Contestable markets are markets where the mere threat of potential entry influences existing firms to act competitively, even when few firms actually operate.
What is a contestable market?
A contestable market is defined as one where there are low barriers to entry and exit, and where new firms can enter and exit easily without incurring significant losses. The key idea behind contestability is that potential competition, rather than actual competition, is sufficient to drive competitive behaviour.
Even in a market dominated by a single or a few firms, if the market is contestable, these firms will behave as if under competitive pressure — they will keep prices low and operate efficiently — for fear of "hit-and-run" entry by rivals looking to exploit high profit margins.
Key conditions for a contestable market
To classify a market as contestable, certain structural and behavioural characteristics must be present:
Freedom of entry and exit: New firms must be able to enter and leave the market easily, without incurring heavy costs or facing regulatory obstacles.
Absence of sunk costs: Costs that cannot be recovered when a firm exits (e.g. advertising, specialised machinery) must be negligible.
Symmetrical access to technology: New entrants should have access to the same technology and resources as incumbent firms.
Perfect or near-perfect information: Potential entrants must have knowledge about existing firms’ cost structures, pricing strategies, and demand conditions.
No long-term contracts or legal constraints: Existing firms must not lock in customers or suppliers in a way that prevents competition.
A market does not need to be perfectly contestable to be influenced by contestability. The greater the threat of entry, the more competitive the behaviour of incumbent firms is likely to be.
Characteristics of contestable markets
Hit-and-run entry
Hit-and-run entry is a core feature of contestable markets. It occurs when a firm enters the market quickly to take advantage of supernormal profits, and exits just as rapidly before existing firms can retaliate.
For example, if an incumbent is charging a high price that generates abnormal profits, a new firm may enter, undercut the price, gain sales, and leave before the incumbent can respond by lowering prices or increasing advertising. The possibility of such behaviour forces incumbents to price competitively, even if entry never actually occurs.
Low sunk costs
Sunk costs are expenditures that cannot be recovered once spent. They form one of the biggest barriers to contestability, as they increase the risk of market entry.
Examples of sunk costs include:
Advertising campaigns specific to a product or market.
Research and development spending that cannot be resold.
Industry-specific training or licenses with no resale value.
Custom machinery with no alternative use.
If sunk costs are low or zero, firms can exit the market easily without substantial financial losses, making hit-and-run entry viable. Thus, low sunk costs are essential for a contestable market.
Access to production technology
For a market to be contestable, potential entrants must be able to use the same production processes and technologies as established firms. If technology is restricted through patents, trade secrets, or exclusive supplier contracts, it becomes difficult for new firms to compete, reducing contestability.
Technological barriers can include:
Proprietary software or production techniques.
Scale-dependent production equipment.
Exclusive access to efficient logistics networks.
The more accessible and standardised the technology, the more contestable the market becomes.
No long-term contracts or legal barriers
Long-term contracts that tie in customers or suppliers act as barriers to new firms entering a market. These include:
Exclusive supply agreements with retailers.
Long-term service contracts with customers.
Government regulations or licences that limit participation.
For example, utility markets (such as water or electricity) are often legally restricted, with licensing requirements or monopoly franchises, which reduce contestability.
Implications for firm behaviour in contestable markets
Firms operating in contestable markets must be constantly aware that new competitors could enter at any moment, especially if they raise prices or relax efficiency. As a result, these firms adjust their behaviour strategically, even in the absence of actual competitors.
Pricing just above average cost
In contestable markets, firms often set prices close to or equal to average cost (AC) in order to deter entry. Pricing just above average cost allows incumbents to make a small profit, but not enough to attract entrants. If prices were significantly above average cost, potential entrants would see an opportunity for profit and be incentivised to enter the market.
If price = average cost → only normal profit → no incentive to enter.
If price > average cost → supernormal profit → high incentive to enter.
This concept explains why even monopolies in highly contestable markets may behave like competitive firms.
Operating efficiently
Firms in contestable markets must operate at productive efficiency — producing at the lowest possible average cost. If they fail to do so, potential entrants can exploit cost inefficiencies, undercut prices, and gain market share. This pressure ensures that contestable markets lead to cost minimisation and efficient resource use, even without multiple active firms.
Innovation and service quality
To reduce the risk of losing customers to new entrants, incumbent firms may also:
Innovate to improve products or services.
Invest in customer loyalty schemes.
Enhance customer service or after-sales support.
While these actions may raise costs temporarily, they act as non-price barriers to entry by making it harder for new firms to match the same value proposition.
Types of barriers to entry and exit
For a market to be contestable, it must have minimal entry and exit barriers. The following types of barriers often restrict contestability:
Legal and regulatory barriers
These include any government-imposed requirements that prevent or restrict entry:
Licencing (e.g. for taxis, airlines, broadcasting).
