This theory was first developed by the American economist W.J.Baumol in the early 1980s. The theory argues that what really matters in determining an industry's price and output is not, in reality, whether the industry is perfectly competitive or a monopoly, but the potential of new firms to enter or leave the market. The theory is based on the idea that a firm may enjoy a monopoly position within a market, but if there existed the real threat of competition from other firms, this would force the firm to behave as if it actually faced competition; that is, the firm would not pursue a policy of charging exorbitant prices to make excessive profits.
What is a contestable market?
The term 'contestability' has nothing to do with the number of firms currently in the industry, but refers instead to the ease with which firms are able to enter or leave a market; a perfectly contestable market is one in which there are no barriers or costs to entry or exit: the greater these are, the less contestable is the market, and thus the greater is the monopoly power of existing firms; so for a market to be contestable, a barrier to entry, such as a patent protecting technical knowledge, must be absent.
We previously discussed the various restrictions to entry, the idea of barriers to exit needs further explanation. A firm will incur substantial costs of leaving an industry of its capital equipment cannot be transferred to other uses. In this case these costs are known as sunk costs or irrecoverable costs, and are costs which cannot be recovered in the event of exit from the market. For example, the air travel industry is often cited as an example of a contestable market as an established airline operating on a particular route would easily be able to gain entry to another route, and, just as importantly, would be able to withdraw from that route if it so desired. Should operations on the new route prove unprofitable, the airline could transfer its operations without incurring high sunk costs because aircraft can easily be switched from one particular route which is loss making to another which is more profitable. Thus, so long as a firm is able to redeploy its capital or sell it when it wishes to leave a market, then the sunk costs would be low and relatively costless exit would be ensured.
One feature of markets which are contestable, that is where entry and exit costs are low, is that it may encourage hit-and-run competition - because entry to the industry is easy, firms may enter that industry to share in the fruits of temporarily high profits, and then withdraw as soon as the abnormal profits have been whittled away. However, the threat of such competition may be sufficient to force firms to price as competitively as possible.
Implications of the theory
The theory implies that, given easy entry to and exit from an industry, monopoly or oligopoly firms will behave as if they actually existed in perfect competition; that is they will:
- Equate MC with MR to maximise profits
- Only earn normal profits (AR = ATC) in the long run, because if supernormal profits were made, new firms would enter the industry increasing supply and driving down price to a level where only normal profits are made; and if losses are made, some firms will be forced to leave the industry, causing supply to fall and price to rise back to a level consistent with the making of normal profits.
- Operate with productive efficiency on the lowest point of the ATC curve where AC = MC; if this were not the case, new firms could enter the industry, produce at the most efficient level, price their goods more competitively and force existing firms out.
- Operate with allocative efficiency where P = MC; this will occur because the earning of long run normal profits requires that AR or price should equal AC, and as AC = MC (see above point), the MC should equal the price.
It would appear from the theory that the 'best of both worlds' can be enjoyed; that is, so long as there exists the threat of entry into an industry, consumers will be protected from the worst abuses of monopoly power, whilst at the same time firms will be able to reap the advantages of large scale production in the form of greater economies of scale, and will operate in accordance with the criteria for economic efficiency.
The theory has been 'taken to heart' by right-wing politicians and economists who argue the case for non-intervention by the government and a policy of deregulation. The theory, it is argued, implies that providing there is sufficient potential for competition, there is no need for the government to interfere with the pricing and output policies of firms, but should instead confine itself to ensuring contestability through the use of deregulatory policies designed to remove barriers to entry and exit. Such policies have had a major influence on government's monopoly policies in recent years.
It has been argued that the theory represents an improvement on the simple perfect competition and monopoly models:
Like perfect competition, the perfectly contestable market may exist only rarely in practice and could be said to represent a model or abstraction of the real world rather than the real world itself. However, advocates of the theory of contestable markets argue that it is a more useful model than that of perfect competition as it provides a more effective means of making predictions about firms' price and output behaviour than does the number of sellers in a market.
The theory of monopoly only considers the markets in terms of the number of firms operating in it or in terms of concentration ratios, but does not make any allowance for the impact that potential competition might have.
Criticisms of the theory
The extent to which the theory of contestable markets may be applied in practice is limited. Two pre-requisites may not be met:
- Firstly, firms' sunk costs must be low so that they can easily leave the market. However, in reality sunk costs may be extremely high, even when capital is transferable. For example, if the Ford Motor Company decided to switch its operations from Dagenham (UK) to Delhi (India), it could not do so without substantial costs, despite the possibility of taking much fixed capital to India with it.
- Secondly, the specific technical knowledge necessary to operate in the industry must be freely available. However, sole possession of technical knowledge, often protected by patent, is a common and powerful barrier to entry to monopolistic markets where production is of a highly sophisticated nature, and is underpinned by extensive R&D - for example, the case of the drugs industry.
The theory ignores the possible aggressive actions of existing firms to potential entrants. In a market where cost barriers to entry and exit are low, existing firms may behave like monopolists by charging high prices and making supernormal profits, but might frighten off potential entrants by making it quite clear that any firm attempting to enter their 'patch' would face 'big trouble' in the form of all-out, to-the-death competition.
Those on the political right view the theory in terms of a justification of free markets and non-government intervention as both consumers and producers appear to benefit. However, this standpoint may be criticised on the grounds that even if perfect contestability exists, which is in itself by no means common in practice, government intervention in the free market may be warranted for a whole variety of other reasons.