Contestable Market
The Secret Door: No Barriers to Entry or Exit
Imagine a lemonade stand. If you want to start one, you just need a table, lemons, and a pitcher. It's easy to set up. If you decide to stop, you can just pack up your things. There's no huge cost to enter or leave. In economics, a market with these characteristics is called contestable. The main idea is that the door to the market is always open, and there is no trap door to prevent you from leaving. This easy entry and exit is the most important feature.
Barriers like government licenses, patents, or the need for very expensive machinery would make a market not contestable. But when barriers are low, even a monopoly (a single seller) must behave well. They have to keep prices fair and offer good service, because if they don't, a new company could quickly jump in, take their customers, and then leave just as fast. This is known as hit-and-run competition.
Real-World Stage: Airlines and the Threat of New Planes
A great example of a contestable market is the airline industry for a specific route, like flying between two big cities that are not hubs for a major airline. The cost to enter is renting a plane and hiring a crew. The cost to exit is low because you can just fly the plane somewhere else. If the only airline on that route starts charging very high ticket prices, a rival airline can quickly start flying the same route, offer lower prices, and capture the business. When the first airline lowers its prices again, the rival can simply leave the route and move its plane to a different market. This constant potential for new competition keeps the existing airline honest.
Think about it like a popular video game server. If the server admin starts charging too much for a special item, players might go start their own server (easy entry). If the new server doesn't work out, they can just shut it down and go back to the old one (easy exit). The threat of players leaving is what keeps the original admin from being unfair.
Quick View: Market Types vs. Contestability
| Market Feature | Perfect Competition | Contestable Market | Pure Monopoly |
|---|---|---|---|
| Number of Firms | Many | Can be few or one | One |
| Barriers to Entry | None | None or very low | High |
| Power over Price | None (price taker) | Limited by potential entry | Significant |
Important Questions
A: No, they are different. A perfectly competitive market requires many small sellers. A contestable market can have only one or two sellers. The key difference is that contestability focuses on the threat of new competition, while perfect competition focuses on the actual presence of many competitors.
A: A great example is the market for tap water in a city. Building the pipes and water treatment plants requires a massive investment (high barrier to entry). A new company cannot easily start delivering water, and they couldn't easily take their pipes with them if they left (high exit cost). This makes it incontestable.
A: We can think of it this way: If $P$ is the price and $MC$ is the marginal cost, in a contestable market with a monopoly, the price will be forced down toward the cost of production. This means $P = AC$ (average cost) and the firm makes zero economic profit, just like in perfect competition. The threat of entry is what keeps prices low.
Footnote
[1] Hit-and-run competition: A situation where a new firm enters a market, makes quick profits by undercutting existing firms, and then exits easily before the established firms can lower their prices to compete.
[2] Sunk Cost: A cost that has already been incurred and cannot be recovered. In contestable markets, sunk costs are very low, which makes exit easy.
[3] Perfect Information: An assumption in the theory that new firms have all the knowledge they need about the market's technology and prices to decide if they should enter.