Why the threat of entry can keep even a monopolist’s price close to average cost, what makes a market contestable, and why perfect contestability is rare.
In 2010 Ryanair pulled out of Belfast City Airport after a row over extending its runway. Within a week, Flybe announced three new routes from the airport and based two extra aircraft there to fill the gap. In 2021 Ryanair came back to Belfast City with eight summer routes, then left Northern Ireland altogether that October, blaming Air Passenger Duty. In 2023 it reopened a base at Belfast International with two aircraft.
How can airlines enter and leave routes so quickly? And what does that do to the fares of an airline that has a route to itself?
Sources: Air Journal (October 2010); Irish News (March 2021); Travel Weekly (August 2021); Ryanair (July 2022); Breaking News (2023).
A market is contestable when firms can enter and leave easily. The theory, from the economist William Baumol, says the threat of entry can discipline firms, however few of them there are. A perfectly contestable market needs:
No real market is perfectly contestable. It is a benchmark, like perfect competition, that tells you which way a market will be pushed.
Only one airline flies a route from Belfast.
It knows another airline could start flying the same route next season, using planes it already owns.
What is the airline most likely to do with its fares?
If entry is easy, high fares would attract a rival. The airline does best by keeping fares close to its average cost, so there is no abnormal profit to tempt anyone in. The threat of entry, not the number of firms, keeps the price down.
One airline has a route to itself. It has high fixed costs, so its average cost falls as it carries more passengers. To keep it simple, marginal cost is constant: each extra passenger costs the same.
If it behaved like a protected monopolist, it would produce where MC = MR, at Qm, and charge Pm. Price is well above average cost, so it would earn abnormal profit.
But this market is contestable. An entrant with the same costs can come in, undercut Pm, take the abnormal profit, and leave as soon as prices fall. With no sunk costs, leaving costs it nothing. That is hit-and-run entry.
Check: Why can an entrant take this profit and leave without losing money?
With no sunk costs, leaving costs nothing: the aircraft simply flies another route. So entering is almost risk-free whenever there is abnormal profit.
So the incumbent’s best defence is to leave nothing to hit. It sets its price where AR = AC, at Pc, and supplies Qc. Price equals average cost, so it earns only normal profit, and an entrant would gain nothing by coming in. One firm, behaving as if it faced competition.
Teacher tip: AR = AC is the furthest the threat of entry can push price. Most real markets are only partly contestable, so expect price to move towards Pc rather than all the way, and say so in your answer.
Is the outcome efficient? Price equals average cost, so there is no abnormal profit, and the threat of a lower-cost entrant pushes the incumbent to keep costs down: little room for X-inefficiency. But price is still above MC, so it is not allocatively efficient, and average cost is still falling, so it is not productively efficient either.
Check: In a contestable market, what disciplines the incumbent’s price?
Even a single firm keeps its price close to average cost if entry is easy, because any abnormal profit would attract rivals.
Now apply this to real airline routes.
Check: Which feature of the airline industry makes a route fairly contestable?
An aircraft is the biggest cost of serving a route, and it can be flown elsewhere if the route fails. So most of the cost of entry can be recovered on exit.
Back to Belfast. Aircraft are not sunk: they can be moved, as Ryanair and Flybe showed. That makes airline routes fairly contestable. But some costs are sunk, such as advertising a new route, and airport slots and runway rules can block entry, as Heathrow’s slots do.
Contestability is not fixed. It changes over time.
Check: Which change would make a market less contestable over time?
A patent is a legal barrier: entrants cannot use the technology, so the threat of entry weakens. The other three all make entry and exit easier.
They put it where demand meets MC, as if it were perfect competition. With high fixed costs, AC is above MC there, so the firm would make a loss. The threat of entry only pushes price down to average cost, where AR = AC.
Explain how the threat of entry can make a monopolist behave like a competitive firm.
In a contestable market, firms can enter and leave freely and there are no sunk costs, so anything spent on entry can be recovered on exit.
If a monopolist charged the profit-maximising price, where MC = MR, it would earn abnormal profit. That would attract a hit-and-run entrant: a firm with the same costs could come in, undercut the price, take the profit and leave as soon as the incumbent responded, losing nothing because its costs are not sunk.
To remove the incentive, the monopolist sets its price where AR = AC. It earns only normal profit, so there is nothing left for an entrant to take. The threat of entry also pushes it to keep its costs as low as possible, because an entrant with lower costs could undercut it. So a single firm behaves much as a competitive firm would, even though it has no rivals.
**Evaluation:** perfect contestability is rare. Sunk costs, such as advertising, make entry risky; incumbents may be able to cut prices instantly or use limit pricing; and legal barriers such as airport slots can block entry altogether. The more of these there are, the more a monopolist can keep its abnormal profit.
Airline sources: Air Journal (2010), Irish News and Travel Weekly (2021), Ryanair and Breaking News (2023). Diagrams drawn with Rough.js and perfect-freehand, both MIT licensed. Your answers are saved only on this device.