contestable market theory

8/6/2019 Contestable Market Theory

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Contestable Market Theory

(An Overview)by

Robert R. Ebert. Ph.D.

Professor of Economics

Baldwin-Wallace College

Copyright 2003 Robert R. Ebert


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Contestable Markets The Questions:

How much rivalry exists in markets?

Is the number of firms in a market a good measure ofindustry rivalry?

Contestable Market Theory:

Suggests that under certain conditions, markets with

just a few firms can yield results with the sameeconomic welfare effects as perfect competition

i.e., rivals in the markets can attain both productive and

allocative efficiency.


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General Micro Theory

Assumption Standard models of imperfect competition

(monopoly, oligopoly, monopolistic

competition)

Competition is limited and impeded

Entry is limited

Firms are price makers Firms have some degree of market power


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Perfectly Contestable MarketsA market which achieves an equilibrium

that protects it from entry of new firms

Prices must be set at P = MC

Does not depend on number of firms in the

industry

Key factor is firms price in such a way as toward off entry


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Perfectly Contestable Markets

(conditions necessary for)

Entry is absolutely free and exit is costless Does not mean there is no expense at entry

Does mean a new entrant suffers no

disadvantage in terms of productive technique

or product quality relative to established firm


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(conditions necessary for, contd.) Potential entrants evaluate profitability

in terms of established firms pre-entry

prices Freedom of exit means firms can leave

without impediment

In the process of departure, can recoupany costs incurred in the entry process For example, all capital is salable or reusable

without loss other than costs associated withnormal use and depreciation

Thus, any risk of entry is eliminated


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The Critical Feature

Critical Feature is vulnerability to hit-

and-run entry

Even a transient profit would not be

neglected by a potential entrant

A new entrant could go in, and beforeprices change, collect gains and then exit

the market without cost before the climate

turns hostile


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(PCM)

and Economic Welfare

A PCM never offers more than a normal rate of

profit Because of hit-and-run entry, economic profits must

be zero, even if it is an oligopoly or monopoly

Any positive profit means a transient entrant can set up

business and undercut the established firms price and stillearn a profit

There is an absence of inefficiency in a PCM

Any unnecessary cost constitutes an invitation to

entry


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(PCM)

and Economic Welfare (contd.)

Predatory pricing not possible i.e. price cannot be below MC

If P < MC; invites entry

New entrant sells less but at a lower price


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Perfectly Contestable Markets (PCM)

and Economic Welfare

P > MC (like at PE) not

possible;

New entrants compete themarket away

P < MC irrational

New entrant lowers price and takes part of market

Operates at Qz where P' = MR = MC

Existing firm retaliates and lowers price to below P'

Price war drives firm out

AC

D

MC

MR

PE

P'

P < MC

QE

QZ

QY

. ... D


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Policy Implications

Number of firms in the industry is not a good

measure of either market power or competition Deviations from classical competitive norm need

not prevent invisible hand from working if hit-

and-run entry exists

Absence of entry may be a virtue, not a vice if P = MC (allocative efficiency)

if productive efficiency achieved


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Policy Implications

Policy should aim to reduce entry costs to

stimulate potential competition Government tax incentives/subsidies to bear

sunk costs Government actually operate certain facilities (ex.

airports) Rapid depreciation and tax benefits for new

investment in tooling

contestable market theory

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