The Theory of the Contestable Market

The theory of contestable markets, along with the static and dynamic views of competition, are used as theories to analyse how markets perform. The static view focuses on the structure of the market as the determining factor of competition, with the dynamic view focusing on dynamic aspects such as technology and entrepreneurship. The contestable markets theory has a different focus, focusing on the importance of barriers to entry and exit. Nonetheless it does incorporate features from both views.
More importantly it shifts the focus and provides new insight into the workings of competition. The two differing views of competition will be examined, followed by an examination of the contestable market theory, concluding with an analysis of the degree to which there is synthesis. Static view of competition The static view of competition focuses on the market structure as the key determining factor in the performance and behaviour of firms. It is the neoclassical approach of competition, origination from the work of economist’s Cournot and Edgeworth.
This traditional view sees market structure as rigidly determining firm’s conduct (its output decisions and pricing behaviour), which yields an industry’s overall performance, such as its efficiency and profitability. Firms limit their behaviour to a certain industry model or strategic logic that is built on frequent price cuts, in order to out-compete rivals and deter entry. An industry is considered competitive depending on its market structure. At one extreme is perfect competition, which is considered perfectly competitive. At the other extreme is a monopoly structure, with a sole producer, characterised by low competition.

In between the spectrum is an oligopolistic structure, and a monopolistic structure. These structures embody less competition than in perfect competition, but more than in a monopoly situation. The characteristics of competitive markets are thus large number of firms, or in other words a low concentration ratio. The number of firms is determined by the market demand and the output level set at that which minimises average cost. As the number of firms that enter the industry increases, firms become price takers rather than price makers, and they are forced to apply the price that is set in order to survive in the market.
They thus receive normal profits, as opposed to abnormal profits when the market structure was more concentrated (please refer to figure 1 below). Fig 1 Thus the organisation of industries is considered to be generated exogenously. Therefore the market concentration decides the nature of competition within each market. The static view of competition thus concentrates on the structural characteristics of competition, with a ‘structure-conduct-performance’ based paradigm, in which market structure decided conduct of firms, deciding their performance.
The static competition approach excludes non-price competition, such as quality and product differentiation, and strategic behaviour which does occur. This view of competition has been criticised for ignoring the more dynamic methodology of competition, which will now be analysed. Due to the importance of market share in the static view of competition, the resultant policy implication calls for regulation of markets, in order to ensure low marker concentration, in order to move towards perfect competition, and its associated benefits. (Schwartz 1986). Dynamic view of competition
The dynamic view of competition revolves around the role of the entrepreneur and firms using innovation to compete with their rivals. The neo-Austrian school of thought, in particular, Schumpeter, and those economists influenced by it have been redefining the concept along classical lines, although with a much greater emphasis on the entrepreneurial role, the role of discovery, and rivalrous competition. Performance in industries is argued to be characterized by dynamic competition, expressed through innovation and variation rather than through efficiency and price reductions, which is the case in the static approach.
This view portrays competition as a process of change and evolution rather than a static state in which equilibrium will be reached. Hayek, a main architect of this approach, defines competition as a dynamic behavioural activity. Central to this activity is knowledge, how it is acquired and communicated through the economy. He criticises the neoclassical assumption of perfect knowledge, with the view that costs are not a given, and so not exogenous. Competition is a process of interaction with the environment, in which innovation, such as new methods of production and new products, are a response to the unique situation of the economy.
It results in the optimal use of resources. (Auerbach 1988) Alchian believes that there is a natural selection process which results in a competitive outcome. Such competition depends not only on the physical possibilities but also the abilities and attitudes of participants, the entrepreneurs and consumers. It therefore argues for property rights, as to increase the level of competition, forcing companies to undergo research and development and to innovate, in order to survive.
For competition to be improved and sustained there needs to be a genuine desire on behalf of entrepreneurs to engage in competitive behaviour, to innovate and to invent to drive markets forward and create what Schumpeter famously called the “gales of creative destruction”. (Vickers, 1995, pp15). In the classic dynamic view, it argues that there is a tendency for rates of return to equalise, due to profit seeking behaviour, and the movement of capital from low profit areas to that of higher profit areas. However equilibrium may never be reached.
Before the tendency for equalisation, the economy may have changed, such as the structure of demand, or the available technology, and products may have evolved. The general criticism of the dynamic view of competition is that is lacks the simplicity and decisiveness than the static view of competition. The policy implications of the dynamic view of competition is less concerned with regulation of markets, instead encouraging property rights in order to allow firms to benefit from their own research and development, allowing for technological advancement, and the ensuing competition.
Theory of the contestable market The theory of contestable markets describes how competition will exist in any market if there are no barriers to entry and exit, as firms will be forced to act competitively in fear of new firms entering the market. The contestable markets approach to competition represents an alternative to the neo-classical theory of the firm. It came to prominence in the early 1980s, largely through the work of the American economist Baumol. The threat posed by the possibility of new firms entering the market is taken to be a key determinant of the behaviour of existing firms.
