A contestable market is one in which there are no barriers to entry or exit and no sunk costs. In
contestable markets, even a monopoly would behave as if it were competitive, as the possibility
of "hit-and-run" competition leads incumbents to set prices close to average cost. Back in 2013,
the government in the UK emphasized that energy markets, in which the "Big Six" firms had
been accused of overcharging customers, should have additional competition. The issue is
whether the increased contestability by itself is sufficient, or whether government regulation is
nonetheless needed.
Contestable market theory suggests that with barriers removed, supernormal profit cannot be
sustained in the long run by firms. Any attempt to price above AC would be countered by new
entrants, who could "hit and run" — enter temporarily, undercut the incumbent, and then exit
without sustaining any loss. This competitive threat leads incumbents to be efficient, to price at
P = AC, and to yield allocative and productive efficiency. The airline industry after deregulation
saw EasyJet and Ryanair enter with low expenses, challenging incumbent carriers. Here,
deregulation (making contestable) was a substitute for price regulation.This can be
demonstrated using the Monopoly outcome (P > AC, MR=MC) versus contestable outcome
(P=AC, Q higher, P lower). Therefore, if energy markets were made contestable, there might be
no necessity for regulation as market forces by themselves would discipline suppliers.
But in practice, contestability is never perfect. There are high sunk costs (infrastructure,
licenses, advertising) and high consumer switching costs in the energy industry. These
discourage new entry and lessen the threat of competition. In addition, consumer inertia and
brand loyalty tend to rule out successful hit-and-run entry. In the UK electricity market, despite
reforms and the arrival of challenger firms like Bulb, the Big Six were able to retain market share
until recent price caps. Consumers were mostly "sticky," failing to switch to cheaper providers.
New entrants fell out when wholesale prices rocketed, showing low actual contestability. Thus,
in markets where there are structural barriers to entry, contestability cannot completely replace
government intervention.
Technological change can make contestability more likely by reducing information asymmetry
and switching costs. For instance, energy price comparison websites have enabled households
to compare tariffs and switch suppliers more easily, increasing discipline on incumbents.
However, technology can also reduce contestability because of network effects. In digital
platforms, once one company gets critical mass (Google in search, Facebook in social media),
competition is reduced. In energy, digital infrastructure and smart meters are usually in the
hands of incumbents, which makes it difficult for challengers to access. So while technology
may facilitate contestability in a sense, regulation would nevertheless need to be in place to
ensure fairness and prevent abuse of market power.
