What is the theory of contestable markets?

As Chapter 9 explains, in recent years, much of the debate about the best way of dealing with the problems posed by monopoly has reflected the growing influence of contestable market theory. Before the advent of this theory (and of the wider free-market revival of which the theory of contestable markets is a part), competition policy was generally interventionist. Increased intervention was justified by the alleged need to countervail the growing power of large business organisations.

By contrast, contestable market theory is now used to justify a much less interventionist approach.The theory suggests that monopoly should be defined not by the number of firms in the market or by concentration ratios, but rather by the potential ease or difficulty with which new firms may enter the market. Actual competition in a market is not essential; the threat of entry by new firms (or potential competition) is quite enough to ensure efficient and non-exploitative behaviour by existing firms within the market.

For a market to be perfectly contestable, in the long run there must be zero costs of entry and exit and firms must be able to enter or leave it quickly. This means there must be no barriers to entry and no sunk costs. Sunk costs are costs that must be incurred to enter the market, but which cannot be recovered if the firm decides to leave the market. In these conditions, hit-and-run market activity is likely to occur. ‘Hit and run’ describes a situation in which a new firm enters or hits the market to see if normal profit can be made. If profit is insufficient, then given the absence of sunk cost, the firm leaves or runs from the market.