Contestable Market Theory
What Is Contestable Market Theory?
The contestable market theory is an economic concept expressing that companies with not many rivals act in a competitive way when the market they operate in has weak barriers to entry. The theory expects that even in a monopoly or oligopoly, incumbents will act competitively when there is a lack of barriers, for example, government regulation and high entry costs, giving their best for prevent new contestants from one day shutting them of down.
How Contestable Market Theory Works
Contestable in economics means that a company can be tested or challenged by rival companies hoping to enter the industry or market. All in all, a contestable market is a market where companies can enter and leave openly with low sunk costs.
As per contestable market theory, when access to technology is equivalent and barriers to entry are weak, low, or non-existent, there is a consistent threat that new contenders will enter the marketplace and challenge the existing, deep rooted companies.
The continuous risk of contestability burdens the companies that as of now operate in the space, keeping them on their toes and impacting how they conduct business. Such an environment generally holds prices low and prevents imposing business models back from shaping.
Characteristics of a contestable market include:
- There are no barriers to entry or exit barriers
- There are no sunk costs: costs that have proactively been incurred and can't be recuperated
- Both incumbent companies and new participants approach a similar level of technology
Contestable Market Theory Methods
In a contestable market, contestants could execute a quick in and out strategy. The new participants can "hit" the market, given there are no or low barriers to entry, make profits, and afterward "run," without causing any exit costs.
These types of risks play on the minds of the executive management groups inside the industry, leading them to change their business strategies and incline toward sales maximization instead of profit maximization. As per the theory, limitless profits would be pushed down to normal profits in a really contestable market.
Therefore, even a monopoly may be forced to operate competitively on the off chance that barriers to entry are weak. Those operating a monopoly could presume that assuming that they're too profitable, a contender could undoubtedly enter the market, challenge their business, and undercut their profits.
The key principle of a contestable market is that there exists a believable threat to existing companies with next to zero obstructions for new contestants.
History of Contestable Market Theory
The contestable market theory was acquainted with the world by economist William J. Baumol in 1982, through his book: Contestable Markets and the Theory of Industrial Structure. Baumol contended that contestable markets generally yield competitive equilibrium due to the continuous threat of new contestants.
Limitations of Contestable Market Theory
The necessities for an entirely contestable market are rare. It is rarely simple for an upstart to enter one more company's turf and promptly end up on a level playing field.
Costs to enter and exit a market are rarely negligible, while factors, for example, economies of scale quite often reward companies that have been around for longer.
Special Considerations
Parts of contestable market theory vigorously impact the perspectives and methods of government regulators. That is on the grounds that opening up a market to potential new participants might be adequate to support efficiency and put enemy of competitive behavior down.
For instance, regulators might force existing companies to open-up their infrastructure to possible contestants or to share technology. This approach of expanding contestability is common in the communications industries, where incumbents are probably going to have critical power or control over the network and infrastructure.
Highlights
- The continuous risk of new participants emerging and taking market share drives incumbents to zero in additional on augmenting sales as opposed to profits.
- The contestable market theory states that companies with not many rivals act in a competitive way when the market they operate in has weak barriers to entry.
- That's what they understand assuming they are too profitable, a participant could without much of a stretch come and undercut their business.
