Question

Explain what is contestability theory?

Answer 1

The contestability theory was propounded by William Baumol. According to this theory, a contestable market is on in which there are no entry and exit barriers. As a result of this, even when there are only a few firms in the industry they will behave like a perfectly competitive firm and produce at P=MC ie.. they make no economic profit. This is because the firms know that the economic profit would incentivize other firms to enter the industry. Hence, the incumbent firms behave like perfect competitive firms because of the threat of new entrants.