Theory of Contestability
The economic theory of contestability describes the conditions under which a monopoly will operate at the socially optimal point. This is where the firm only earns normal profit meaning they only earn enough to cover variable, startup, and opportunity costs. The theory describes three conditions for this:
- Zero barriers to entry
- The time to start up a new entrant is lower than the time for the incumbent firm to enter
- Zero barriers to exit
If these conditions are met, the theory states that existing firms will keep prices low to deter new competitors from appearing in the market. A market that meets these conditions is said to be contestable. This usually applies to small, localized markets
However, it has been argued that the conditions described in the theory are idealistic and therefore non-existent. Zero barriers to entry and exit will never exist due to the opportunity cost and conversion cost of any factors of production involved.
Additionally, it can be said that the notion of zero barriers to entry is incompatible with price inflexibility. Generally the smaller the entry cost, the greater the market flexibility. For example, if barriers to entry are low, acquisition of a customer base is cheap and therefore alienation of customers is not a significant risk when switching prices.
Because of credit and other forms of private sector fundraising, barriers to entry need not be zero for new entrants to the market. Similarly, the opportunity for super-normal profit in new entrants negates the need for zero exit costs.
Expanding on the initial theory, necessities for a contestable market can be derived from analyzing the incentives of potential entrants into the market. We then assume, that if it is in an agent’s best interest to enter the market they will do so. As long as the incumbent firm is operating below the maximum efficient scale, they will attempt to prevent new entrants by keeping prices low despite of the monopoly they hold.
Through this anylisis, one way to illustrate the conditions required for a contestable market is the following equation:
Key variables:
- Captureable sales
- Optimal average revenue
- Average variable cost
- Unrecoverable startup cost
Capturable sales are a function of time returning sales frequency. It will start high as the entrant’s price point undercuts the incumbent. As the incumbent lowers the price to a competitive point, the capturable sales tend to zero as the new firm likely has higher operating costs out of inexperience. This is the exit point.
The optimal average revenue is the price that the new entrant sets to increase their own profit.
The average variable cost is the cost faced by the new entrant. It is likely higher than that of the incumbent due to a smaller sales volume and less experience in the market.
The unrecoverable startup cost is the sunk cost of the new entrant: costs that cannot be recovered upon exist
This shows a more complete picture of the conditions where firms must act competitively. The most important factor here is unrecoverable startup costs. This is the clearest identifier of uncontestable markets. For example, railroads are infamously uncompetitive; the primary reason for this is the immense cost of building railroads which cannot be recovered upon exit. Alternatively, for shoe stores, the unrecoverable startup cost is a store lease and leftover inventory, indicating a contestable market.
Applying this analysis over the conventional analysis, we can identify more contestable markets, particularly markets with large capital costs but diseconomies of scale which would not have been identified under the old criteria.
