The Theory of Contestable Markets
The Theory of Contestable Markets
• Potential competition or monopoly
In recent years, economists have developed the theory of contestable markets. This theory argues that what is crucial in determining price and output is not whether an industry is actually a monopoly or competitive, but whether there is the real threat of competition. If a monopoly is protected by high barriers to entry – say that it owns all the raw materials – then it will be able to make supernormal profits with no fear of competition.
If, however, another firm could take over from it with little difficulty, it will behave much more like a competitive firm. The threat of competition has a similar effect to actual competition.
• The importance of costless exit
Setting up in a new business usually involves large expenditures on plant and machinery. Once this money has been spent, it becomes fixed costs. If these fixed costs are no higher than those of the existing firm, then the new firm could win the battle. But, of course, there is always the risk that it might lose. But does losing the battle really matter? Can the firm not simply move to another market? It does matter if there are substantial costs of exit. This will be the case if the capital equipment cannot be transferred to other uses (e.g. a power station).
In this case, these fixed costs are known as sunk costs. The losing firm is left with capital equipment that it cannot use. The firm may therefore be put off entering in the first place. The market is not perfectly contestable, and the established firm can make supernormal profit. If, however, the capital equipment can be transferred, the exit costs will be zero (or at least very low), and new firms will be more willing to take the risks of entry.
For example, a rival coach company may open up a service on a route previously operated by only one company, and where there is still only room for one operator. If the new firm loses the resulting battle, it can still
• Potential competition or monopoly
In recent years, economists have developed the theory of contestable markets. This theory argues that what is crucial in determining price and output is not whether an industry is actually a monopoly or competitive, but whether there is the real threat of competition. If a monopoly is protected by high barriers to entry – say that it owns all the raw materials – then it will be able to make supernormal profits with no fear of competition.
If, however, another firm could take over from it with little difficulty, it will behave much more like a competitive firm. The threat of competition has a similar effect to actual competition.
• The importance of costless exit
Setting up in a new business usually involves large expenditures on plant and machinery. Once this money has been spent, it becomes fixed costs. If these fixed costs are no higher than those of the existing firm, then the new firm could win the battle. But, of course, there is always the risk that it might lose. But does losing the battle really matter? Can the firm not simply move to another market? It does matter if there are substantial costs of exit. This will be the case if the capital equipment cannot be transferred to other uses (e.g. a power station).
In this case, these fixed costs are known as sunk costs. The losing firm is left with capital equipment that it cannot use. The firm may therefore be put off entering in the first place. The market is not perfectly contestable, and the established firm can make supernormal profit. If, however, the capital equipment can be transferred, the exit costs will be zero (or at least very low), and new firms will be more willing to take the risks of entry.
For example, a rival coach company may open up a service on a route previously operated by only one company, and where there is still only room for one operator. If the new firm loses the resulting battle, it can still
References: http://classof1.com/homework-help/economics-homework-help/