What Is Contestable Market Theory?

Contestable market theory is an economic concept stating that companies with few rivals behave in a competitive manner when the market they operate in has weak barriers to entry. Contestable in economics means that a company can be challenged or contested by rival companies looking to enter the industry or market. In other words, a contestable market is a market whereby companies can enter and leave freely with low sunk costs. Sunk costs are major irrecoverable costs to enter an industry such as the purchase of a manufacturing plant or equipment.

The contestable market theory assumes that even in a monopoly or oligopoly, dominant companies will act competitively when there is a lack of barriers for competitors. Dominant players in an industry will do everything to reduce the contestability of their industry by preventing new entrants from driving them out of business.

How Contestable Market Theory Works

According to contestable market theory, when access to technology is equal, and barriers to entry are weak, low, or non-existent, a constant threat exists that new competitors will enter the marketplace. Examples of barriers to entry include government regulation or high entry costs. Without these barriers, competitors can enter the market and challenge the existing, well-established companies.

The continuous risk of contestability weighs on the existing companies operating in the space, keeping them on their toes and influencing how they conduct business. Also, the contestable threat typically keeps prices low and prevents monopolies from forming.

Characteristics of a contestable market include:

  • There are no barriers to entry or exit barriers
  • There are no sunk costs: costs that have already been incurred and cannot be recovered
  • Both incumbent firms and new entrants have access to the same level of technology

Key Takeaways

  • Contestable market theory states that companies with few rivals behave in a competitive manner when the market they operate in has weak barriers to entry.
  • The continuous risk of new entrants emerging and stealing market share leads incumbents to focus more on maximizing sales rather than profits.
  • They realize that if they are too profitable, an entrant could easily come and undercut their business.

Contestable Market Theory Methods

A contestable market might have companies entering using entrants a hit and run strategy. The new entrants can "hit" the market, given there are no or low barriers to entry, make profits, and then "run," without incurring any exit costs.

The contestable risks play on the minds of the executive management teams within the industry. As a result, the established companies adjust their business strategy leading them to gravitate toward sales maximization rather than profit maximization. In a contestable market, unlimited profits would be pushed down to normal profits in a truly contestable market.

Consequently, even a monopoly might be forced to operate competitively if barriers to entry are weak. Those operating a monopoly might conclude that if they're too profitable, a competitor could easily enter the market and contest their business–undercutting the monopoly's profits.

History of Contestable Market Theory

The contestable market theory was introduced to the world by economist William J. Baumol in 1982, via his book: “Contestable Markets and the Theory of Industrial Structure.” Baumol argued that contestable markets always yield competitive equilibrium due to the continuous threat of new entrants.

The key tenet of a contestable market is that there exists a credible threat to existing companies with little-to-no impediments for new entrants.

Limitations of Contestable Market Theory

The requisites for a perfectly contestable market are hard to come by. It is seldom easy for an upstart to enter another company’s turf and immediately find itself on a level playing field.

Costs to enter and exit a market are rarely minimal, while factors such as economies of scale almost always reward companies that have been around for longer. Economies of scale are when well-established companies become so efficient, they can reduce their per-unit costs while simultaneously increasing production. In other words, companies that have economies of scale can increase their profit margins faster than newer companies–reducing the chances of their industry from becoming contestable.

Special Considerations

Aspects of contestable market theory heavily influence the views and methods of government regulators. That is 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 existing companies to open-up their infrastructure to potential entrants or to share technology. This approach of increasing contestability is common in the communications industries, where incumbents are likely to have significant power or control over the network and infrastructure.