Contestable Markets

• Contestable market


  A market where there is a threat of competition, not necessarily actual competition, but the threat could be enough to affect the behavior of firms in the market
• Characteristics of a contestable market


  • Lower barriers to entry and exit
  • Large pool of potential entrants
  • Good information of market conditions so new firms can compete on a level playing field
  • Incumbent firms are subject to hit and run competition due to low barriers to entry and exit
• Technology

  Has increased the contestability of markets by reducing barriers to entry and exit, allowing for greater innovation and disruption, and improving information
• Behavior of firms in a contestable market

  1. Monopolist lowers price and increases quantity to the limit price (where average cost equals average revenue) to eliminate the threat of entry and competition

  2. Monopolist is prepared to compete with lower prices and higher quantities if entry does occur
• Pros of contestable markets

  • Allocative efficiency (lower prices, higher consumer surplus, higher quality, greater choice)
  • Productive efficiency (greater exploitation of economies of scale, lower costs)
  • X-efficiency (minimizing waste, lower costs)
• Contestable markets can provide similar benefits to competitive markets, even without actual competition
• Potential issues with contestable markets

  • Lack of dynamic efficiency over time (less incentive for progress and innovation)
  • Concerns about cost-cutting in dangerous areas (health, safety, environment, wages)
  • Creative destruction leading to job losses
  • Anti-competitive strategies by incumbent firms (limit pricing, predatory pricing, mergers) reducing contestability over time
• The length of time a market remains contestable is a key consideration
• The role of technology in affecting contestability is complex - it can both increase and decrease contestability
• Regulation can help minimize the issues of cost-cutting and anti-competitive strategies in contestable markets
• Evaluating the dynamic efficiency benefits of contestable markets by looking at innovation is important