A contestable market is one in which there are little (or no) barriers to entry or exit, entry/exit costs are low (or zero) so the threat of potential competition is high. Also, firms do not collude and there is perfect information (so all incumbent and potential firms know all the prices, profits and products of each firm). Any market could be contestable.
An incumbent firm in a contestable market must set a low price and earn low super-normal profit (maybe even normal profit) in the long-run and short-run.
Assume there is a monopoly in a contestable market earning low super-normal profit. If this incumbent firm sets a high price to try and earn high super-normal profit it will suffer ‘hit and run’ competition. ‘Hit and run’ firms are firms that quickly enter and exit the industry to earn supernormal profit. ‘Hit and run’ firms can do this because there are little entry/exit barriers. Because more and more firms enter the market, prices are competed down and high super-normal profit is competed away until low super-normal profit is earned again.
After super-normal profit is competed away, most ‘hit and run’ firms then leave the industry because they earned the super-normal profit they came in for. Any firm that stays in the industry takes away some of the market share of the original incumbent firm.
So the incumbent firm must act as if the market is competitive, set a low price and earn low supernormal profit. It is the ‘threat’ of potential entrants that brings about a competitive outcome, not current competition.
A market may be perfectly contestable so that and only normal profit is earned. Contestability is a matter of degree. The more contestable the market, the lower the incumbent firm’s prices and profits must be to deter potential entrants.
A market may be contestable, it may not be. Below is a summary to evaluate whether a market is contestable or not:
A merger/takeover may increase contestability, but it may not. Below is a summary to evaluate whether a merger/takeover increases contestability or not: