a market with low barriers to entry and exit.
By Chris Rodda
In recent years the term contestable markets
has been used by Baumol, Panzer and Willig. A contestable
market requires barriers to entry to be low, and a perfectly
contestable market requires a total absence of barriers
to entry. Barriers to entry for example being, special licences,
patents, copyrights, high fixed costs, marketing barriers
(legal and illegal) constructed by incumbent firms.
A monopoly or firms in oligopoly may not behave
as neo-classical economic theories of the firm predict because
they may be fearful of new entrants to the market. If super-normal
profits are earned potential competitors may enter the market,
so it is argued that the existing firm(s) will keep prices
and output at a level where only normal profits are made.
In some cases potential competitors may engage in hit-and-run
behaviour. A hit-and-run competitor will notice when super-normal
profit is being made, enter the market and take advantage
of the situation. As prices settle down once more the hit-and-run
competitor exits the market again. Thus the incumbent firms
become wary of the potential competitor and set prices so
that hit-and-run competitors are discouraged.
Attention is now focused on the costs of exit
from a market. For hit-and-run competition to be a threat,
not only must the costs of entry to the market be low, the
costs of exit need to be low too. The costs of exit are
sometimes called ‘sunk costs’. These are costs
that cannot be recovered when the firm leaves the market.
For example a high street shop can be sold easily to another
retailer, its stock can be sold off at cost price, and even
some of the shop fittings may be sold off. However, some
things might not be sold off, for example shop signs and
changing room curtains, maybe some stock will have to be
sold at less than cost price. Nevertheless the sunk costs
are not too high.
However, with some businesses the sunk costs
are a large percentage of the business costs. Creating a
brand name or corporate image can be hugely expensive. Advertising
costs are often a significant part of a company’s
total costs for products such as cigarettes, perfume, soap
powder and the like. Leaving the market means that all the
money spent creating the brand may be lost – although
even brand names can be sold. The costs of car production
involve very high fixed costs in terms of machinery, design,
staff training, advertising etc. so that sunk costs are
high and this will discourage companies from entering the
market unless they are planning to stay for the longer term.
Thus a contestable market requires both low entry and exit
barriers. But an established company does not have to leave
the market entirely, it can leave part of the market. A
high street multiple can close one shop in its chain in
one town without closing the whole chain. A motor manufacturer
might retreat from a country or a continent without closing
down in the rest of the world.
The theory of contestable markets has been used as a defence
for companies with established monopolies. Microsoft have
argued that they might have a monopoly of supplying operating
systems but because the costs of entry are so low (a PC
is all that is required!) that the software business is
contestable. One result of this thinking is in anti-monopoly
legislation which has undergone a change of emphasis from
‘is there a monopoly?’ to ‘is there a
Baumol W J, Panzer J and Willig R D, (1986)
Contestable Markets and the Theory of Industrial Structure,
Harcourt Brace and Jovanovitch.