This is “Contestable Market Model”, section 6.9 from the book Managerial Economics Principles (v. 1.0).
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The contestable market modelAn idealized market that is similar to perfect competition but in which there are a modest number of sellers, each of which represents a sizeable portion of overall sales.The key text on the contestable market model is by Baumol, Panzar, and Willig (1982). alters a different assumption of the perfect competition model: the existence of many sellers, each of which is a barely discernable portion of all sales in the market. When we consider most of the markets that exist in the real world, it is rare that this condition of the perfect competition model applies. Rather, most markets have sellers that represent a substantial presence and would noticeably change the market if any one of them would suddenly suspend production and sales. Also, in many industries, the minimum efficient scale is so large that any firm that manages to increase to that size will be necessarily contributing a substantial fraction of all market sales.
In the contestable market model, there can be a modest number of sellers, each of which represents a sizeable portion of overall market sales. However, the assumptions of free entry and exit and perfect information need to be retained and play a key role in the theory underlying this model. If buyers in the market know which seller has the lowest price and will promptly transfer their business to the lowest price seller, once again any firm trying to sell at a higher price will lose all its customers or will need to match the lowest price.
Of course, it may be argued that the selling firms, by virtue of their size and being of limited number, could all agree to keep prices above their average cost so they can sustain positive economic profits. However, here is where the assumption of free entry spoils the party. A new entrant could see the positive economic profits of the existing sellers, enter the market at a slightly lower price, and still earn an economic profit. Once it is clear that firms are unable to sustain a pact to maintain above cost prices, price competition will drive the price to where firms will get zero economic profits.
In the late 1970s, the U.S. government changed its policy on the passenger airline market from a tightly regulated market with few approved air carriers to a deregulated market open to new entrants. The belief that airlines could behave as a contestable market model was the basis for this change. Previously, the philosophy was that airline operations required too much capital to sustain more than a small number of companies, so it was better to limit the number of commercial passenger airlines and regulate them. The change in the 1970s was that consumers would benefit by allowing free entry and exit in the passenger air travel market. Initially, the change resulted in several new airlines and increases in the ranges of operations for existing airlines, as well as more flight options and lower airfares for consumers. After a time, however, some of the larger airlines were able to thwart free entry by dominating airport gates and controlling proprietary reservation systems, causing a departure from the contestable market model.A good account of airline industry deregulation is in chapter 9 of Brock (2009).