Contestability

This paper explores the history, flaws, fixes and real-world applications of contestability theory. The writer explains that the underlying theory has contradictions which limit how useful and respectable the theory is.

The contradiction lies in its initial assumptions for defining a contestable market:
1) Entry is free; 2) Entry is absolute; and 3) Exit is free. At face value these seem fair, however 1) assumes entry is total (meaning the newcomer can compete with incumbent firms immediately) and 2) assumes that incumbent firms regard the newcomer as too small to care about. These contradict immediately. Does this mean that the entire theory that it is built up from these pillars is superfluous?

Later the writer talks about examples where contestability theory has been used in real life. He gives the examples of a merger between Santa Fe and Southern Pacific Railroads and AT&T’s diminishing concentration ratio. In looking through the examples, contestability theory was proved to be correct but also inconstant and not an exact science. The merger between the railroad companies was rejected even after economists proved that it wouldn’t result in higher market share or higher prices(due to trucking still being a main competitor). The theory behind this conclusion was that the market was contestable so prices will have to stay low to gain profits. This shows that the theory of contestability wasn’t taken seriously in 1985 or that is wasn’t a strong argument. (diagram won’t paste).

Personally, I believe that markets are never truly contestable. The closest example would be highly competitive markets but even then, barriers to entry and exit may be substancial.