Contestable markets refer to a market situation where there are very few, perhaps even only one, firm yet perfectly competitive market outcomes may still be observed (as opposed to expected monopolistic or oligopolostic outcomes). Contestable markets exist in the total absence of barriers to entry or exit. Contestable markets are characteristed by 'hit and run' entry. If a firm in a market with no entry or exit barriers raises its prices above marginal cost and begins to earn abnormal profits, potential rivals will enter the market to take advantage of these profits. When the incumbent firm(s) respond by returning prices to levels consistent with normal profits the new firms will exit.
The theory of contestable markets has been used to argue for weaker application of anti-trust laws as simply observing a highly concentrated or monopoly market does not mean that the firm is harming consumers by earning super-normal profits. The applicability of the theory to real world situations has been questioned, however, particularly as there are very few markets which are completely free of sunk costs and entry and exit barriers.
Low cost airlines are commonly referred to as an example of a contestable market. Entrants have the possibility of leasing aircraft and should be able to respond to high profits by quickly entering and exiting. In practice there may be barriers to entry and exit in the market associated with terminal leases and availability and predatory pricing by incumbents, signalled through built in overcapacity.
References
Baumol, W. J.; Panzer, J. & Willig R. D. (1986) Contestable Markets and the Theory of Industrial Structure
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A contestablemarket is characterized by free entry and free exit.
But the theory does vividly illustrate that market structure and incumbent behaviour cannot be deduced simply by counting the number of firms in the industry.
The contestablemarkets approach to competition represents an alternative to the neo-classical theory of the firm.
Contestability is a measure of the extent to which a market is open to new entry.
To the extent that contestablemarkets theory is correct in assuming that the threat of competition is a key determinant of the behaviour of existing firms, it reinforces the link between barriers to entry and profit, but removes the link between barriers to entry and market concentration.
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