Contestable Markets: When the Threat of Entry Matters

Why even a market with one or two firms can behave competitively if new firms could easily enter, and what makes entry easy or hard.

You might assume a market with only one firm will always have high prices. But the theory of contestable markets, developed by William Baumol and colleagues in the early 1980s, shows that the threat of new competitors can discipline even a single firm.

The idea

A market is contestable if new firms can enter easily and leave without losing much money. In such a market, if an existing firm charged high prices and earned large profits, new firms would quickly enter to take a share, then leave if profits disappeared. Knowing this, the existing firm keeps prices close to costs, even without visible competitors.

Sunk costs are key

The crucial factor is sunk costs: costs that cannot be recovered when leaving a market. If entering requires building a factory that could not be sold or used elsewhere, entry is risky, and the market is less contestable. If assets can be easily resold or redeployed, entry is less risky.

Airline routes

Airlines were an early example economists discussed. An aircraft can be moved from one route to another relatively easily. So even if only one airline flies a route, the threat that another could start flying it may keep fares in check. In practice, research found airline routes are not perfectly contestable, because airport slots, gate access and loyalty programmes create barriers.

The pop-up competitor

A single coffee cart serves a busy office building and charges high prices. Because setting up a coffee cart costs little and the equipment can be moved elsewhere, a competitor soon sets up nearby. Prices fall. If the first cart had kept prices reasonable, the competitor might never have bothered. The mere possibility of entry shaped prices.

Lessons for policy

Contestability suggests that competition authorities should look not just at how many firms are in a market, but at how easy it is to enter. Reducing barriers to entry, such as licensing hurdles, access to essential facilities or switching costs for customers, can make markets more competitive without needing more firms immediately.

Thinking the number of firms tells you everything

A market with few firms can be competitive if entry is easy, while a market with many firms may still be uncompetitive if they coordinate or if barriers protect them. How easy it is to enter matters as much as how many firms are present.

Key takeaways

A contestable market is one where firms can enter and exit easily.
The threat of entry can keep prices close to costs even with few firms.
Sunk costs determine how contestable a market is.
Reducing barriers to entry can make markets more competitive.