Contestible Market Theory

Developed in the last 50 years and favoured by supply side economists. It explains that economic growth and market competition can rise merely by taking away the barriers to entry that exist in most markets, to improve supply conditions, rather than demand such as changing the propensity to consume for example.

What is A Contestible Market?

Defined as one with low sunk costs, entreprenuers find it easier to enter becuase less of an initial capital investment is required and there is less risk of losing a significant part of it if they wish to exit in future.

Sunk Costs are those which cannot be recovered if the firm decides to exit the market. Includes advertising costs, research and development, consultancy and legal fees, wages and patenting costs.

How can a Contestible Market Improve Welfare

Contestible markets can be concentrated, but remain efficient due to the threat of competition rather than the current level of it. For instance, a duopoly cannot enter a price cartel agreement due to the likelihood that entrants will undercut their price until they stop.

Efficiency: Firms tend to being productively and allocatively efficient, whilst being dynamically efficient also as they are still able to obtain abnormal profit to reinvest in product development. They are kept on their toes and only the one’s which keep a good product and reasonable prices remain.

For this reason, the theory recemmends to keep dominant firms as they are so long as the market is contestible. In this way, the benefits of ‘monopoly’ such as economies of scale can be realised without the disadvantages such as satisficing and price hikes.

Reducing Barriers To Entry in a concentrated market can result in this. Time should be put toward technology developments to reduce barriers rather than excess regulation, which itself is a barrier. The internet is an example of tecnhology making a contestible market, with firms such as Google earn great profit but kept on their toes.

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