What is the difference between limit pricing and contestable markets

On the basis of these two criteria, natural monopolies are the least contestable markets. Asymmetric information is a key barrier to entry, with incumbents likely to know much more about their industry than potential entrants, and are likely to be unwilling to share their knowledge or technology. This means that even if there are a few firms, or a single firm, as with oligopolistic and monopolistic markets, a market with no barriers will resemble a highly competitive one.

If we assume there are only a few firms in a market, and there are few barriers to entry and exit, then we can state that:.

The theory of contestable markets is often seen as an alternative to the traditional, Neo-classical , theory of the firm. Perfectly contestable markets can deliver the theoretical benefits of perfect competition, but without the need for a large number of firms. Firms are forced to keep excess profits to a minimum, and move towards sales maximisation rather than profit maximisation. Contestable market theory has clearly influenced the views and methods of regulators.

Opening up a market to potential entrants may be sufficient to encourage efficiency, and deter anti-competitive behaviour. For example, regulators may force incumbents to open-up their infrastructure to potential entrants, or to share technology — as in the case of broadband operators being allowed to use British Telecom BT Openreach infrastructure.

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Contestable in economics means that a company can be challenged or contested by rival companies looking to enter the industry or market. In other words, a contestable market is a market where companies can enter and leave freely with low sunk costs. According to contestable market theory, when access to technology is equal and barriers to entry are weak, low, or non-existent, there is a constant threat that new competitors will enter the marketplace and challenge the existing, well-established companies.

The continuous risk of contestability weighs on the companies that already operate in the space, keeping them on their toes and influencing how they conduct business. Such an environment generally keeps prices low and prevents monopolies from forming. Characteristics of a contestable market include:. In a contestable market, entrants might execute a hit-and-run strategy. The new entrants can "hit" the market, given there are no or low barriers to entry, make profits , and then "run," without incurring any exit costs.

These types of risks play on the minds of the executive management teams within the industry, leading them to adjust their business strategies and gravitate toward sales maximization rather than profit maximization. According to the theory, unlimited profits would be pushed down to normal profits in a truly contestable market. Consequently, even a monopoly might be forced to operate competitively if barriers to entry are weak. Those operating a monopoly might conclude that if they're too profitable, a competitor could easily enter the market, contest their business, and undercut their profits.

The key tenet of a contestable market is that there exists a credible threat to existing companies with little-to-no impediments for new entrants. The contestable market theory was introduced to the world by economist William J. Baumol argued that contestable markets always yield competitive equilibrium due to the continuous threat of new entrants.

The requisites for a perfectly contestable market are hard to come by. Costs to enter and exit a market are rarely minimal, while factors such as economies of scale almost always reward companies that have been around for longer. Aspects of contestable market theory heavily influence the views and methods of government regulators. That's because opening up a market to potential new entrants may be sufficient to encourage efficiency and discourage anti-competitive behavior.

For example, regulators may force existing companies to open-up their infrastructure to potential entrants or to share technology. This approach of increasing contestability is common in the communications industries, where incumbents are likely to have significant power or control over the network and infrastructure.

Tools for Fundamental Analysis.