The contestable market theory states that the behavior of firms in a market is determined more by the threat of new competition than by the actual number of companies currently selling there.

Key features of a contestable market:

• No sunk costs: Companies can enter or leave the market without losing money.
• Hit-and-run competition: New firms can easily enter to make a quick profit if existing firms charge prices that are too high.
• Pressure on incumbents: Existing firms must keep their prices low to prevent new competitors from entering.

Main assumptions:

• There are no barriers to entry or exit.
• New firms can easily challenge existing ones.

Key implications:

• Even a monopoly might act competitively if the threat of new entry is high.
• There is less need for government regulation because the threat of competition forces firms to act fairly and efficiently.