Experiments on Potential Competition Regulating Monopoly Behavior
Clark (1887) emphasized on the role of latent competition and questioned the effectiveness of it as compared to actual competition in restraining monopoly pricing. More recently the theory of contestable markets formalized the effects of potential entry. Baumol (1982) formalised the idea of contestability.
Conditions for a market to be contestable
Baumol, Panzar, and Willig (1982) characterized a contestable market as one in which there is
The fundamental result is that in contestable markets the incumbent monopolist charges the average cost price in equilibrium.
Coursey, Isaac, and Smith (1984) conducted an experiment to designed to evaluate the effects of contestability under decreasing cost conditions with human buyers. In the contested experimental markets, four of the duopolies yielded competitive price outcomes, and the other two exhibited downward trends in prices.Harrison and Mckee(1985) and Harrison, Mckee, and Rutstrom (1989) observed similar results in their experiments with simulated buyers.
A key behavioral assumption of the contestable markets theory is that the entrant evaluate the profitability of entry given the incumbent's current prices. Harrison (1986) conducted an experiment in which this restriction was built in. In his experimental institution the incumbent had to post a price first, which the entrant could observe before choosing a price. Harrison again found contestability hypothesis to generate the predicted monopoly restraining effects in his experiment.
Milner, Pratt, and Reily (1990) implemented another environment where at any instant the seller with the lowest price makes the sale. This flow market experiment involved decreasing costs up to capacity, and simulated continuous time buyers. The authors did not observe any stable pricing behavior though. When the price fell too low one seller often exited at which the other seller raised the prices dramatically.