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Contestable markets are those in which the short-term threats from potential competitors exert such a degree of pressure over the incumbents, that their behaviour is conditioned. Contestable markets are therefore in a competitive equilibrium even though the market can be considered to have a relatively small number of firms, meaning these could as well behave as in imperfect competition.  In any case, the amount supplied by the industry and the prices of the goods are held at perfect competition levels and therefore maintain a desirable welfare outcome.

This threat of new entrants is real, these should be able to enter the market without any complications and have the same advantages as the incumbent firms, once inside the market. This theory pays special attention not only to barriers of entry but also to exit barriers. Firms that want to enter should know they can enter and exit the market without inquiring into high costs, which would otherwise restrain their incentives to enter.

For a market to be considered a contestable market a series of requisites must be met:

-potential entrants should have access to the same technology as incumbents. If this is not the case entrants would be in a disadvantage position compared to incumbents.

– sunk costsshould not exist. Firms that enter the market must be able to recover their investments.

-the reaction time to changes for an incumbent firm should be longer than the time for a new firm to enter the market. This gives entrants the possibility to enter markets and perform hit-and-run strategies.

The theory was proposed by William J. Baumol in his “Contestable Markets and the Theory of Industrial Structure” 1982. As he argued, perfectly contestable markets would always result in a competitive equilibrium independently of the number of firms in the market, as the threat of potential rivals would guarantee it. Nevertheless these conditions are subject to important limitations. Demand should be significantly sensitive to price, for the threat of entrants charging lower prices and attracting consumers to be real one. Technology should have constant returns so incumbents do not have an advantageous position over entrants. Due to all these restrictive assumptions perfectly contestable markets are of a rare nature.