In economics, a contestable market is a business theory wherein a market has few competitors but has a high threat of entry. As a result, businesses tend to be competitive. This prevents monopoly in the market and ensures the products have competitive prices and quality.
For a market to have a high threat of entry, several criteria must be met. First, new suppliers must be able to enter and exit without much cost. The sunk cost of establishing a new business should be minimal. Sunk costs are the unrecoverable expenses incurred when entering a market. In a perfectly contestable market, entry and exit would be free.
Second, all the information and technology required to produce goods of the same quality should be available to all competitors. No producer should have technological superiority. This is practically impossible to see in reality, as businesses generally try to maintain every competitive advantage they have.
Lastly, the new suppliers must be allowed market to the customers. They must have free access to the incumbent firm’s customers and advertise to them at no cost. This discourages a coercive monopoly from taking place.
A contestable market is characterized by its susceptibility to hit and run entry. When a market becomes lucrative for the incumbent firm, new suppliers suddenly enter it to gain shares in the profits. After the market is exhausted, the suppliers then leave at virtually no cost.
There are fundamental differences between contestable markets and perfect competition. In a contestable market, a producer can set prices, whereas in a perfect competition, prices are dictated by the competitors. A firm’s size is irrelevant in a contestable market. On the other hand, the sizes of the firms in a perfect competition will be relatively uniform. Furthermore, a contestable market can be comprised of just one producer, while a perfect competition must have several competitors.
One reason why contestable markets are difficult to put into practice is their profitability. An incumbent firm may set a product’s price, but new producers can exploit it. Seeing that the technology and market are accessible to all, a new producer can easily conquer the market by selling the same goods at a slightly lower price. A sole producer will always feel threatened and act as if there are always several competitors in the field. Conversely, since the firms receive the same revenue and incur the same expenses, they may decide to increase their profit margins by forming an oligopoly.