Tài liệu Microeconomics for MBAs 38 docx

Chapter 11 Firm Production under Idealized

Competitive Conditions

Contestable Markets

One of the most important developments in the study of markets is the theory of contestable

markets.2

The contestable market model stresses the importance of potential rather than

actual competitors in a market. A market is deemed to be contestable if entry and exit are

relatively easy. A market is perfectly contestable if entry is absolutely free and exit is

costless. Free entry has a particular meaning in the theory of contestable markets; it means

that new firms entering an industry are not at any cost disadvantage compared to existing

firms in the industry. In other words, latecomers suffer no cost handicaps. Costless exit

means that firms can leave the industry at any time and can recoup all costs incurred by

entry.

A contestable market, then, is marked by ease of entry and exit and in that respect is

similar to a perfectly competitive market. Like a perfectly competitive market, a contestable

market will be characterized by zero economic profits in the long run. For a contestable

market, however, we do not need a large number of firms and a homogeneous product.

Indeed, multiproduct firms are possible in contestable markets. A contestable market may

have only two or three firms operating in it. Moreover, those firms produce at rates of output

where price is equal to marginal cost.

What brings about this result? Why do firms in contestable markets not produce and

price at the monopoly equilibrium? The reason is entry and exit. If price is not equal to

marginal cost, profit opportunities exist and new firms will quickly enter the market, causing

existing firms to make losses. The potential competitors force the existing firms to produce

where price equals marginal cost. A firm in a contestable market is always open to hit and

run attacks from its potential competitors. They will therefore be forced to produce and sell

at an output where price equals marginal cost and economic profits are zero. Any attempt to

exploit market power will bring about entry into the market and the dissipation of all profits.

The firms in the contestable market will be forced to operate as it they were in perfectly

competitive markets.

A contestable market is depicted in Figure 11.14. Note that although only three firms

are in the industry, they all produce where price equals marginal and average cost. For the

industry as a whole, price is equal to the minimum on the long-run average total cost curve.

Each firm produces one-third (q) of total industry output (3q). Production at an efficient rate

of output and marginal cost pricing, then, do not require the atomistic markets of the

perfectly competitive model. A perfectly contestable market will do.

What industries might this model fit? The air travel industry is one candidate. Many

major markets are served by only two or three airlines. Yet if an airline with a dominant

position in a particular regional market attempted to set price well above costs, entry would

quickly follow. Airplanes can be shifted from one market or use to another with ease. New

2

The basic model of a contestable market is presented in William J. Baumol, “Contestable Markets: An

Uprising in the Theory of Industry Structure,” American Economic Review, 72 (March 1982), 1-15. For a

critical analysis of the model, see William G. Shepherd, “‘Contestability’ vs. Competition,” American

Economic Review 74 (September 1984), pp. 572-587.