Explain why, in theory, a perfectly contestable market results in an efficient allocation of resources

William J Baumol’s theory of contestable markets (1982) holds that there are markets served by a small number of firms, which are nevertheless characterized by competitive equilibria, and therefore, desirable welfare outcomes because of the existence of potential short-term entrants. The assumptions of a perfectly contestable market include no entry or exit barriers, no sunk costs, access to the same level of technology to incumbent firms and new entrants and low consumer loyalty. In theory, perfectly contestable markets result in an efficient allocation of resources as it will result in allocative and productive efficiency. Allocative efficiency occurs when neither too little nor too much of a good is being produced. This is achieved when the cost of producing the last unit of a good is equal to the value consumers place on that good as reflected in the price they are willing to pay. This is shown on the diagram below at the point where marginal cost equals price. Productive efficiency exists when production takes place at the lowest possible average cost. Contestable markets are characterized by “hit and run” competition. This means if a firm in a perfectly contestable market raises its prices much beyond the average price level of the market and thus begins to earn excess profits, potential rivals will enter the market, hoping to exploit the price level for easy profit. Therefore, because of this threat of competition, incumbent firms will produce at a level of output that earns them only normal profits so new firms are not attracted and entered the industry. Normal profits are defined as the minimum required to keep factors of production in their current use. This point of production occurs where average revenue equals average costs. Also, because of this threat of hit and run competition, firms will produce where average costs are minimised, where marginal revenue equals average cost. Therefore, a perfectly contestable market will result in both allocative and productive efficiency.

In this perfectly contestable market, the firm produces where the AC curve cuts the AR curve, resulting in only normal profits. This point is also where the marginal cost curve cuts the average cost curve, meaning the firm produces at the lowest average cost. Therefore, a perfectly contestable market will be both productively and allocatively efficient, meaning it will result in an efficient allocation of resources.