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The main characteristic of a contestable markets is that there are no entry and exit barriers. Hence there is always a threat of new entrants. When the incumbent firms are always facing a threat of new entrants, what is the effect on pricing polices and how does the contestability affect a firm in perfect competition and in monopoly.
This attracts new players to the field as there are no entry or exit barriers. When the number of players in the industry increases, the industry output increases. This reduces the profit margins of the firms. Will the entry of new players stop at this level No, the entry will not stop until the firms are able to make profits. But as the number of firms increases, the industry is squeezed of profits and the firms start making losses. When the firms start making losses, financially weak and the operationally inefficient leave the industry and that is also because there is no barrier to exit from the industry.
The example of the competition in the Video rental market in United States shows how the lack of entry or exit barriers help shape the industry. In the early 1980s when the Video cassette recorder(VCR) and video cassette player (VCD) was available to the consumers it became a must in many of the households. Statistics show that in 1980 less than 1% of American households owned a VCR. But by 1990 over 70% of families owned one. This led to a huge increase in demand for video cassettes. So movie tapes rental business was a very popular ones. The initial players in the industry had huge profits upto five dollars a night and they were able to recover the cost of the tape after a few rentals. ...
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