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William Baumol defined contestable markets as existing where “an entrant has access to all production techniques available to the incumbents, is not prohibited from wooing the incumbent’s customers, and entry decisions can be reversed without cost.”
The model of contestable markets is based on a number of simplifying
assumptions:
• The number of firms can vary from one to many
• The firms can produce homogeneous or branded goods
• All agents have perfect knowledge
• There are no barriers to entry (specifically, no sunk costs)
• All firms must compete – there is no collusion
In a perfectly contestable market the threat of competition is enough to encourage incumbent firms to produce at an output level which earns them only normal profits (where AC = AR). At the same time the threat of hit-and-run competition forces the firm to produce at a point where average costs are minimised (where MC = AC). If the incumbent firm was productively inefficient competitors would enter the market, produce more efficiently, and undercut the incumbent. Therefore a perfectly contestable market will be both productively efficient (produce where AC are minimised) and allocatively efficient (produce where MC = P).
lydiajane74 answered the question on July 4, 2018 at 11:40
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