Contestable Markets
A2 Economics
What is a Contestable Market?
• Firms in contestable markets face real and
potential competition
• The threat of “hit and run entry” from new
rivals may be sufficient to keep the industry
operating at a competitive price and output
• The key requirement for a contestable market
is the absence of sunk costs
• A perfectly contestable market occurs only
when entry and exit into is perfectly costless
Perfectly Contestable Markets & Perfectly
Competitive Markets
• Different from perfect competitive markets
• In a perfectly contestable market it is still possible
for one or a few firms to dominate the industry
• Each existing firm in the market produces a
differentiated product
• There are 3 conditions for market contestability
– The ability to use the best available technology
– Legal freedom to enter a market
– The relative absence of sunk costs / exit costs
What are Sunk Costs?
• Sunk costs are those costs which are irrecoverable
to the owners of the firm should it decide (a) to
close down or (b) leave the market
• A sunk cost is a past expense or loss that cannot
be altered by current or future actions
• Sunk costs represent a barrier to entry in an
industry because they scare potential entrants
from entering
Hit and Run entry and cream-skimming
• Hit and run entry
– Short run entry into a contestable market seeking
to take some of the monopoly profits available
and then get out quickly
– Possible when the entry and exit costs are low
• Cream-skimming
– This strategy involves finding segments of the
market that are high in value added (or high profit
margins) and exploiting those markets by selling
only to the most profitable parts of the business
– E.g. business post rather than household mail
Making Markets More Contestable
• Main approaches
– De-regulation - I.e. reducing statutory barriers to
entry to liberalise a market
– Tougher competition laws acting against
predatory behaviour by existing firms / tough rules
against cartels
– The changing nature of technology – which has
brought down entry costs in some markets (an
increase in capital mobility)
Examples of increased contestability in UK markets
– Free newspapers
– New entrants into the broadband market
– Radio stations in the digital age
– Low cost domestic airlines
– Cross channel transport
– Domestic Retail Clothing Industry - (Matalan,
TK Max and Primark)
– Telecommunications
• Voice over internet
• New entrants into fixed line market
Deregulation of markets – increased contestability
From postal services, to telecommunications and
the suppliers of your electricity and gas, many
markets have become more contestable in recent
years
This affects the conduct and behaviour of rival
firms within each market
Barriers to entry in the aviation industry
• (1) Availability of take-off and landing 'slots'
• (2) Necessity of entering a new route on a large
enough scale to achieve acceptable cost levels
• (3) The costs of leasing new fleets of aircraft
• (4) Securing an air operator’s licence from the EU
• (5) Contracts with ground-handling companies
• (6) Retaliatory behaviour by rivals (e.g. an
expansion in flight frequency, cuts in fares)
• (7) Overcoming existing customer loyalty achieved
by companies who have exploited first-mover
advantage on specific routes
The Low Cost Airline Model
• (1) Use of the Internet to reduce distribution costs
• (2) Maximise the utilisation of the aircraft assets
• (3) Direct sell only via the net
• (4) Ticketless travel
• (5) No free airline food
• (6) Use smaller airports - cheaper to fly from
• (7) One kind of aircraft: Commonality maximises
efficiency in the recruitment and training of staff
Barriers to Contestability
• Existing firms can engage in predatory behaviour
to make entry more costly
• Raising rivals’ costs
– Vertical integration means that some firms act
as component suppliers to other firms in their
industry – they have control over the supply-chain
(also known as vertical restraint)
– The use of import tariffs to increase the relative
prices of overseas output
• Reducing rival’s revenues – “bundling”
• A monopoly can use profits in one market to boost
market power in another (cross-subsidisation)
Evaluating Contestable Markets
• There are no perfectly contestable markets
• What matters is the degree of competition
• What also matters is the threat of entry of new
suppliers – but this may not be enough to affect
the behaviour of existing firms
• The absence of competition in a market over a
long period of time does not necessarily suggest a
lack of contestability
• Structural changes in costs in different industries
can change the degree of contestability
• Contestability may force existing firms away from
profit-maximising behaviour (e.g. towards salesrevenue maximisation)
Implications of contestable market theory
• The number of firms in an industry is irrelevant in
terms of economic efficiency
• Abnormal profits attract new entrants driving down
prices and ensuring economic efficiency
• All markets (excluding natural monopoly) can be
efficient so long as they are contestable
• The benefits of perfect competition can be
achieved without the need for highly restrictive
assumptions
• Shifts the emphasis of competition policy away
from number of firms to barriers to entry
• Potential competition may be more important for
economic efficiency than actual competition