What a contestable market is

A contestable market is one where new competitors can easily join, even if there are few firms operating in it at present. This openness comes from low obstacles to starting or leaving the market, which keeps existing firms alert to possible rivals.

Key features of contestable markets

• Low barriers to entry and exit - New firms can enter quickly if existing ones earn high profits.
• Threat of potential competition - Existing firms face constant pressure from possible new entrants, especially if they make large supernormal profits, as rivals will aim to capture some of those gains.
• Impact on pricing - To avoid attracting newcomers, existing firms often keep prices at levels that limit supernormal profits.
• Potential for supernormal profits - New entrants might achieve high returns initially.

Factors that reduce contestability in markets

Contestability decreases when obstacles make it harder for new firms to enter or exit a market. High barriers protect existing firms from rivals, allowing them to maintain higher prices and profits without fear of competition.

Barriers that lower contestability

• Patents on products or processes - These provide legal safeguards, stopping others from copying inventions or methods, which keeps new firms out.
• Strong brand loyalty from advertising - Established firms build customer attachment through marketing, making it tough for newcomers to gain market share.
• Limit pricing by existing firms - Incumbents may set low prices temporarily to deter entrants, sparking a potential price war that new firms cannot afford.
• Trade restrictions - Measures like tariffs or quotas limit foreign competitors, preventing them from challenging domestic firms on equal footing.
• Vertical integration - When firms control their supply chains, new entrants struggle to access raw materials or distribution channels.
• High sunk costs - These are expenses that cannot be recovered upon exit, such as specialised machinery or advertising spends, raising the risk of failure and discouraging potential rivals.

Hit-and-run tactics in contestable markets

In markets with low entry and exit barriers, new firms can use hit-and-run tactics to exploit short-term opportunities. This involves entering to capture profits quickly and leaving before conditions worsen.

How hit-and-run tactics work

1. New firms spot supernormal profits being made by existing players.
2. They enter the market to grab a share of these profits.
3. Once prices drop to normal profit levels, the new firms exit.
4. The strategy succeeds if the profits earned exceed the costs of entering and leaving.

How contestability influences the behaviour of existing firms

The degree of contestability shapes how firms already in the market operate, as the risk of new rivals encourages strategies to protect their position and ensure long-term success.

Effects on incumbent firm strategies

• Response to competition threats - Firms avoid maximising short-term supernormal profits through high prices, knowing this could draw in rivals who would then lower prices overall.
• Focus on long-term pricing - To deter entrants, firms often accept lower short-term gains by setting competitive prices, which helps maximise profits over time.
• Efforts to raise barriers - Existing firms may invest heavily in advertising to build loyalty or signal readiness for aggressive pricing.
• Drive towards efficiency - In highly contestable markets, supernormal profits are eroded by competition, pushing firms to achieve productive efficiency and allocative efficiency, often resulting in normal profits in the long run.