The Age of Contestability

Bryan Caplan.

When economists want to measure the competitiveness of an industry, they usually start by counting the number of competing firms.  If they see a lot of firms, they infer a lot of competition.  Few firms?  Little competition.  One firm?  No competition at all.

Three decades ago, a model came along to challenge this mindset: thecontestable market model.  In the contestable market model, a single firm often behaves exactly like a perfectly competitive firm.  Why?  Because of potentialcompetition.  Sure, your firm may be the sole supplier of a good right now.  But if you raise your price above the competitive level, all sorts of competitors might suddenly spring up.  To prevent this from happening, you need to keep your prices so low than no potential competitor bothers to become an actual competitor.

The contestable markets model enjoyed immediate attention.  But as you'd expect, believers in the traditional structure-conduct-performance model were not impressed.  It doesn't google, but I still remember Leonard Weiss's summary dismissal.  It went something like this: "The contestable markets model is empirically irrelevant and should play no role in policy."

There hasn't been much new research on the contestability model in recent years.  But I recently realized that the empirical and policy relevance of this much-maligned model is now very hard to deny.  

Consider: The internet has given us a long list of near-monopolies: Amazon, Apple, and Netflix are only the beginning.  Funny thing: consumers love these "monopolies."*  Despite their market dominance, these firms deliver amazing products at low prices.  And almost no one is "waiting for the other shoe to drop."  If someone claimed that Amazon, Apple, or Netflix were planning to gouge us as soon as they devour their last competitors, we'd laugh.

The contestable markets model has a simple explanation.  Sure, Amazon, Apple, and Netflix look a lot like monopolies.  But the people who run these firms can feel their potential competitors breathing down their necks.  If these "monopolies" start taking their customers for granted, they'll quickly cease to be monopolies.  Indeed, they may quickly cease to exist at all.  

In fact, the results we see are better than the simple contestability model predicts.  Amazon, Apple, and Netflix don't just keep offering customers the same attractive terms.  They're constantly trying to improve the terms they offer.  Why?  Because they realize that in the Age of Contestability, market leaders will fall behind unless they keep running full speed ahead.

* Yes, I know that Netflix recently burned up a lot of good will with some bad decisions.  But consumers still love the product. 

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