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.
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.
- atleast one potential rival with the same cost structure,
- potential entrants evaluate the profitability of entry at the
incumbent firm's prices, and
- there are no barriers to entry and exit and in particular there
is a possibility of hit-and-run entry.
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
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.
- Clark, John Bates (1887). The Limits of Competition. Political
Science Quarterly 2: 45-61.
- Coursey, D., M. Isaac, and V. Smith (1984): Natural Monopoly and
Contested Markets: Some Experimental Results. Journal of Law and
Economics 27: 91-113.
- Harrison, Glenn W. (1986). Experimental evaluation of the
contestable markets hypothesis. Public Regulation, E. Bailey,
editor, Cambridge, Mass.: MIT Press.
- Millner, Edward L., Pratt, Michael D., Reilly, Robert J (1990).
Contestability in real time experimental flow markets. Rand Journal
of Economics 21: 584-99.