Contestable Markets Are Disciplined by the Threat of Entry, Not the Number of Firms
Definition
Contestable market: a market in which there are low barriers to entry and exit, so the threat of hit-and-run competition keeps existing firms behaving competitively.
- A contestable market is disciplined by the threat of entry, not the number of firms.
- Even a single firm may behave competitively if entry and exit are easy.
- Contestability depends on low barriers and, above all, low sunk costs.
- Sunk costs are costs that cannot be recovered if a firm leaves, such as bespoke advertising or highly specialised equipment; because low sunk costs mean little is lost by exiting, they are what make hit-and-run entry possible.
Hit-And-Run Entry Lets Firms Grab Short-Run Profit Then Leave
- A new firm enters to grab short-run supernormal profit.
- It leaves again before the incumbent can respond.
- The mere threat of this keeps the incumbent's prices low.
Example
- A charter airline can enter a profitable route, then leave if profits fade.
- Because aircraft can be redeployed to other routes, its sunk costs are low.
High Contestability Pushes Firms Towards Normal Profit and Lower Prices
- High contestability pushes firms towards normal profit.
- Prices fall and efficiency improves, even with few firms.
- Sunk costs are the key determinant of how contestable a market is.
High Sunk Costs and Entry Deterrence Can Blunt the Threat
- Even a monopolist may price competitively if entry is easy.
- But high sunk costs make hit-and-run entry unrealistic.
- Incumbents can also use limit pricing or brand loyalty to deter entry, so perfect contestability is rare.
Note
- A credible threat of entry matters more than the current number of firms.
- High sunk costs weaken that threat and reduce contestability.
Make Sunk Costs the Hinge of the Analysis
Exam technique
- Explain contestability through the threat of entry and low sunk costs.
- Link high contestability to normal profit and lower prices, but note that perfect contestability is rarely met.
Common Mistake
- Do not equate contestability with the number of firms.
- It depends on the threat of entry and the level of sunk costs.
Self review
- Define a contestable market and explain its significance for industry performance.
- What are sunk costs?
- What is hit-and-run competition?
- Why can a single firm still behave competitively?
- Why is perfect contestability rare in practice?
