Introduction to contestability theory
A contestable market has no entry barriers - firms can enter or leave an industry costlessly. 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.
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: