Introduction to contestable markets

PPRINCIPLES OF MICROECONOMICS- LECTURE 11 BY V.POLODOO
LECTURE 11: CONTESTABLE MARKETS.
A contestable market is a type of market in which the existing firm or firms have market
power and are subject to the possibility of hit and run entry by new firms. William
Baumol of New York University and John Panzar of Bell Laboratories were the first
economists to describe this type of market.
In the recent decades, the role played by entry has taken on something of a new form in
the context of what are known contestable markets. This shares some of the
characteristics of perfect competition but can be applied across the entire spectrum of
industry structures through oligopoly to monopoly.
Characteristics/Features
(i) Absence of significant barriers to entry
This is the principal feature of a contestable market. The short run is extremely short- so
short in fact, that hit and run entry becomes a possibility. If investors see that an
industry is profitable , they can enter, take a share of the profits and exit before the
existing firms have a chance to react. Under these conditions, price is driven to average
cost even if the industry consists of a single firm. Baumol and Panzar named these
markets contestable rather than competitive because of the zero profit result does not
depend on having a large number of firms.
2. Number and size of firms are irrelevant.
A contestable market can be a monopolist, an oligopolistic market or may consist of any
number of either small or large firms. In a contestable market the size and the number of
firms is completely irrelevant.
3. Consumer benefits
The threat that new firms would enter oblige oligopolists and monopolist to offer
consumers the benefits that they would have derived in a competitive markets.
4. Abolition of cross subsidisation.
Since firms will not make normal profits if they sell below costs, cross subsidies are
abolished.
5. Irrespective of the size of firms, government regulations and control are the same.