Concept Clarification: Contestable Markets (1)3 min read

This is a first of a series of post discussing the concepts of contestable markets and contestability.

An analogy

Jesse likes to play street soccer with his friends. There’s a street court in the neighbourhood that they always go to. It’s surrounded by a fence that’s 10 metres tall. Because Jesse’s dad is friends with the town council manager, he gets priority to the keys. Other kids can’t come in and play with them.

After some time, the government decides to redevelop the area and they removed the fence. Smaller kids want to play at the courts. So Jesse and his friends start acting a bit fiercer to chase them away. They become bullies in order to maintain their control over the territory. However, when from time to time, these smaller kids will still come by and shoot rubber bands at Jesse and his friends. The small kids don’t linger for long though. Once damage is inflicted and revenge exacted, they run away.

What is contestability?

An industry is said to be contestable when there is increasing freedom of entry and exit. It’s like the fence coming down around the playground. A perfectly contestable market will have costless entry and exit. Barriers to entry will be low or non-existent.

Examples of contestable markets

In the real world, it’s hard to find examples of oligopolies or monopolies operating in perfectly contestable markets. However, a relatively good example of an oligopoly that has become increasingly contestable is the mobility-on-demand service industry. It used to be dominated by taxi companies and other limousine services, but the traditional barriers to entry have been circumvented by technology companies such as Uber and Grab. Barriers to entry to the industry has thus come down significantly.

Why can oligopolies be contestable? I thought they have high barriers to entry?

The theory of contestable market is a separate theory from the traditional analysis of market structures. The thing to understand here is that Economics theory is made up of a bunch of models that serve to describe and explain real world phenomena. In Primary School, your Math teacher would have told you that every math word problem sum requires you to draw a different model. You can’t keep repeating the same model. For Economics, sometimes one model does not represent reality well enough, so economists come up with another one to better explain the behaviour of firms in the real world. We will return to the playground story and examine the differences between contestability and competition as well as the implications of contestability in the subsequent posts. Till then, dream economics.

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