Contestable Markets:  What Does It Mean
                     Contestable 
Markets: What 
Does It Mean?
INTRODUCTION
The theory of contestable 
markets is associated with the 
American economist William 
Baumol. In essence, a 
contestable market is one with 
firms facing zero entry and exit 
costs.
Source: www.economicsonline.co.uk
The implications
• Potential entrants can freely 
enter and leave the market.
• Potential entrants could, if they 
wished, operate a hit and run 
strategy.
• Just the threat of entry is enough 
to ‘keep firms on their toes’, to 
the extent that existing firms 
behave ‘as if’ the market has a 
highly competitive market 
structure.
Source: www.economicsonline.co.uk
Evaluation
• The theory of contestable 
markets is often seen as an 
alternative to the traditional, 
Neo-classical, theory of the 
firm. 
• Perfectly contestable markets 
can deliver the theoretical 
benefits of perfect competition, 
but without the need for a 
large number of firms.
Source: www.economicsonline.co.uk
Profits
• Firms are forced to keep 
excess profits to a minimum, 
and move towards sales 
maximisation rather than 
profit maximisation. 
• In a perfectly contestable 
market with an unlimited 
number of potential entrants, 
profits would be pushed down 
to normal profits.
Source: www.economicsonline.co.uk
Factors which determine 
the contestability of a 
market
Sunk Costs
• Sunk Costs If sunk costs are 
high this makes it difficult for 
new firms to enter and leave 
the market. Therefore it will be 
less contestable.  
• For example, if a new firm had 
to purchase raw materials, 
that it wouldn’t be able to 
resell on leaving the market, 
this may act as a deterrent.
Source: www.economicshelp.org
Levels of 
advertising and 
brand loyalty
•  If an established firm has 
significant brand loyalty such as 
Coca-Cola, then it will be difficult 
for a new firm to enter the 
market. This is because they 
would have to spend a lot of 
money on advertising which is a 
sunk cost.  
• Even if they spend money on 
advertising it may not be 
sufficient to change customer 
loyalty to very strong brands. 
Source: www.economicshelp.org
Vertical 
Integration
• If a firm does not have access 
to the supply of a good then 
the market will be less 
contestable. E.g. Oil firms could 
restrict the supply of petrol to 
petrol stations, making it 
difficult for new firms to enter. 
• If you wish to sell electricity to 
domestic customers, a big 
issue is whether you can gain 
access to the electricity grid.
Source: www.economicshelp.org
Access to 
technology and 
skilled labour
• For some industries like car 
production it is difficult for 
new firms to have the right 
technology. 
• Nuclear power may require 
skilled labour that is difficult 
to get. This makes the market 
less contestable.
Source: www.economicshelp.org
Contestability 
and regulation
• Contestable market theory 
has clearly influenced the 
views and methods of 
regulators. 
• Opening up a market to 
potential entrants may be 
sufficient to encourage 
efficiency, and deter anti-
competitive behaviour.
Source: www.economicsonline.co.uk