Contestable market theory suggests that in markets where the costs of entering and leaving are very low, existing firms are continually threatened by the entry of new competitors. Contestable market theory challenges one of the assumptions of PERFECT COMPETITION: that a large number of firms is needed to maintain COMPETITION and eliminate economic PROFITs. A contestable market is one in which firms can enter and leave the market without incurring significant COSTS. Fixed costs—costs that are required to start a business and do not change as output expands—act as a barrier to entry to would-be competitors. If new competitors can enter and exit a market without large expenditures, they can take advantage of market conditions when prices and profits are high and leave a market when prices are low. Many types of direct consumer sales, such as cosmetics, healthcare PRODUCTs, and consumer information SERVICES, can be entered and exited at relatively little cost. When a new product or service suddenly becomes popular, the few existing firms make economic profits. Seeing opportunities, new competitors enter the market, driving down prices and eliminating profits. Once the market price has dropped, some firms will exit the market. Recognizing the threat of potential entrants into contestable markets, existing firms will often cut prices and expand output to reduce the incentives for new competitors to enter their market. Contestable market theory is used to explain why firms with local monopolies or few competitors do not try to charge higher prices and maximize profits.
See also BARRIERS TO ENTRY; MONOPOLY.