What is Contestable Market Theory

Contestable market theory is an economic concept that refers to a market in which there are only a few companies that, because of the threat of new entrants, behave in a competitive manner. Contestable market theory assumes that even in a monopoly or oligopoly, the existing companies will behave competitively when there is a lack of barriers, such as government regulation and high entry costs, to prevent new companies from entering the market. Considerable criticism surrounds this theory because there are often large entry and exit costs associated with entering a market.

BREAKING DOWN Contestable Market Theory

According to contestable market theory, when access to technology is equal and barriers to entry into a market are weak, low or non-existent, there is a constant threat of potential entry. This continuous risk increases competition in the market, due to lack of entry or exit costs. This aspect of contestable market theory heavily influences the views and methods of government regulators. That's because opening up a market to potential new entrants may be sufficient to encourage efficiency and discourage anti-competitive behavior. For example, regulators may force incumbent companies to open-up their infrastructure to potential entrants or to share technology. This is a common approach in the communications industries, where incumbents are likely to have significant power in terms of control of a network and infrastructure.

Such potential entrants to a market can operate a hit and run strategy, which means that they can 'hit' the market, given there are no or low barriers to entry, make profits, and then "run," as long as there are low barriers to exit.

Characteristics of a Contestable Market

In a truly contestable market:

  • There are barriers to entry or exit from a business
  • There are no sunk costs. A sunk cost is a cost that has already been incurred and cannot be recovered.
  • Access to the same level of technology (to incumbent firms and new entrants).

Profits According to Contestable Market Theory

Contestable market theory says firms in a contestable market gravitate toward sales maximization rather than profit maximization. According to the theory, unlimited profits would be pushed down to normal profits in a truly contestable market.

Consequently, even a monopoly may be forced to operate competitively if barriers to entry remain weak. They will realize that if they are too profitable, an entrant could easily come and undercut their business. Typically, in a monopoly market structure, there is only one firm prevailing in a particular industry. For example, Low-cost airlines or courier services.