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economics Economics () is the social science that studies the production, distribution, and consumption of goods and services. Economics focuses on the behaviour and interactions of economic agents and how economies work. Microeconomics anal ...
, the theory of contestable markets, associated primarily with its 1982 proponent
William J. Baumol William Jack Baumol (February 26, 1922 – May 4, 2017) was an American economist. He was a professor of economics at New York University, Academic Director of the Berkley Center for Entrepreneurship and Innovation, and Professor Emeritus at Prin ...
, held that there are markets served by a small number of firms that are nevertheless characterized by competitive equilibrium (and therefore desirable welfare outcomes) because of the existence of potential short-term entrants.Brock, 1983. p.1055.


Theory

A perfectly contestable market has three main features: # No entry or exit barriers # No
sunk costs In economics and business decision-making, a sunk cost (also known as retrospective cost) is a cost that has already been incurred and cannot be recovered. Sunk costs are contrasted with '' prospective costs'', which are future costs that may be ...
# Access to the same level of technology (to incumbent firms and new entrants) A perfectly contestable market is not possible in real life. Instead, the degree of contestability of a market is talked about. The more contestable a market is, the closer it will be to a perfectly contestable market. Some economists argue that determining price and output is actually dependent not on the type of market structure (whether it is a monopoly or perfectly competitive market) but on the threat of competition.Critic Capital LLC
"Contestable markets"
Economics Online (at www.economicsonline.co.uk).
Thus, for example, a monopoly protected by high barriers to entry (for example, it owns all the strategic resources) will make supernormal or abnormal profits with no fear of competition. However, in the same case, if it did not own the strategic resources for production, other firms could easily enter the market, which would lead to higher competition and thus lower prices. That would make the market more contestable. Sunk costs are those costs that cannot be recovered after a firm shuts down. For example, if a new firm enters the steel industry, the entrant needs to buy new machinery. If, for any reason, the new firm cannot cope with the competition of the incumbent firm, it will plan to move out of the market. However, if the new firm cannot use or transfer the new machines that it bought for the production of steel to other uses in another industry, the fixed costs on machinery become sunk costs so if there are sunk costs in the market, they impede the first assumption of no exit barriers. That market will not be contestable, and no firms would enter the steel industry. It is very important for firms to have access to the same level of technology as that helps determine the average cost of the product. An incumbent firm having more knowledge and access to a technology for the production of a commodity could enjoy higher
economies of scale In microeconomics, economies of scale are the cost advantages that enterprises obtain due to their scale of operation, and are typically measured by the amount of output produced per unit of time. A decrease in cost per unit of output enables ...
in the form of lower average cost of production. A new firm entering the market, with insufficient information or technology, could incur a higher average cost of production and so be unable to compete with the incumbent firm. That would lead to the incumbent firm enjoying monopoly power and supernormal profit in the market, as the new firm will exit the market. A solution to the problem could be governments providing equal access to knowledge and technology, as well as financial resources for the same. Its fundamental features are low
barriers to entry In theories of competition in economics, a barrier to entry, or an economic barrier to entry, is a fixed cost that must be incurred by a new entrant, regardless of production or sales activities, into a market that incumbents do not have or ha ...
and exit; in theory, a perfectly contestable market would have no barriers to entry or exit ("frictionless reversible entry" in economist William Brock's terms). Contestable markets are characterized by "hit and run" competition; if a
firm A company, abbreviated as co., is a legal entity representing an association of people, whether natural, legal or a mixture of both, with a specific objective. Company members share a common purpose and unite to achieve specific, declared ...
in a contestable market raises its prices so as to begin to earn excess profits, potential rivals will enter the market, hoping to exploit the high price for easy profit. When the original incumbent firm(s) respond by returning prices to levels consistent with normal profits, the new firms will exit. Because of that, even a single-firm market can show highly competitive behavior. A concise theoretical statement of contestable markets with an illustrative graph is at Economics Online.


