A contestable market is a market for a good or service that is served by a very small number of suppliers, yet behaves in a manner close to perfect competition as far as pricing is concerned, mainly because of the following two characteristics:
- There are low barriers to entry in the market.
- There are low barriers to exit, so that new entrants can exit quickly without needing to stay for long to recoup the investment.
The low barriers to entry and exit serve to prevent existing suppliers in the market from raising prices as follows: the existing suppliers know that if they raise prices significantly, new entrants (i.e., potential competition) can join immediately, compete on price, and take away their customers. If the existing firm then lowers its price, making the new entrants unprofitable, the new entrant can quickly exit the market.
Contestable markets and the efficient market hypothesis
Note that the existing firms may still have some advantages (economies of scale, experience, special knowledge) that allows them to be more profitable than new entrants, thus discouraging new entrants into the market in the normal course of business.
The importance of contestability is that even though there may be very few firms at present, the price and quantity traded may still be close to socially optimal, because existing firms keep their price sufficiently low and their quantity of production sufficiently high to deter new entrants. Thus, in cases where a market structure with a smaller number of firms is more efficient due to economies of scale, contestability allows for these efficiencies to be realized without a corresponding sacrifice in economic surplus that arises from the deadweight loss due to market power of sellers.