• Firms in contestable markets face real and potential competition
• The threat of “hit and run entry” from new rivals may be sufficient to keep the industry operating at a competitive price and output
• The key requirement for a contestable market is the absence of sunk costs
• A perfectly contestable market occurs only when entry and exit into is perfectly costless

Perfectly Contestable Markets & Perfectly
Competitive Markets
• Different from perfect competitive markets
• In a perfectly contestable market it is still possible for one or a few firms to dominate the industry
• Each existing firm in the market produces a differentiated product
• There are 3 conditions for market contestability
– The ability to use the best available technology
– Legal freedom to enter a market
– The relative absence of sunk costs / exit costs

• Sunk costs are those costs which are irrecoverable to the owners of the firm should it decide (a) to close down or (b) leave the market
• A sunk cost is a past expense or loss that cannot be altered by current or future actions
• Sunk costs represent a barrier to entry in an industry because they scare potential entrants from entering

• Hit and run entry
– Short run entry into a contestable market seeking to take some of the monopoly profits available and then get out quickly
– Possible when the entry and exit costs are low
• Cream-skimming
– This strategy involves finding segments of the market that are high in value added (or high profit margins) and exploiting those markets by selling only to the most profitable parts of the business
– E.g. business post rather than household mail

• Main approaches
– De-regulation - I.e. reducing statutory barriers to entry to liberalise a market
– Tougher competition laws acting against predatory behaviour by existing firms / tough rules against cartels
– The changing nature of technology – which has brought down entry costs in some markets ( an increase in capital mobility )

Examples of increased contestability in UK markets
– Free newspapers
– New entrants into the broadband market
– Radio stations in the digital age
– Low cost domestic airlines
– Cross channel transport
– Domestic Retail Clothing Industry - (Matalan,
TK Max and Primark)
– Telecommunications
• Voice over internet
• New entrants into fixed line market

Deregulation of markets – increased contestability
From postal services, to telecommunications and the suppliers of your electricity and gas, many markets have become more contestable in recent years
This affects the conduct and behaviour of rival firms within each market

• (1) Availability of take-off and landing 'slots'
• (2) Necessity of entering a new route on a large enough scale to achieve acceptable cost levels
• (3) The costs of leasing new fleets of aircraft
• (4) Securing an air operator’s licence from the EU
• (5) Contracts with ground-handling companies
• (6) Retaliatory behaviour by rivals (e.g. an expansion in flight frequency, cuts in fares)
• (7) Overcoming existing customer loyalty achieved by companies who have exploited first-mover advantage on specific routes

• (1) Use of the Internet to reduce distribution costs
• (2) Maximise the utilisation of the aircraft assets
• (3) Direct sell only via the net
• (4) Ticketless travel
• (5) No free airline food
• (6) Use smaller airports - cheaper to fly from
• (7) One kind of aircraft: Commonality maximises efficiency in the recruitment and training of staff

• Existing firms can engage in predatory behaviour to make entry more costly
• Raising rivals’ costs
– Vertical integration means that some firms act as component suppliers to other firms in their industry – they have control over the supply-chain
(also known as vertical restraint)
– The use of import tariffs to increase the relative prices of overseas output
• Reducing rival’s revenues – “bundling”
• A monopoly can use profits in one market to boost market power in another ( cross-subsidisation )

• There are no perfectly contestable markets
• What matters is the degree of competition
• What also matters is the threat of entry of new suppliers – but this may not be enough to affect the behaviour of existing firms
• The absence of competition in a market over a long period of time does not necessarily suggest a lack of contestability
• Structural changes in costs in different industries can change the degree of contestability
• Contestability may force existing firms away from profit-maximising behaviour (e.g. towards salesrevenue maximisation)

• The number of firms in an industry is irrelevant in terms of economic efficiency
• Abnormal profits attract new entrants driving down prices and ensuring economic efficiency
• All markets (excluding natural monopoly) can be efficient so long as they are contestable
• The benefits of perfect competition can be achieved without the need for highly restrictive assumptions
• Shifts the emphasis of competition policy away from number of firms to barriers to entry
• Potential competition may be more important for economic efficiency than actual competition