It has been argued that in some markets that in order to prevent the entry of new firms, the existing firm would have to charge such a low price that it would be unable to reap any supernormal profits at all.
The theory was developed by industrial economist William Baumol, and is known as the theory of contestable markets. It was in recognition of this theory that the monopoly model included the assumption that there must be no substitutes for the good, either actual or potential.
For a market to be contestable, it must have no barriers to entry or exit, and no sunk costs. Sunk costs refer to the costs that a firm incurs in setting up business that cannot be retrieved if the firm exits the market. Common examples are intangible costs, such as advertising, construction and advisory costs. Furthermore, new firms in the market must have no comparative disadvantage compared to the incumbent firm/s; in other words, they must have access to the same technology, and there must be no significant learning-by-doing effects i.e. productivity should not significantly increase the longer the firm is in the market. Entry and exit must be rapid
Under these conditions, the incumbent firm cannot set a price that is higher than average cost, because as soon as it does it will open up the possibility of hit-and-run entry by new firms, which can enter the market and compete away the supernormal profits.
Consider the above diagram, which shows a monopoly firm in a market. The argument is that, if the monopolist charges the profit-maximising price then if the market is contestable the firm will be vulnerable to a hit and run entry – a firm could come in to the market, take some of the supernormal profits, and exit again. The only way that a monopolist can avoid this is by setting price equal to average cost, (Pc), so that there are no supernormal profits to at as an incentive to entry.
On the face of it, the conditions for contestibility sound pretty stringent. In particular, the firm in the diagram above enjoys some economies of scale so you would think that some sunk costs have been incurred.
However, suppose a firm has a monopoly on a domestic air route between two destinations. An airline with surplus capacity, i.e. spare aircraft, could enter this route and exit again without incurring sunk costs in response to the profits being made by the incumbent firm. This is an example of how contestibility may limit the incumbent firm’s ability to use its market power.
Notice that in this example, although the firm is making only normal profits, neither productive or allocative efficiency is achieved.
A moot point is whether the threat of entry will in fact persuade firms that they cannot set a price above average cost. If entry and exit are so rapid, then maybe the firms can risk making some profit above normal profits and then respond to the entry very aggressively when it happens.
This will be re-examined in a future article when discussing competition policy, as it is an important issue in that contest, and the degree of contestibility may affect the perception of how much market power is in the hands of exitsting firms.