Contestable markets

A contestable market is one in which the pressure of potential entry is strong enough to prevent the incumbent firm or firms from setting a price above average cost for any sustained period. In a contestable market, the existing firm can at most earn normal profit in the long run, because any attempt to charge a price that yields supernormal profit will attract entry that removes the gain. The emphasis is on the threat of entry rather than the number of firms currently producing. The moment supernormal profit appears, new firms can come in quickly, sell at the ruling price, take part of the market, and then leave again without being trapped by unrecoverable costs.

The hit-and-run entry describes exactly this behaviour. A firm watches the market, sees a price that sits above average cost, enters to capture short-run profit, and exits as soon as the profit is competed away. This is only feasible when entry and exit can be done rapidly and without cost that cannot be recovered. If those conditions hold, the incumbent cannot rely on barriers to entry to protect high prices. The rational response for the incumbent is to set a price that removes the attraction for hit-and-run entry by keeping the price equal to the average cost.

The theory highlights that the existence of a monopoly supplier does not by itself guarantee monopoly pricing power. A single firm can operate in a way that resembles competitive behaviour if the market is highly contestable. The pressure comes from potential rivals who can enter easily, can produce with the same technology as the incumbent, and can withdraw just as easily once the short-run opportunity closes. When those conditions hold, the incumbent faces a hard limit on price. Any attempt to set price above average cost opens the door to immediate entry.

Conditions that make a market contestable

A market approaches full contestability when several stringent conditions hold at the same time. There must be no barriers to entry or exit, so that a potential entrant can begin production without legal restriction, licensing delays, or capital requirements that cannot be met by a newcomer.

There must be no sunk costs, meaning that any outlay needed to enter can be fully recovered upon exit. If advertising outlays, brand building, or specialised equipment would be lost on exit, then the market fails this condition and potential entrants face a real risk.

Entrants must not be at a competitive disadvantage relative to the incumbent. They must have access to the same technology and the same cost conditions.

They must also be able to enter and to exit rapidly. If delay is unavoidable, the incumbent can adjust before the entrant begins to sell, which weakens the disciplining effect of the threat.

When these conditions hold, the incumbent cannot rationally set a price above average cost. If it did so, the resulting supernormal profit would function as an invitation for entry. Any entrant could copy the incumbent’s technology, produce at the same cost, sell at the prevailing price, and withdraw before suffering any loss. The only safe pricing policy is to keep price at or below average cost so that entry yields no gain.

How a Contestable Market Operates

The mechanics of contestability can be set out on a standard price and output diagram for a single firm that currently holds the market.

Begin at the point where marginal revenue equals marginal cost. Mapping this point up to the average revenue curve gives the monopoly price P1 and the monopoly output. At that price average cost sits below price, which implies supernormal profit. In a market that is highly contestable, this outcome is not secure. The supernormal profit is a signal to potential entrants that they can enter, produce with the same technology, sell at the prevailing price, and earn profit without facing unrecoverable outlays. The arrival of entrants removes the incumbent’s ability to keep price at P1.

To prevent the attraction for entry the incumbent can set price equal to average cost. This is shown at P2 in the diagram. At P2 the gap between price and average cost is removed. The prospect of supernormal profit disappears and hit and run entry is no longer rewarded. The incumbent sacrifices monopoly profit in order to keep the market to itself. This is a defensive pricing policy that relies on the credibility of the threat to enter. If potential entrants truly can arrive quickly and leave without loss, then P2 is a rational choice for the incumbent.

There is an additional discipline that arises from the position of the minimum point of the average cost curve. If the incumbent is concerned that any price above the minimum of average cost will eventually tempt entry, the firm has a strong incentive to keep its cost curve as low as possible and to avoid inefficiency. Reducing waste and operating close to the minimum of average cost reduces the room for new firms to profit. However, if the incumbent tried to produce at the exact minimum point while maintaining monopoly status, it would not be on its own demand curve and the quantity that consumers wish to buy at that price would exceed the monopolist’s output. That gap invites entry. Once entry occurs and several firms operate with the same technology, the market can settle with each firm producing where price equals the minimum point of average cost. At that point price equals marginal cost and both productive efficiency and allocative efficiency are achieved. The theory explains the discipline but does not specify the path by which the market moves from monopoly to that final outcome.

