What makes a market contestable—and why potential entrants keep incumbents honest

What is a market that looks like an oligopoly or a monopoly but can behave competitively, thanks to the possibility of new players stepping in tomorrow?

A contestable market.

Let me explain what that really means and why it matters in IB Economics at HL. It’s one of those concepts that can feel a bit abstract at first, but it helps you see why some industries don’t always look like what their number of firms would suggest.

What makes a market contestable?

Think of a market as contestable when the threat of easy entry and easy exit keeps incumbent firms on their toes. The actual number of firms (one, three, or a handful) is less important than the possibility that a new firm could enter and push prices down or push today’s high profits back toward normal levels. The key word is threat: not guaranteed entry, but the ability for a new competitor to slip in if incumbent firms act too greedily.

Two big ideas drive this:

• Low sunk costs. If a would-be entrant can get in and out without splashing cash that’s irrecoverable, entry is more likely. Sunk costs are the costs a firm can’t recover if it leaves the market. If those are small or avoidable, new players can test the waters without wrecking their finances.

• No or limited barriers to exit. If a firm can leave a market without paying a huge price, it’s easier for new entrants to take the plunge when they spot a better deal for customers or a better price for themselves.

Put those together and you have a market where incumbents can’t count on long-run monopoly profits. The imagined or possible threat of entry becomes a real force in shaping behavior today.

How does the threat of entry shape behavior?

In a contestable market, incumbents don’t get to flirt with high prices for long. If they push prices above what buyers are willing to pay, even briefly, a nimble entrant can step in, offer a better deal, and attract customers away. That threat causes incumbents to price closer to competitive levels, even if there aren’t many other firms around.

Economists often summarize this with a simple intuition: the market behaves, in many respects, like a perfectly competitive market because new players can come in and erode profits at little cost. The result is, in the long run, prices that reflect the true cost of serving customers rather than the markups you’d expect from a monopoly or a tight oligopoly.

A common way to frame it in the theory you meet in HL courses is this: if entry and exit are frictionless, the expected profits are driven down to normal levels, and prices tend toward marginal cost. If entry isn’t easy, or if sunk costs are high, the contestable nature fades and incumbents can sustain higher prices.

How does this differ from other market structures?

• Monopoly: One seller, high barriers to entry, the power to set prices above competitive levels for a long time. A contestable market can still look like a monopoly, but the day-to-day pressure from potential entrants keeps behavior in check.

• Oligopoly: A few sellers with obvious interdependence. In a priceless sense, a contestable market emphasizes how easy it would be for new players to disrupt the status quo, even if there aren’t many current competitors right now.

• Sealed or protected markets: These imply barriers that block entry almost entirely. In such settings, the threat of entry is weak or non-existent, so incumbents can act more like monopolists.

A simple takeaway: contestability isn’t about the number of firms; it’s about the ease with which new firms can join or leave the game.

What matters in the real world?

The neat thing about the contestable market idea is that it helps explain why some industries don’t behave as badly (or as well) as you might expect, based on the count of incumbents alone. Here are a few factors that often matter in practice:

• Regulatory structure. If the rules don’t lock existing firms in with heavy, lasting commitments, it’s easier for newcomers to come in. Think about sectors where licenses or temporary concessions can be obtained quickly, rather than a lifetime monopoly license.

• Access to essential inputs or infrastructure. If a new entrant can share or lease the same infrastructure the incumbents use, entry costs fall. This is common in some service sectors where digital platforms, payment rails, or access to spectrum can be opened up to entrants without colossal upfront investments.

• Brand loyalty and switching costs. Even with the ability to enter, customers might be slow to switch. When switching costs are small, the entry threat bites harder; when switching costs are large, the entrance threat weakens.

• Sunk costs. If an entrant must bear heavy irrecoverable costs to get started, the market becomes less contestable. That doesn’t just apply to money spent—it includes time, regulatory hurdles, and the need to establish trust.

To ground this, imagine a fictional yet plausible example. A city hosts a handful of bus routes in a compact area. The incumbent firms operate with long-standing contracts and own some limited, necessary bus depots. If a new operator could form quickly, lease the same depots, hire drivers, and start running on those routes with little upfront irrecoverable spending, the threat of entry would keep the incumbents honest on fares and service quality. If instead the new entrant would face steep sunk costs—custom schedules, offline branding, and the need to secure lengthy, hard-to-recover contracts—the contestability erodes and prices may stay higher than in a fully competitive scenario.

Where HL economics learners often stumble

• It’s not all about profits. Contestability is about behavior and price signals. Incumbents may still earn normal profits, but the standard of competition remains high because entry is plausible, not just theoretical.

• High-scale industries aren’t automatically un-contestable. Many sectors with giant firms can still be contestable if entry costs are low and exit is painless. The reverse is also true: a market with many firms isn’t automatically contestable if each firm faces heavy barriers to entry.

• The theory rests on a key assumption: threat rather than certainty. If entrants face delays, policy delays, or if the threat of entry is purely hypothetical, the protective shield around incumbents tightens.

Common misconceptions worth clearing up

• A contestable market isn’t a guarantee of lower prices forever. It’s a structural idea about potential competition, not a promise of constant price declines.

• It isn’t about “open season” for any firm, regardless of behavior. If incumbents respond forcefully to signals of entry (for example, by slashing prices briefly to deter a challenger), you still have a contestable market, but the dynamics become more nuanced.

• It doesn’t require perfect information. Potential entrants might not know all profit opportunities, yet the mere possibility of entry can influence how incumbents act.

A few straightforward takeaways for HL learners

• Look for the threat of entry, not just the current players. If new entrants could reasonably enter and compete, that’s the contestable edge.

• Note the ease of entry and exit. Low sunk costs and minimal regulatory friction boost contestability.

• Remember the price signal: in a contestable market, prices tend to be driven toward competitive levels because entry remains a credible threat.

A tiny digression that still serves the point

You know how sometimes a tech-enabled startup shakes up an old industry by making onboarding insanely easy? Think about streaming services that can launch in days rather than years, or rideshare apps that can go from zero to rubber on the road in a few weeks. Those kinds of capabilities lower the barriers to entry in a broader sense—even if incumbent firms own legacy networks or customer bases. The contestable market idea helps explain why incumbents in those spaces often price aggressively, or at least keep price increases in check, even when there aren’t dozens of competitors nipping at their heels.

Putting it together for your mental map

• Contestable market = a market with few firms but with credible entry and exit that keep prices and behavior in check.

• The ultimate hinge: how easily can a new firm enter, compete, and leave if it needs to?

• The practical upshot: even if a market looks like it’s owned by one or a few players, the threat of new entrants can force those players to behave more competitively than their market share would suggest.

• In exams or essays, you’ll want to spotlight the entry barrier story: what would a potential entrant face? How high are sunk costs? What signals does the incumbents’ behavior send about fear of competition?

Final thought

Contestable markets aren’t a neat label that fits every situation. They’re a lens—a way to ask the question, “What would happen if someone else showed up with a better deal or a lighter setup?” When you’re thinking like an HL economist, that question matters, because it helps explain why some industries stay relatively affordable and responsive, even when the battlefield isn’t crowded. And in the end, that’s the whole point: pricing and performance guided by what could happen next, not just by what’s happening today. If you can keep that thread in mind, you’ll spot the contestability dynamic in a surprising number of real-world stories.