Contestability is a topic that is becoming ever more popular with examiners. One of the reasons for this is the fact that there are so many good examples around nowadays. Many of the privatised utilities have been modelled, to a certain extent, on the theory of contestability.
- Numbers: Unusually, this is not such a relevant assumption. There can be very few firms in the industry (very oligopolistic) or there may be numerous firms.
- Ease of entry: This one is about barriers to entry. It is also the most important in this model. As with perfect competition, we assume that there is total freedom of entry into and exit from the market. There are no barriers to entry or exit. Of course, in the real world, there are always some barriers. Essay questions often ask, 'to what extent is the blah, blah industry contestable?' (for blah, blah fill in any industry). You have to assess the level of barriers. If barriers are low, then the industry can be said to be fairly contestable. If barriers are high, then the industry is unlikely to be contestable.
- Knowledge: As with the perfectly competitive market, it is assumed that there is perfect knowledge in a perfectly contestable market. Whether this happens in the real world is another matter.
- Product: Another less important assumption. The product sold by the firms in the market could be homogenous, or differentiated, branded goods.
- Maximising assumption: As with all models of market structures, all firms aim to maximise their profits. That is their sole objective. Buyers aim to maximise their welfare through their purchases.
- Collusion: As we shall see, many examples of contestability occur in oligopoly. In the contestable market model, we assume that firms do not collude, but compete freely with each other.
It should be noted that the most important assumption is that of barriers. If barriers are low in an industry, then it is often considered contestable, regardless of size and type of product.
As I said earlier, many of the good examples are in industries where there are only a small number of firms. The railways were privatised in such a way that barriers were relatively low to encourage entrants into the market. Railtrack was sold off in one. It owns all the track and the stations. The rolling stock (the trains) were sold to three 'rolling stock' companies. The right to offer services were then sold as franchises, usually for a seven-year period.
The reason why the railway industry is, to a certain extent, contestable is due to the low barriers to entry and exit. If you wanted to run the London to Birmingham route, for example, you would rent the use of the track from [n]Railtrack[/n], rent the use of the trains from one of the rolling stock companies, set up a booth at Euston and off you go! There are no big sunk costs. Exit is easy as well; you just stop renting the track and the trains!
Another key point is that of potential competition. The initial 25 rail operating companies often had no direct competition. But it was felt that they would be kept on their toes due to the threat of potential competition. All firms had only seven years to prove themselves (some of the contracts were a bit longer). They all knew that if they were seen to be failing at any point during the seven years, and then there would be competitors waiting in the wings, ready to bid for the franchise at the end of the seven-year period (no barriers to entry, remember).
Also, this pressure will stop the incumbent firms from making too high a profit. If they make lots of money over the seven years, they will attract lots of firms when the franchise is up for renewal. Theoretically, firms in contestable markets should earn only normal profits in the long run, although I'm not sure that is quite the case in the real world!
Due to the changes made in the 90s to the electricity and gas industries, they are quite contestable for similar reasons. Companies rent the use of the national grid and the gas pipes. Some companies are now offering both products.