Incumbent behaviour that reduces the risk of entry

The best chance for an incumbent to reduce the risk of hit and run entry is to keep long run average cost as low as possible and to avoid any rise in costs that could be read as slack. If the cost curve drifts upward through inefficiency, the space for entry widens. A potential entrant with access to the same technology would be able to produce at lower cost and sell at the ruling price. The incumbent can also maintain a policy of not setting price above the minimum of average cost. If price is at or below that minimum, there is no room for a rival to make supernormal profit by simply copying the product and selling at the same price. Even then, if there is demand in excess of the incumbent’s chosen output, new firms may still enter and share the market while making normal profit.

When entry is easy and sunk costs are absent, the discipline of potential competition forces behaviour that resembles competitive pricing. It is not the number of firms that matters most, but the absence of barriers that makes entry quick and costless.

Consider a domestic air route with one incumbent airline, for example, between Chicago and St. Louis. If there is spare aircraft capacity available to a potential entrant, for example an aircraft sitting in a hangar that can be used without any sunk outlay, the route can be contestable even if only one airline currently operates it. If the incumbent sets a price above average cost and begins to earn supernormal profit, a rival airline can move the spare aircraft onto the route, sell tickets at the going price, take a share of the profit, and then withdraw once the price has fallen back. The absence of sunk costs limits the incumbent’s market power in a very direct way. The credible threat of that short run response forces the incumbent to choose a price that removes the attraction to enter.

The impact of the internet on contestability

The spread of the internet has increased contestability in many sectors. Easier access to information improves the ability of consumers to compare offers and it helps potential entrants to judge market conditions and reach buyers without the need for a costly physical presence. The growth of online sales reduces the importance of some traditional distribution barriers and can allow new firms to enter markets that were once dominated by a few large chains.

Travel services provide a clear example of how online channels have altered competitive conditions. In a recent year, United States residents made more than seventy million trips abroad. In the past, many overseas trips were arranged by high street travel agents, and large chains held a significant share of bookings. Online platforms now allow new firms to compete effectively with established brands, and they also allow consumers to assemble their own travel arrangements more easily. This change has increased contestability by lowering the cost of reaching customers and by weakening the need for sunk outlays on physical retail networks. The overall effect is stronger competitive pressure on incumbents and a closer alignment between price and cost.

Evaluation of the advantages and disadvantages of a contestable market

From the viewpoint of society, a contestable market tends to deliver a lower price than would be set by a profit-maximising monopolist. If a monopolist tried to charge P1 and earn supernormal profit, entry would be encouraged and the price would be forced down. If the incumbent pre-emptively chooses P2 by setting price equal to average cost, the gain from monopoly power is removed and consumers pay a price that reflects the full cost of production. If the process continues and new firms enter, the market can come to rest at P3 with each firm producing at the minimum point of average cost and with price equal to marginal cost. At that point both productive efficiency and allocative efficiency are achieved. Productive efficiency is achieved because each firm operates at the lowest point on its average cost curve. Allocative efficiency is achieved because the price paid by consumers equals the marginal cost of the last unit produced.

There are important cautions. The conditions required for full contestability are very demanding. The assumption that there are no sunk costs may fail in many real markets. Advertising may be needed to make customers aware of a new supplier, and such outlays cannot always be recovered if the firm later exits. The shift from a monopoly position to a long run competitive outcome is not instantaneous. The theory does not explain in detail how quickly entry occurs, how many firms will finally share the market, or how any temporary losses are financed. In addition, perfectly contestable markets are rare in practice. Many industries involve some fixed investment that is specific to the product, and some customer acquisition spending that cannot be recovered.

A further issue is the credibility of the threat of entry. Incumbent firms may believe that potential entrants will not actually come in unless the price is kept above average cost by a significant margin. That belief can tempt the incumbent to set a price that is slightly above average cost in the hope of keeping some supernormal profit in the short run. If a new firm does enter, the incumbent may then react aggressively to push price back to the level that keeps only normal profit. The benefit to consumers from contestability therefore depends on how quickly entry occurs, on how easy exit really is, and on how forcefully the incumbent responds when threatened.

Despite these caveats, the discipline of contestability matters for policy. When information flows are strong and sunk costs are weak, the presence of a single producer does not automatically imply monopoly power. Ensuring that barriers to entry and exit are low, that technology is accessible, and that information reaches consumers can push concentrated markets toward outcomes that are closer to competitive benchmarks.