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The theory of contestable markets states than in imperfect markets, the threat of competition may be enough to prevent the firm acting against the public interest (i.e. keeping prices high and output low).

Conditions for contestable markets:

1. Perfect information - all firms have the same access to technology, no patents etc.
2. Freedom to enter the market legally
3. No sunk costs

In contestable markets incumbent firms are forced to act as if they are in competition, and therefore make only normal profits. If they don't, hit and run entry will occur - in the short run new rivals enter the market and by charging a lower price, take the incumbent firm's market share. Hit and run entry can only occur in barriers to entry and exit are low.

No market is perfectly contestable. Barriers to contestability always exist. What matters is the degree of contestability.

Sunk costs

Sunk costs are costs which are irrecoverable to the owners of the firm if it leaves the market. For example, the Channel Tunnel has very high sunk costs. It is a past expense that cannot be altered by current/future actions.

Sunk costs act as a barrier to entry.

Causes of sunk costs:

• No second hand market
• Industry specific capital
• Future liabilities (e.g. nuclear power plants)

Implications

The theory tells us that all markets can be efficient as long as they are contestable. Therefore regulation is not necessary; in fact it may worsen the situation if regulation acts as a barrier to entry, discouraging potential competition. Instead the government's role should be to:

• Make the market more competitive by increasing the degree of contestability
• Lower barriers to entry and exit in an industry
• Allow take-overs (if they don't prevent competition)

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