Contestable market

In economics, the theory of contestable markets, associated primarily with its 1982 proponent William J. Baumol, holds that there are markets served by a small number of firms that are nevertheless characterized by competitive equilibria (and therefore desirable welfare outcomes) because of the existence of potential short-term entrants.

A perfectly contestable market has three main features:

A perfectly contestable market is not possible in real life. Instead, the degree of contestability of a market is talked about. The more contestable a market is, the closer it will be to a perfectly contestable market.

Economists argue that determining price and output is actually dependent not on the type of market structure (whether it is a monopoly or perfectly competitive market) but on the threat of competition.

Thus, for example, a monopoly protected by high barriers to entry (for example, it owns all the strategic resources) will make supernormal or abnormal profits with no fear of competition. However, in the same case, if it did not own the strategic resources for production, other firms could easily enter the market, which would lead to higher competition and thus lower prices. That would make the market more contestable.

Sunk costs are those costs that cannot be recovered after a firm shuts down. For example, if a new firm enters the steel industry, the entrant needs to buy new machinery. If, for any reason, the new firm could not cope up with the competition of the incumbent firm, it will plan to move out of the market. However, if the new firm cannot use or transfer the new machines that it bought for the production of steel to other uses in another industry, the fixed costs on machinery become sunk costs so if there are sunk costs in the market, they impede the first assumption of no exit barriers. That market will not be contestable, and no firms would enter the steel industry.

It is very important for firms to have access to the same level of technology as that helps determine the average cost of the product. An incumbent firm having more knowledge and access to a technology for the production of a commodity could enjoy higher economies of scale in the form of lower average cost of production. A new firm entering the market, with insufficient information or technology, could incur a higher average cost of production and so be unable to compete with the incumbent firm. That would lead to the incumbent firm enjoying monopoly power and supernormal profit in the market, as the new firm will exit the market. A solution to the problem could be governments providing equal access to knowledge and technology, as well as financial resources for the same.

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