Contestable Markets

 The theory was developed by William J.

Baumol in 1982 to explain why in some
monopoly or oligopolistic markets, firms may
operate in a competitive manner which will
enable consumers to obtain the benefits of
economies of scale and lower prices as well as
reducing welfare losses associated with
markets dominated by a few firms.
 The equilibrium position for a firm in a
contestable market will be closer to that……….
 Contestable Markets
 …predicted by perfect competition than
monopoly or oligopoly.
 In the theory of contestable markets, it is not
the number of firms in the industry, the actual
level of competition, which is important in
determining the behavior of firms within it, but
the threat of potential competition from new
firms possibly entering that industry.
 Contestable Markets
 If an incumbent firm in a monopoly or oligopoly
market believes that by fixing high prices and
earning supernormal profits there is the
possibility that this will attract new firms into
the industry who might take over the market,
then it might set prices equal to or relatively
close to average costs to prevent this from
happening.
 This strategy of setting a price below that which
will maximize a firm’s profits in order to
deter…..
 Contestable Markets
 …new entrants into the market, is known as
Limit Pricing.
 In order for it to be successful it is necessary for
the incumbent firm to have an accurate
knowledge of the cost structure of potential
entrants.
 This will enable it to set a price below the
minimum average costs of potential new
entrants, which would mean that they would
be…
 Contestable Markets
 …unable to set a price which would enable
them to make a profit.
 Limit pricing may also have the advantage of
making it less likely that a monopoly firm
would attract the attention of a country’s
regulator.
 Clearly the extent to which a market is
contestable will depend upon how easy it is for
new firms to enter the industry and so an…
 Contestable Markets
 Absence of barriers to entry or low barriers to
entry are crucial in determining this.
 It is also important for any prospective new
entrant that the product is standardized and
that they have access to the same technology as
established firms.
 There must be no collusion between existing
firms.
 Contestable Markets
 However, it is not only the case of entering the
market that is important. Any prospective new
entrant needs to plan for the eventuality that its
attempt to enter a particular market may fail
and that it will be forced out of the industry by
the existing firms.
 The costs for the firm if it has to exit the
market, therefore, need to be considered.
 Sunk costs are those costs which cannot be….
 Contestable Markets
 …recovered if a firm goes out of business and
may act as a barrier to entry.
 If entering the market involves the purchase of
expensive capital equipment which could not
be diverted to other uses or sold if the firm
goes bankrupt, then this expenditure
represents a sunk cost.
 If the risk of potential sunk costs is perceived
by the firm as great this is likely to deter it….
 Contestable Markets
 …from entering the market.
 Hence the lower the perceived risk of high
sunk costs the more contestable the market is
likely to be.
 A characteristic of contestable markets is “hit
and run” competition.
 If an incumbent firm in the industry raises its
price significantly above AC in order to
increase profits to earn supernormal profits,…
 Contestable Markets
 … the absence of barriers to entry will attract
new firms into the industry who will remain,
offering lower prices as long as there are profits
to be made.
 When the incumbent firm reduces its price the
new entrants leave.
 In order to avoid the possibility of hit and run
competition the existing firm in the industry
will have to keep prices close to AC.
 Contestable Markets
 It is important to remember that it is the threat of
competition not the actual competition that
forces firms to be productively and allocatively
efficient.
 Contestable markets theory has been used by
some governments as an argument for reducing
regulatory and legal barriers to entry to some
industries in order to increase competition.
 The extent to which contestable markets can
be…
 Contestable Markets
 …applied to the real world is questioned by some
economists.
 It is unlikely that a market will be free from sunk
costs.
 Any new firm entering a market is likely to have
to undertake expensive advertizing and
promotion costs at the outset which will be
irretrievable.
 It is also likely that there will be some barriers to
entry, either innocent in the form of economies….
 Contestable Markets
 …of scale for existing firms, or ones deliberately
created by incumbents such as mergers and
takeovers, limit and predatory pricing.
 Limit pricing is a strategy adopted by a monopoly
or oligopoly of setting prices below that which will
maximize profits in order to deter new entrants.
 Predatory pricing is another strategy adopted by a
monopoly or oligopoly of setting extremely low
prices, often below average costs of production,…
 Contestable Markets
 …in order to force competitors out of the
market and enable a firm to exploit increased
monopoly power in the market by raising
prices in the future.

Other Theories of the Firm