Contestable Market Theory – Definition

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Contestable Market Theory Definition

A market is said to be contestable when a market’s existence is not controlled by market forces or when there are barriers to entry and exit. Contestable market theory is an economic concept that states that companies which have few rivals behave in a competitive manner because the market entry conditions they operate in is weak, low or in some cases non-existent. This implies that even a monopolistic or oligopolistic company may be forced to behave as a contestable market. Due to the presence of large entry and exit costs associated with entering the market, this theory raises considerable criticisms.

A Little More on What is Contestable Market Theory

The contestable market theory implies that there is a continuous threat of potential entry by a company’s rivals looking to enter the same industry or market as it due to the presence of equal unrestricted access to technology and absence of or low barriers to entry associated with the theory. This further has a great effect on government influence in the market. Existing companies may be forced to share their technology with potential entrants (this can be seen in the communications sector); leaving room for a “hit and run strategy” where potential entrants make profits and back out of the market.

Characteristics of a Contestable Market

Characteristics of a contestable market include:

  • Freedom of entry or exit: There is no condition for firms trying to enter into the market.
  • Absence of irrecoverable incurred cost, i.e., sunken cost: Firms should be able to exit the market without incurring any capital cost.
  • Presence of equal access to the same level of technology by both existing firms and new entrants.
  • The new market entrants must be able to execute the “hit and run tactics”: Free and costless market entry enables new entrants to make profits and exit the market before existing firms bring down their prices.

Profits According to Contestable Market Theory

According to the contestable market theory, firms operating under its market conditions tend to move toward maximizing sales instead of maximizing profit. It further states that in a perfectly contestable market, firms will be forced to keep excess profits to a minimum; thereby, making normal profits rather than unlimited profits. This is so due to the realization of existing firms that new entrants can freely and easily enter the market if they are too profitable. This realization may even force a monopolistic firm to operate competitively. An example of this is seen in Low-cost airlines or courier services.

Reference for “Contestable Market Theory” › Insights › Markets & Economy

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