Application

The theory of contestable markets has been used to argue for weaker application of
antitrust laws Competition law is the field of law that promotes or seeks to maintain market competition by regulating anti-competitive conduct by companies. Competition law is implemented through public and private enforcement. It is also known as antitrust ...
, as simply observing a monopoly market may not prove that a firm is exploiting its
market power In economics, market power refers to the ability of a firm to influence the price at which it sells a product or service by manipulating either the supply or demand of the product or service to increase economic profit. In other words, market powe ...
to control the price level. Baumol himself argued based on the theory for both deregulation in certain industries and for more regulation in others. The applicability of the theory to real-world situations may be questioned, however, particularly as there are very few markets which are completely free of
sunk costs In economics and business decision-making, a sunk cost (also known as retrospective cost) is a cost that has already been incurred and cannot be recovered. Sunk costs are contrasted with '' prospective costs'', which are future costs that may be ...
and entry and exit barriers.Brock, 1983. p. 1057. "Some readers may feel that perfect contestability is an idealized notion of purely academic interest..." Low-cost airlines remain a commonly referenced example of a contestable market; entrants have the possibility of leasing aircraft and should be able to respond to high profits by quickly entering and exiting. However, it is now generally admitted that Baumol's judgment that the US airline industry was therefore best left deregulated was incorrect since the now duly deregulated industry is "well on its way" to evolving into a concentrated
oligopoly An oligopoly (from Greek ὀλίγος, ''oligos'' "few" and πωλεῖν, ''polein'' "to sell") is a market structure in which a market or industry is dominated by a small number of large sellers or producers. Oligopolies often result f ...
.Martin, 2000. p. 43. More generally, experimental evidence collected since the publication of Baumol's paper has suggested that perfectly competitive markets would, if they existed, behave in the way Baumol outlined, but the performance of imperfectly contestable markets (i.e. real-world markets) depends "on actual rather than potential competition" perhaps in part due to the range of "strategic responses" available to incumbents that were not considered by Baumol as part of his theory.


See also

*
Bertrand–Edgeworth model In microeconomics, the Bertrand–Edgeworth model of price-setting oligopoly looks at what happens when there is a homogeneous product (i.e. consumers want to buy from the cheapest seller) where there is a limit to the output of firms which are wil ...
*
Coercive monopoly In economics and business ethics, a coercive monopoly is a firm that is able to raise prices and make production decisions without the risk that competition will arise to draw away their customers. Greenspan, Alan''Antitrust'', in ''Capitalism:The ...
*
Monopolistic competition Monopolistic competition is a type of imperfect competition such that there are many producers competing against each other, but selling products that are differentiated from one another (e.g. by branding or quality) and hence are not perfec ...
*
Perfect competition In economics, specifically general equilibrium theory, a perfect market, also known as an atomistic market, is defined by several idealizing conditions, collectively called perfect competition, or atomistic competition. In theoretical models whe ...


Notes


References

*
William J. Baumol William Jack Baumol (February 26, 1922 – May 4, 2017) was an American economist. He was a professor of economics at New York University, Academic Director of the Berkley Center for Entrepreneurship and Innovation, and Professor Emeritus at Prin ...
, John C. Panzar, & Robert D. Willig (1982). ''Contestable Markets and the Theory of Industry Structure''. * William A. Brock (1983).
Contestable Markets and the Theory of Industry Structure: A Review Article
. ''The Journal of Political Economy'', v. 91, no. 6, pp. 1055–1066. * John C. Panzar (1987). "Competition and efficiency," ''The New Palgrave: A Dictionary of Economics'', v. 1, pp. 543–44. * George J. Stigler (1987). "Competition," ''The New Palgrave: A Dictionary of Economics'', v. 1, pp. 531–46.
''Antitrust'' by Alan Greenspan
(arguing against the existence of anti-trust laws based on theory that government is solely responsible for coercive monopoly) * Stephen Martin (2000).
The Theory of Contestable Markets
'. *Essentials of Economics, John Sloman (3rd edition) {{ISBN, 0-273-68382-9 Monopoly (economics) Market (economics)