Contestable markets

Characteristics

A perfectly contestable market has:

• No barriers to entry or exit.
• No sunk costs: an entrant can leave and recover its spending.
• Access to the same technology as incumbents (no cost disadvantage).
• Perfect information.

This allows hit-and-run entry: a firm can enter when supernormal profit exists, take the profit, and leave.

Implications for prices and profits

Even a monopoly or oligopoly in a contestable market cannot safely earn large supernormal profits, because they would attract hit-and-run entry. So incumbents keep prices close to average cost and earn close to normal profit in the long run, and they have a strong incentive to keep costs low. They may use limit pricing: setting price at a level an entrant could not profitably undercut.

Sunk costs and degrees of contestability

Sunk costs are the key: the higher the unrecoverable costs of entry (advertising, specialist equipment, research), the less contestable the market. Markets are more or less contestable rather than perfect. Example: a single airline route can be fairly contestable if aircraft can be moved to other routes (low sunk cost), but airport slot shortages reduce contestability.

Costs and benefits

Benefits: lower prices, productive and X-efficiency, normal profit; a structure test (number of firms) can be misleading, so regulators look at contestability.

Costs/limits: perfect contestability rarely exists; limit pricing still keeps price above the competitive level; in practice incumbents can react quickly with price cuts, which deters entry; low profits may reduce dynamic efficiency.

Worked example

A firm can enter a market by buying equipment for $10m, which it could resell for $7m if it left. Find the sunk cost and explain its significance.

1. Sunk cost = 10 - 7 = $3m: the part that cannot be recovered.
2. The larger this is relative to expected profit, the riskier entry is.
3. So the market is less contestable, and incumbents can keep higher profits.

Answer: Sunk cost $3m; it reduces contestability.

Check yourself

1. Entry requires $25m of spending, of which equipment worth $16m can be resold on exit. Find the sunk cost in $m.
   Show answer

   $9 m. 25 - 16 = $9m cannot be recovered.

2. For the same entrant ($25m spending, $16m recoverable), what percentage of entry spending is sunk?
   Show answer

   36 %. 9 / 25 x 100 = 36%.

3. Which feature is most important for a market to be contestable?
   • Low sunk costs
   • A large number of firms
   • Identical products
   • High advertising spending
   Show answer

   Low sunk costs. Low sunk costs make hit-and-run entry possible.

4. Hit-and-run entry means
   • a firm drives rivals out with low prices
   • two firms merge and then demerge
   • a firm enters a market with a patent
   • a firm enters to take supernormal profit and leaves when it disappears
   Show answer

   a firm enters to take supernormal profit and leaves when it disappears. Possible only when exit is cheap.

5. In a highly contestable market with one incumbent firm, the incumbent is likely to
   • charge the full monopoly price
   • keep prices close to average cost
   • earn large supernormal profits indefinitely
   • ignore potential entrants
   Show answer

   keep prices close to average cost. High prices would attract entrants.

6. Why might an incumbent use limit pricing in a contestable market?
   • To maximise short-run profit
   • To drive out an existing rival by pricing below AVC
   • To raise barriers to exit
   • To make entry unprofitable while still earning some profit
   Show answer

   To make entry unprofitable while still earning some profit. Price is just below the level that would attract entry.

7. What does contestability theory suggest about judging competition by the number of firms?
   • It is always accurate
   • It can be misleading, since the threat of entry also disciplines firms
   • Only monopolies need regulation
   • Concentration ratios measure contestability exactly
   Show answer

   It can be misleading, since the threat of entry also disciplines firms. Behaviour depends on potential competition too.

Practise with instant feedback Print this lesson

Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (XEC11/YEC11), Unit 3 Business behaviour and Appendices 6 and 7

Last updated 8 November 2026. Spotted a mistake? Tell us.