The Contestable Market Model

The contestable market model is a model of oligopoly in which barriers to entry and barriers to exit, not the structure of the industry, determine a firm's price and output decisions. Thus, it places the emphasis on entry and exit conditions, and says that the price that an oligopoly will charge will exceed the cost of productionand be dependent only on the entry and exit barriers to new firms. The higher the barriers, the more the price exceeds cost. If there are no barriers to entry or exit the price an oligopolist sets will be equivalent to the competitive price. Thus, an industry that structurally looks like an oligopoly could set highly competitive prices and output levels.

In a contestable market, even low profits will encourage new entrants. As the new entrants come in, supply increases and price falls to eliminate profits. Oligopolistic firms selling in such a market know they can gain little in the long run from using their monopoly power to raise prices. If they do raise prices, a new firm (such as a foreign supplier) may enter the market. The new firm can eventually become a major supplier, thus reducing the existing firm’s market share.

Comparison of the Contestable Market Model and the Cartel Model

Because of the importance of the invisible handshake in determining strategies of oligopolies, no one "oligopolistic model" exists. The stronger the ability of oligopolies to collude (i.e., the more the invisible handshake can prevent entry), the closer to a monopolist solution the oligopoly can reach. The weaker the invisible handshake and the harder it is to prevent new entry, the closer is the oligopoly solution to the competitive solution. That's as explicit as one can be.

An oligopoly model can take two extremes:

(1) cartel model in which an oligopoly sets a monopoly price,

(2) contestable market model in which an oligopoly with no barriers to entry sets a competitive price.

Thus, we can say that an oligopoly's price will be somewhere between competitive price and monopolistic price. Other models of oligopolies give results in between these two.

Much of what happens in oligopoly pricingis highly dependent on the specific legal structure within which firms interact. In Japan, where large firmsare specifically allowed to collude, we see Japanese goods selling for a much higher price than those same Japanesegoods sell for in the United States. For example, you may well pay twice as much fora Japanese television in Japan as you would in the United States From the behaviorof Japanese firms;we get a sense of what pricing strategy U.S. oligopolists would follow in the absence of the restrictions placed on them by law.

Notice that both the cartel modeland the contestable market model usestrategic pricing decisions—firms set their price based upon the expected reactions of other firms. Strategic pricing is a central characteristic of oligopoly.

One can see the results of strategic decision making all the time. For example, consider a firm that announces that it will not be undersold—that it will match any competitor's lower price and will even go under it. Is that a pro-competitive strategy leading to a low price? Or is it a strategy to increase collusive information and thereby prevent other firms from breaking implicit pricing agreements? Recent work in economics suggests that it is the latter.

Let's nowsee how a specific considerationof strategic pricing decisions shows that the cartel model and the contestable market model are related.

Other Oligopoly Models

Behavior in oligopolistic markets is very difficult to analyze. The difficulty seems from the fact that the way firms behave depends crucially on how they think their rivals will respond to their pricing policies. The way firms compete in a market also depends on how they think their rivals will react to changes in advertising policies or to the introduction of new products.

In the preceding analysis of oligopoly we considered only the possibility of price wars and the tendency of firms to collude to maximize group profits. There are many other possible outcomes in oligopolistic markets. Each outcome depends on how firms regard their rivals, on their willingness to collude with their rivals, and on the penalties they may pay for illegal collusion. Each oligopolistic market must be examined by itself to determine what is going on.

Price leadership

In some oligopolistic markets, one dominant firm in the industry sets its price to maximize its own profits; other firms simply follow its lead by setting exactly the same price. The dominant firm is called the price leader. There's no collusion or quota setting. For example, in banking markets one or two large banks typically set the prime rate, which is the interest on loans to large corporations. Other banks quickly follow the large banks' lead and adjust their own interest rates.