium within an economy as to economic efficiency and the resulting income distribution associated with it...

) because of the existence of potential short-term entrants.
A perfectly contestable market has three main features. It is a market that has -
  1. No entry or exit barriers
  2. No sunk costs
  3. Access to the same level of technology (to incumbent firms and new entrants)

Although, a perfectly contestable market is not possible in real life, therefore we talk about the degree of contestability of a market. The more contestable a market the closer it will be to a perfectly contestable market.

Economists argue that determining price and output is not actually dependent on the type of industry, that is whether it is a monopoly or perfectly competitive market, but, rather is the real threat of competition.
Hence, for example a monopoly protected by high barriers to entry (e.g. it owns all the strategic resources) will make supernormal or abnormal profits with no fear of competition. However, in this same case if it did not own the strategic resources for production then other firms could easily enter the market, leading to higher competition and thus lower prices, thus making the market more contestable.

Sunk costs are those costs that cannot be recovered after a firm shuts down. For example a new firm enters the steel industry. For this, the entrant needs to buy new machinery. Now, if for any reason this new firm could not cope up with competition of the incumbent firm then it will plan to move out of he market. However, if the new firm cannot use or transfer the new machines that he bought for the production of steel to other uses in another industry, then these fixed costs on machinery become sunk costs. Hence if there are sunk costs present in the market it impedes the first assumption of no exit barriers. Hence this market will not be contestable and no firms would enter the steel industry.

It is very important for firms to have access to the same level of technology as that determines the average cost of the product. An incumbent firm having more knowledge and access to a technology for the production of a commodity would enjoy higher economies of scale in the form of lower average cost of production. However a new firm entering the market, not have information about the right technology will end up incurring higher average cost of production. Hence, not being able to compete with the existing firm. This will again lead to the incumbent firm enjoying monopoly power and supernormal profit in the market as the new entrant will exit the firm. A solution to this problem could be governments providing equal access and knowledge to everyone in the market regarding new technology and also provide financial resources for the same.

Its fundamental features are low barriers to entry
Barriers to entry
In theories of competition in economics, barriers to entry are obstacles that make it difficult to enter a given market. The term can refer to hindrances a firm faces in trying to enter a market or industry - such as government regulation, or a large, established firm taking advantage of economies...

 and exit
Barriers to exit
In economics, barriers to exit are obstacles in the path of a firm which wants to leave a given market or industrial sector. These obstacles often cost the firm financially to leave the market and may prohibit it doing so....

; in theory, a perfectly contestable market would have no barriers to entry or exit ("frictionless reversible entry" in economist William Brock's terms). Contestable markets are characterized by "hit and run" competition; if a firm
Theory of the firm
The theory of the firm consists of a number of economic theories that describe the nature of the firm, company, or corporation, including its existence, behavior, structure, and relationship to the market.-Overview:...

 in a contestable market raises its prices much beyond the average price level
Price level
A price level is a hypothetical measure of overall prices for some set of goods and services, in a given region during a given interval, normalized relative to some base set...

 of the market, and thus begins to earn excess profits, potential rivals will enter the market, hoping to exploit the price level for easy profit. When the original incumbent firm(s) respond by returning prices to levels consistent with normal profits, the new firms will exit. Because of this, even a single-firm market can show highly competitive behavior.

The applicability of the theory to real world situations may be questioned, however, particularly as there are very few markets which are completely free of sunk costs and entry and exit barriers. Low-cost airlines remain a commonly-referenced example of a contestable market; entrants have the possibility of leasing aircraft and should be able to respond to high profits by quickly entering and exiting. However, it is now generally admitted that Baumol's judgment that the US airline industry was therefore best left deregulated was incorrect, since the now duly deregulated industry is "well on its way" to evolving into a concentrated oligopoly
Oligopoly
An oligopoly is a market form in which a market or industry is dominated by a small number of sellers . The word is derived, by analogy with "monopoly", from the Greek ὀλίγοι "few" + πόλειν "to sell". Because there are few sellers, each oligopolist is likely to be aware of the actions of the others...

. More generally, experimental evidence collected since the publication of Baumol's paper has suggested that perfectly competitive markets would - if they existed - behave in the way Baumol outlined, the performance of imperfectly contestable markets (i.e. real world markets) depends "on actual rather than potential competition", perhaps in part due to the range of "strategic responses" available to incumbents that were not considered by Baumol as part of his theory.

The theory of contestable markets has been used to argue for weaker application of antitrust laws
Competition law
Competition law, known in the United States as antitrust law, is law that promotes or maintains market competition by regulating anti-competitive conduct by companies....

, as simply observing a monopoly market may not prove that a firm is exploiting its market power
Market power
In economics, market power is the ability of a firm to alter the market price of a good or service. In perfectly competitive markets, market participants have no market power. A firm with market power can raise prices without losing its customers to competitors...

to control the price level. Baumol himself argued based on the theory for both deregulation in certain industries and for more regulation in others.
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