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.

    RELATED TERMS
    1. Barriers to Entry

      Barriers to entry are the costs or other obstacles that prevent ...
    2. Open Market

      An open market is an economic system with no barriers to free ...
    3. New Growth Theory

      New growth theory is a concept that presumes the desire and wants ...
    4. Traditional Theory Of Capital Structure

      The Traditional Theory of Capital Structure states that a firm's ...
    5. Market Power

      Market power describes a company's relative ability to manipulate ...
    6. Time-Preference Theory Of Interest

      The time preference theory of interest explains interest rates ...
    Related Articles
    1. Investing

      Modern Portfolio Theory Vs. Behavioral Finance

      Or: How financial markets would work in an ideal world vs. how they work in the real world.
    2. Investing

      Interest Rate Predictions With Expectations Theory

      The expectations theory uses long-term interest rates to predict future short-term interest rates.
    3. Insights

      Dow Theory

      Learn about the foundation upon which technical analysis is based.
    4. Insights

      How and Why Companies Become Monopolies

      Without competition, monopolies can raise prices and lower quality, leaving consumers little choice. But monopolies can benefit consumers as well.
    RELATED FAQS
    1. What factors influence competition in microeconomics?

      Find out what influences competition in microeconomics and how perfect competition, monopoly and oligopoly vary in their ... Read Answer >>
    2. What Are the Major Differences Between a Monopoly and an Oligopoly?

      Learn about the major differences between a monopoly and an oligopoly. Find answers to some common questions surrounding ... Read Answer >>
    3. What's the difference between agency theory and stakeholder theory?

      Learn how agency theory and stakeholder theory are used in business to understand common business communication problems ... Read Answer >>
    4. How does a monopoly contribute to market failure?

      Read a simple overview of the theory of market monopoly, where it originated and some contemporary challenges to the classical ... Read Answer >>
    5. What are the major barriers to entry for new companies in the drugs sector?

      Find out why barriers to entry for U.S. drug companies are so high and how the Food and Drug Administration, or FDA, inhibits ... Read Answer >>
    6. What is a utility stock?

      Investing in difficult economic conditions requires knowledge of different stock classes. Utility stocks are one vehicle ... Read Answer >>
    Hot Definitions
    1. Monero

      Monero is a digital currency that offers a high level of anonymity for users and their online transactions.
    2. Risk Tolerance

      Risk tolerance is the degree of variability in investment returns that an individual is willing to withstand.
    3. Diversification

      Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
    4. Initial Coin Offering (ICO)

      An Initial Coin Offering (ICO) is an unregulated means by which funds are raised for a new cryptocurrency venture.
    5. Federal Funds Rate

      The federal funds rate is the interest rate at which a depository institution lends funds maintained at the Federal Reserve ...
    6. Ethereum

      Ethereum is a decentralized software platform that enables SmartContracts and Distributed Applications (ĐApps) to be built ...
    Trading Center