4.5 Contestable markets

DEFINITIONS:

1. Contestable markets: a market structure where there are no barriers to entry or exit, allowing potential competitors to freely enter and leave the market, which forces existing firms to act competitively, even if there are only a few of them. The traditional theory of the firm we have studied so far has essentially taught us that the competitiveness of an industry is really determined by the number of firms in it - perfect and monopolistic competition are competitive industries because there are lots of firms, with oligopolies and monopolies being uncompetitive because there are a limited number of dominant firms.

In reality, though, whilst most industries in the world tend to be oligopolistic, we would describe many of them as being highly competitive, despite being dominated by a few large firms.

The theory of contestable markets, proposed by William Baumol, suggests that it's potential, not actual competition, which would determine how firms behave.

Explain:

4.5.1 The characteristics of a contestable market

A contestable market is characterized by the following features:

1. Low Barriers to Entry and Exit: In a contestable market, there are minimal or no barriers to entry and exit. This means that new firms can enter the market easily if they see an opportunity to make profits and can also exit without significant loss if the market conditions change.
2. Potential Competition: The threat of potential competition is what drives firms in a contestable market to behave competitively, even if there are few or no actual competitors. Firms in these markets are disciplined by the possibility that new entrants could appear if existing firms try to exploit their market power by raising prices or lowering quality.
3. No Sunk Costs: Sunk costs are those that cannot be recovered once they are incurred, such as marketing or specialized equipment. In a contestable market, sunk costs are low or nonexistent, which reduces the risk associated with entry and exit.
4. Hit-and-Run Entry: Due to the lack of significant sunk costs and barriers to entry and exit, new firms can enter the market, make profits, and exit quickly if the market conditions become less favorable. This dynamic keeps existing firms in check, as they must consider the possibility of sudden competition.
5. Perfect Knowledge: In a perfectly contestable market, all firms, both potential entrants and incumbents, have perfect knowledge about prices, costs, and technology. This allows new firms to enter the market effectively and compete with existing firms on equal terms. These characteristics mean that even in a market with few firms (oligopoly or monopoly), if the market is highly contestable, the behavior of firms will resemble that of a competitive market. This leads to lower prices, higher quality, and greater efficiency in the market.

4.5.2 Productive and allocative efficiency in a contestable market

In a contestable market, the concepts of productive and allocative efficiency are essential to understanding how resources are used and how goods and services are distributed.

Productive Efficiency occurs when a firm produces at the lowest possible cost, meaning it operates at the minimum point on its average cost (AC) curve. In a contestable market, the threat of potential entry by new firms forces existing firms to minimize costs to remain competitive. This pressure ensures that firms are productively efficient because any inefficiency could lead to new entrants who can produce at a lower cost, driving the inefficient firm out of the market.

Allocative Efficiency happens when resources are allocated in a way that maximizes consumer satisfaction. This occurs when the price (P) of a good or service equals the marginal cost (MC) of production, meaning that the value consumers place on the good is equal to the cost of producing one more unit. In a perfectly contestable market, firms have to set prices equal to marginal costs (P = MC) to prevent entry by potential competitors, which leads to allocative efficiency.

In summary, a contestable market promotes both productive and allocative efficiency due to the constant threat of entry by new firms, which compels existing firms to minimize costs and set prices that reflect the true cost of production.