Contestable markets, trade and development
Baumol, William J. | Kyu Sik Lee
The design of policies to improve economic efficiency using the private sector as principal agent requires a clear understanding of the role of market structure. Contestability analysis provides a tool for the purpose. The concept can guide the government that wants to have it both ways: to protect the public and smaller firms from the threat of monopolistic behavior by large firms, at the same time allowing the larger firms enough freedom to meet the requirements of efficiency and to exercise entrepreneurship. Perfect contestability provides a standard for ideal market behavior. A perfectly contestable market is one in which entry and exit are perfectly costless; in such a market, the mere (perpetual) threat of entry can enforce good conduct by incumbents. So long as sunk costs are zero, a potential entrant can undercut any excessive prices of incumbent firms, yet earn an attractive rate of return. Thus perfect contestability precludes excessive profits and prices as well as waste and inefficiency, and it prevents predatory pricing. What contestability analysis means for policy in developing countries is that an economy that wishes to take advantage of available economies of scale can use the norms of behavior provided by the theory as a guide for regulation of its larger firms, instead of resorting to nationalization or to stifling restrictions as the means to protect its infant industries and its consumers.
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