Health and safety certifications.
Environmental standards.
Zoning restrictions.
Legal barriers are particularly relevant in utilities, healthcare, transport, and education, where governments often regulate entry to maintain service quality or public safety.
Strategic barriers
Incumbents can also create artificial barriers to entry through strategic behaviour:
Limit pricing: Setting prices low enough to make the market unattractive to new entrants.
Excess capacity: Keeping spare production capacity to flood the market and lower prices if new firms enter.
Brand proliferation: Launching multiple brands to dominate shelf space and reduce consumer attention to new entrants.
These tactics raise the perceived risk or cost of entry, deterring competitors.
Natural barriers
Some markets have inherent features that make them hard to enter:
Economies of scale: Large firms have lower unit costs, making it difficult for small entrants to compete.
High fixed costs: Large upfront investment required (e.g. setting up a national mobile network).
Network effects: In markets where the value of the product increases with user numbers (e.g. social media), new entrants find it hard to build a user base.
Natural barriers are common in sectors like telecommunications, utilities, and digital platforms.
Branding and customer loyalty
Strong brand identities and customer loyalty can act as psychological or behavioural barriers to entry. Consumers may prefer to stick with trusted brands, even if new firms offer similar or better products.
To overcome this, entrants must spend heavily on:
Advertising.
Promotions and discounts.
Product sampling and endorsements.
This raises sunk costs, reducing contestability.
Access to essential inputs or distribution channels
If existing firms control:
Raw materials.
Skilled labour.
Distribution networks or shelf space.
then new entrants may find it difficult to produce or sell their goods. Vertical integration, where a firm controls multiple stages of the supply chain, is a key way incumbents maintain such control.
Sunk costs and their role in contestability
What are sunk costs?
Sunk costs are costs that are irreversible once incurred and cannot be recovered if a firm exits the market. These include:
Market-specific advertising expenses.
R&D investments with no second-hand value.
Customised capital equipment.
Entry fees or licenses that are non-refundable.
Sunk costs increase the financial risk of entry and reduce the appeal of temporary or speculative entry.
How sunk costs reduce contestability
Markets with high sunk costs are less contestable because:
Entrants cannot recover investments if they exit quickly.
Hit-and-run entry is no longer viable.
Incumbents can safely raise prices without fearing entry.
For example, if entering a market requires a £2 million advertising campaign, and this cost cannot be recovered, a potential entrant will think twice before taking the risk.
To increase contestability, policymakers can focus on reducing sunk costs by:
Encouraging open standards and interoperability.
Supporting entry-level grants or tax incentives.
Regulating predatory pricing and exclusive contracts.
Real-world examples of contestable markets
Airline industry
Some airline routes, especially short-haul and domestic ones, have become more contestable due to deregulation, online booking, and shared airport infrastructure.
Low-cost carriers like EasyJet and Ryanair engage in route shifting and hit-and-run entry.
Entry and exit are easier thanks to leasing of aircraft, standardised logistics, and minimal sunk costs.
However, slot allocation at airports and airport fees can still act as barriers.
Taxi services
The arrival of ride-sharing platforms such as Uber and Bolt revolutionised the contestability of the personal transport sector.
Low entry requirements for drivers (just a car and an app).
Customers use technology to find the cheapest or nearest driver.
Previously restricted markets became more open and flexible.
However, licensing battles, insurance regulations, and driver caps have re-emerged in many cities, re-restricting entry.
Tech platforms and apps
Initially, digital markets (e.g. mobile apps, software tools) appeared highly contestable:
Low setup costs and ease of scaling.
Access to global markets via app stores or digital platforms.
But over time, dominance by firms such as Google, Apple, and Amazon has created:
High sunk costs in marketing and development.
Network effects where established platforms attract more users.
Barriers in platform algorithms and search visibility.
This means that despite the appearance of ease, many tech markets are not truly contestable in practice.
Local retail and food delivery
In local retail and takeaway markets, contestability has risen due to:
Pop-up shops, ghost kitchens, and cloud retail.
Digital platforms (e.g. Deliveroo, Etsy) offering exposure to customers.
These formats allow quick entry and exit, reducing sunk costs. However, long-term profitability requires ongoing spending on marketing, reviews, and platform fees, which can eventually raise barriers and lower contestability.
FAQ
In contestable markets, incumbent firms often use reputation as a strategic tool to deter potential entrants. A firm with a strong reputation for aggressive pricing or high retaliation can discourage new competitors from entering, even if the market is theoretically open. For example, an incumbent might have a history of initiating price wars or dramatically increasing advertising spend in response to new competition. This behaviour builds a reputation that entry will lead to losses, making the market appear riskier to outsiders. Additionally, if the incumbent is perceived as having strong customer loyalty or brand recognition, new firms may anticipate difficulty gaining market share. Reputation acts as a credible threat—even if the incumbent doesn’t need to take action, the perception alone can prevent entry. This psychological barrier complements structural ones, and helps incumbents maintain market share without breaching competition laws. Reputation, therefore, functions as a powerful deterrent in otherwise contestable markets.
Yes, government policy can significantly enhance contestability by reducing artificial and structural barriers to entry and exit. One way is through deregulation, such as removing licences or restrictions that limit the number of firms in an industry. For example, deregulating bus services or airline routes can encourage new providers. Competition policy can prevent anti-competitive practices like predatory pricing or exclusive contracts that make entry harder. Governments can also increase contestability by investing in shared infrastructure—such as public transport terminals or digital platforms—so that new firms are not at a cost disadvantage. Subsidies or grants for start-ups and access to public procurement contracts can level the playing field for smaller firms. Additionally, legislation promoting data portability, interoperability, and open standards allows new digital firms to compete with incumbents. In all cases, policy aims to make markets more accessible, reduce sunk costs, and enable firms to enter and exit more freely, thus increasing competitive pressure.
High advertising expenditure can reduce contestability by increasing sunk costs, which raises the financial risk of market entry. If a firm must spend millions on marketing just to gain brand recognition or inform customers of its product, this cost becomes unrecoverable if the firm exits the market. This discourages hit-and-run entry, a key feature of contestable markets. Furthermore, incumbents with well-established brands benefit from consumer loyalty and brand recognition, meaning new entrants must invest heavily just to compete for attention. In some cases, dominant firms may engage in saturation advertising, flooding the media with their branding to crowd out new competitors. This creates a barrier to entry that is behavioural rather than structural or legal. Even if there are no licensing or technological barriers, the need to match incumbent marketing levels acts as a deterrent. Therefore, advertising, while legal and common, can significantly undermine the contestability of a market by embedding sunk costs and reinforcing incumbents’ dominance.
Digital platforms can both enhance and reduce contestability, depending on how they are structured and used. On the one hand, platforms like Amazon, eBay, or App Store ecosystems lower the cost of entry by giving small firms immediate access to large customer bases without needing physical infrastructure. They reduce sunk costs related to distribution and marketing, and enable rapid entry and exit. On the other hand, once a platform becomes dominant, it can reduce contestability through algorithmic bias, search prioritisation, and high commission fees. Entrants may struggle to appear prominently unless they pay for visibility, which raises entry costs. Additionally, platforms often gather vast amounts of user data, giving incumbents an informational advantage that newcomers cannot match. Network effects can also entrench dominant platforms, as users prefer larger, more popular networks. Thus, while digital platforms offer tools for entry, they can simultaneously entrench existing firms and create new forms of entry barriers, depending on regulation and governance.
Limit pricing is a deliberate strategy used by incumbent firms to set prices just low enough to discourage potential entrants from entering the market. In contestable markets, where firms can easily enter and exit, incumbents are especially motivated to defend their market position by reducing the profitability of entry. By setting the price just above average cost—where they still earn normal profits but offer little incentive for entry—they make the market unattractive to outsiders. Unlike predatory pricing, which involves setting prices below cost and may breach competition laws, limit pricing is legal and subtle, relying on potential entrants’ cost expectations and risk aversion. It is most effective when the incumbent has a cost advantage due to economies of scale or brand efficiency. If the entrant believes they cannot compete at the current price without incurring a loss, they will stay out. Thus, limit pricing is an important behavioural response to the threat of entry in a contestable market, enabling incumbents to maintain dominance without direct confrontation.
Practice Questions
Explain how the existence of low sunk costs can make a market more contestable.
Low sunk costs reduce the financial risk associated with entering and exiting a market. If firms can recover most of their investment upon leaving, they are more likely to enter, even temporarily. This increases the threat of hit-and-run competition, where new firms enter to exploit supernormal profits and exit before incumbents can respond. As a result, existing firms are incentivised to price competitively and operate efficiently, even in the absence of actual competition. Therefore, low sunk costs increase the level of contestability by lowering barriers to entry and exit, promoting competitive behaviour in the market.
Evaluate the extent to which the taxi industry can be considered a contestable market.
The taxi industry has become more contestable due to the rise of ride-sharing platforms like Uber and Bolt, which reduce entry costs and enable drivers to work flexibly. Low sunk costs and access to technology make hit-and-run entry viable. However, contestability varies by location. In many cities, regulation and licensing limit entry, while customer loyalty and platform dominance create barriers. Furthermore, high commission fees and advertising costs can increase sunk costs over time. While elements of contestability exist, such as low entry thresholds and digital access, the degree of contestability depends on the regulatory environment and market structure.
