This theory was advance by William Baumol, an American economist, and postulates a market where entry and exit cost do not exist. In essence, it is a market with no entry or exit barriers. Since there is no entry barrier, the threats of a new entrant and the underlying competition dictate the operations of the market participants. Therefore, antecedent competition has no role in this kind of market. The table below depicts the types of firms and the corresponding number of firms in a neo-classical gamut of a contestable market
ASSUMPTIONS OF THE THEORY
The main supposition of the contestable market theory is that there is no barrier to entry into, and exist out of the market. A firm can simply enter or exit the industry at will. The assumed openness of the market to new potential entrants is basically anchored on three conditions: lack of impediments to entry, non-existence of sunk cost and great market and industry knowledge.
Barriers to Entry
The impediments or barriers to entry are the prevailing conditions that make it intricate or unworkable for prospective firms to venture into an already existing industry and compete favorably with the already existing industry participants. The impediment to entry thus defines the threats of the imminent competition. The aforementioned barrier may exist in different forms such as: high, unrealistic initial costs, existing monopoly, legal issues, and marketing limitations, amongst others.
The pre-existing firms may be in ownership of some critical contractual accords that may limit new firms from venturing into the industry. Similarly, the initial capital expenditure, together with high fixed cost and technological ineptness may render it impossible to enter and compete on the same level with the incumbent firms. Additionally, the incumbent firm may be possessing high brand loyalty that make it hard for new comers to match. The amount of advertisement expenditure would be very high for such firms. Moreover, in some industries, the only way to operate profitably is by economic of scale which is possible only for few, of possibly one, firm in an industry. This eventually results into a situation of intrinsic monopoly.
In a contestable market, however, the above discussed factor does not exist or are very minimal, resulting into an open and freely accessible market to prospecting new entrants.
Sunk Cost
Also referred to as retrospective costs, sunk cost are expenses that are already incurred but can never be recovered by a firm. At the time of entry, if a firm determines that there would be high sunk cost, then it becomes a hindrance to entry into a new market. Sunk cost is a loss to the firm. The amount of money spent in research and development (commonly referred to as R and D), irrecoverable advertisement costs, the time value spent, equipment and assets that cannot be resold, training and hiring bonus, are some examples of sunk costs.
As much as in a contestable market there assumption is that the entry cost is fully recovered at and that exit is totally costless, in reality, in a contestable market, the retrospective costs are seen to be insignificant.
Perfect Knowledge of the Market
Having a great and perfect knowledge of the market and the industry would be a plus to the new entrant. The knowledge about the behavior of the already existing firms in regards to production techniques, labor costs, appropriate technology to apply, marketing and pricing plans and strategies, amongst others would obviously work to the advantage of the entrant. To this end, perfect knowledge would actually pose a threat to the incumbent as it enables the new entrant to forecast the possible behavior of the existing firms.
B) IMPLICATIONS OF THEORY
The scenarios above, presented about the contestable market, where there do not exist hindrances to entry and exit of a market, has a prevailing impact on the behaviors and operations of the firma that are already active in the market. It is noted that, in the long run, firms only operate to make standard/normal profit. Additionally, since competition is in the air, firms operate as if they are in competition; even when in reality there is no competition.
Normal Profits
Normal profit is a situation where a firm operates in such a way that the amount of revenue generated equals the amount of const incurred. This, in essence, implies that the economic profit equals zero. The firm is making the least possible profit that is able to keep it in operation. Since there lack economic profit, normal profit is not enough to attract new entrants. For normal profit to be made, the average cost must equal the average revenue.
The scenario of free entry and exit would essentially imply that firms, if given enough incentives, would easily infiltrate the market. The incentive here would be, for instance, abnormal profit, that would encourage firms to rush into the industry and make as much profit as economically possible. To protect their interest in the industry, the incumbent firms are comfortable operating at the normal profit so long as their market share is not wrinkled by possible new entrants.
Irrefutably, a downward pressure on prices is presented due to the existing competition in the contestable market structure. This implies that firms are willing to operate at levels of output where profit in normal, instead of where profits is abnormal. As per the below diagram, if a firm opt to produce at the point of profit maximization, Q1, then the resulting price charged at that level would correspond to P1. This results into creation of abnormal profit represented by the areas P1ABC. However, in a contestable market case, firms normally opt to operate at normal profits that corresponds to Q2 for quantity and p2 for price
Competition rather not Collusion
The firms that operate in this market are in constant competition with one another and with a possible new entrant. This implies that prices are not fixed but varied, abnormal profits do not exist and there is need for advertisement. The competitions seem to be strong even when it does not really occur.