1. TRANSPORT ECONOMICS 2885 –CONTESTABILITY THEORY
COMMON QUESTION!
L1 Introduction to contestability theory – What is it?
A contestable market has no entry barriers - firms can enter or leave an
industry at no cost. The threat of potential entry may be enough competition
to ensure imperfectly competitive set price and output at or close to the
competitive price and output.
Imperfectly competitive markets can be contestable. Contestability theory
is associated with Baumol who argues the mere threat of new firms entering
a market means existing firms act competitively ie lowest costs, prices and
profits. The theory of contestable markets argues that what is important is not
actual but potential competition.
L2 A market is perfectly contestable when the costs of entry and exit are
zero where any entry costs can be recovered on exit ie there are no sunk
costs.
In a contestable market the threat of entry by potential rivals will ensure that
the firm or firms in the industry will earn normal profits and deliver allocative
and productive efficiency:
· Few barriers to entry into the market means potential entrants are able to
enter market quickly if abnormal profits are made. This process helps ensure
normal profits only, are earned in the long run;
· The size of firm is irrelevant;
· Price competition is unlikely, although it may occur for short periods;
The government has sought to create contestable markets in the rail, bus,
ferry and air industries through deregulation (buses) and short franchises
(trains).
L3 However, it hasn’t always worked because:
1) Significant entry barriers may exist and incumbent firms can often
scare potential entrants away from entering.
2) Sunk costs refer to expenditure that cannot be recovered if a firm
leaves an industry and represent a barrier to entry. If potential entrants
anticipate high sunk costs contestability theory is less effective in
lowering price and profits
3) Short-term franchises introduce contestability into transport markets
but deter long-term investment where firms feel they may lose their

2. current franchise and experience sunk costs. For this reason, the latest
franchise agreements are for longer periods eg 15 years. 15 year
franchises create uncontested legal monopolies.
If we were to now look at the individual transport markets (are they
contestable?):
· Road haulage:
· Bus:
· Rail operators :
· Airlines:
· Rail Infrastructure:
HOW IS THIS RELEVANT? (L4)
Well theory of the firm states that the greater the degree of competition the
more efficient the industry because firms cannot construct barriers to entry to
maintain their abnormal profit levels.
The profit motive will encourage technical efficiency. (but please remember
that entry into any transport involves very high sunk costs which will naturally
act as a barrier to entry)
Rail network in the UK has a very high level of output for minimum efficient
size, which makes a regulated monopoly possibly the only solution to the
problem.