Accordingly, barriers to entry and exit play a crucial role. Its fundamental feature is low barriers to entry and exit; a perfectly contestable market would have no barriers to entry or exit. This means no sunk costs. Sunk costs will be low where the firm can sell or in other ways dispose of its capital equipment without cost. For example, a new airline might lease aircraft rather than purchase them and can then leave the industry at the end of the lease period without the costs of having to sell its aircraft.
Contestable markets are characterized by ‘hit and run’ entry, whereby if a firm in a market with no entry or exit barriers raises its prices above average cost and begins to earn abnormal profits, potential rivals will enter the market to take advantage of these profits. When the incumbent firms respond by returning prices to levels consistent with normal profits the new firms will exit. In this manner even a monopoly market can show highly competitive behaviour (such as in perfect competition), as it fears potential competition.
Such optimal behaviour applies to the full range of industry structures. Natural monopolies are of course not included in such a theory, as by its nature barriers to entry and exit exist. In this view of competition, the direction of causation between the market structure and competition is reversed from that of the static view. The theory of contestable markets sees contestability as influencing the performance and conduct of firms, and thus deciding on the resultant market structure.
Perfect contestability would lead to firms earning normal profit, embodying cost-minimisation behaviour, resulting in a cost-minimisation structure (P=MC= AC), whatever the actual form of the market structure. Thus, the market structure is determined by the price and output decisions, or the behaviour, of firms. In a perfectly contestable market, there would exist profit equalisation across firms and industries, such as in perfect competition, even under market imperfections, such as a concentrated structure. Under a contestable market there would be maximisation of consumer welfare due to cost and price minimising.
Contestable markets would also result in optimal firm sizes (economies of scale), product-mix (economies of scope) and industrial organisation (dynamic efficiency). Compared to the static view of competition, the contestable market views is not so much competition within the market, but competition for the market. Attention has been shifted away from actual competition to potential competition. Critics of this theory includes the argument that perfectly contestable markets are rare, and thus should only be applied to specific cases.
It is true that perfect contestability is an extreme, and should be viewed as a benchmark rather than the norm, but the same applies to perfect competition in the static view of competition. (Schwartz 1986). More empirical research is needed on the extent of free entry and exit. Criticism has also been placed upon the reaction time of incumbents as new firms enter the market, which is also a hotly debated subject. Contradicting assumptions of ultra-free entry and the response of firms is another criticised aspect of the theory. (Shepherd, 1984, pp585)
In terms of policy implications, the theory suggests that competition policy should be as much concerned with the levels of barriers to entry and exit in a market as with existing levels of competition. Synthesis? There is much debate as to whether contestable market theory is a synthesis of the static and dynamic views of competition. Some observers comment that the theory may even be an uprising from the traditional theories (Baumol, 1982), and to the other extreme where it is a mere extension of the traditional theories of competition.
The theory of contestable markets incorporates important concepts from the static view of competition. The relationship between market structure and competition is a major factor in contestable market theory as it is in the static view, however in the former, as stated earlier, the causation is reversed. So the relationship is still key, albeit with market structure being dependent upon its firm’s behaviour. Furthermore, barriers to entry and exit, which are important in the static view in terms of its negative effects in allowing incumbents to earn economic rent, are of prime importance in the new theory.
Although the new theory turns it on its head and focuses on the positive effects of removing barriers, and the resultant competition that comes with it. Barriers are thus significant market determinants. Thus for some contestable market theory provides a static equilibrium theory of industry structure which is generally more applicable than before. The theory also points towards some dynamic interpretation of markets. Firms are able to enter on an ongoing basis, constraining market behaviour of incumbents.
The degree of contestability of a market can change over time with technology, regulatory breakdown, or changes in other barriers altering the entry and exit conditions. An incumbent pricing optimally can protect them self against new entrants using the same technology, but can’t protect against innovation or technological advancements. Furthermore, the threat of competition should lead to a faster rate of technological diffusion, as firms have to be particularly responsive to the changing needs of consumers. Thus dynamic aspects of competition are also important in the new theory.
Baumol et al have argued the contestable theory as a new general system to replace the original static and dynamic views of competition. However their analysis should only be treated as a specialised, extreme set of conditions, which are unlikely to be found in reality, due to rigid assumptions of contestability theory. Some have even argued that little has been added to the pre-existing entry and exit analysis. (Shepherd, 1984). Conclusion Contestable market theory is an attempt to impose a dynamic mechanism upon a static equilibrium analysis, thus providing new and valuable insights into competition theory.
It offers a host of new analytical methods, new tasks for empirical research, and new results. It allows the reconsideration of the domain of the invisible hand, yields contributions to the theory of oligopoly, provides a standard for policy that is far broader and more widely applicable than that of perfect competition, and leads to a theory that analyses the determination of industry structure endogenously and simultaneously with the analysis of the other variables more traditionally treated in the theory of the firm and the industry.
It aspires to provide a unifying theory as a foundation for the analysis of competition. The theory manages to blends in some aspects from both the static and dynamic analyses of competition, however shouldn’t be seen as an overarching theory. It embodies a different focus to the two traditional views of competition, as already mentioned. It should be applied to unique situations, on which the assumptions of the theory are built. The new theory provides for a new dilemma rather than the final solution.

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