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Contestability Theory: Radicalising the Free Market

From the Trans-Pacific Partnership to the Regional Comprehensive Economic Partnership and a growing number of bilateral agreements, international trade deals are dominating diplomatic talks in the Asia-Pacific and beyond. Many of these heavily scrutinised deals are rooted in an economic theory that can sometimes lead to unintended or even antithetical consequences.

‘Contestability’ is a theory of industrial organisation which claims that even a monopoly will behave competitively if there are no barriers to entry or exit to the market in which the monopoly is operating. Under these conditions, entry into the market is absolutely free and exit is costless, meaning that an ‘entrant suffers no disadvantage’ in terms of cost or production.

The ease of moving in and out of the market will attract potential competitors, thus forcing the incumbent to behave competitively—that is, maintain low prices, often called the ‘entry limit price’. Even unregulated monopolies will not take supernormal profits, as this would encourage new entrants. An incumbent’s purported ‘vulnerability to hit-and-run entry’ by profit-takers is the crucial feature of a contestable market.

Contestability theory renders systematically a perspective of monopoly–oligopoly industry structures that is compatible with free market ideology; once carried into the policy space by economists and free market ideologues, it has been used to advocate for the removal of barriers to market entry and exit, such as regulations and taxes.

Paradoxically, far from subverting the basic principles of free market capitalism, contestability has come to radicalise the free market agenda. Just how radical that agenda has become in Australia is reflected in the various positions of advisors to Australian governments, even to the point of asserting that government providers are themselves a barrier to entry, and that private providers should prevail.

Establishing a foothold

The theory first entered the slipstream of international trade policy in the mid 1990s as a policy advocacy tool used by senior officials from the Organisation for Economic Co-operation and Development (OECD) and the European Commission. They saw its usefulness not as a theory whose calculus could be applied to international markets, but as a notion in setting new objectives for market access in the multilateral trading system, to further its adaptation to the evolving reality of deep integration and the needs of globally active firms.

It rose to global prominence around the time of the formation of the WTO in 1995 and has since played a key role in establishing efficiency and market access as the raison d’être of the Australian economy and the international trade community.

The work of reconceptualising and redefining the multilateral governance overseeing this new role for competition in trade policy came through GATS 2000, the WTO’s millennium negotiating round that would set the trade liberalisation agenda for the global services sector and complete the multilateral framework building on the initial General Agreement on Trade and Services (GATS) ratified in 1995.

Investments in host countries and greater mobility for service suppliers (labour) were key concerns for an enhanced GATS framework of rules and disciplines, which were to be foundational to all subsequent trade and investment agreements.

Fundamental to the GATS 2000 approach was competition policy and the efficiency precept underlying it, influenced by contestability theory. This was considered imperative to achieving coherence between the culturally nuanced competition policy and law of nation states and competition policy at the international level.

Justifying monopoly

Finding a solution to the problem of uncompetitive monopoly behaviour had long vexed economists, including Milton Friedman and Friedrich Hayek, champions of trade liberalisation and free markets. Friedman wanted to abolish antitrust law designed to constrain monopolies, believing it stymied competition which would naturally emerge if markets were unregulated. For Hayek, utilities in particular posed “the problem of how, in the absence of real competition, the effects of competition could be simulated and the monopolistic bodies be made to charge prices equivalent to competitive prices”. He did not find a solution, but pointed to the need for one.

Hayek was an internationalist who vehemently believed that it was possible to create what he variously referred to as an interstate federation and an “international system of coordination” guided by the price mechanism in a free market, if inflation was controlled and economic barriers removed, thus allowing a “self-directing automatic system” to function. For Hayek, as he wrote in his 1939 essay, ‘Economic Conditions of Inter-state Federation’, an inter-state federation “would do away with impediments as to the movement of men, goods and capital between the states and … would render possible the creation of common rules of law, a uniform monetary system, and common control of communications”.

Effects on the free market

Contestability has radicalised free market ideology by providing the rationale to disassemble pro-competition governance and other protections in favour of unfettered market access. This ongoing process has enabled transnational corporations to enjoy enhanced monopoly powers and control over capital flows, backed by the mechanisms of international agreements which are imbued with contestability notions.

The breaking down of economic barriers and aspects of the state apparatus that maintains them has left a vacuum that is being filled by transnational corporations which are accumulating powers once the preserve of the state and international governance bodies. At this juncture in history, where the new order is still emergent, Hayek’s portent from another time and place of rupture may offer salutary pause: “Perhaps even more than elsewhere current notions of what is desirable and practicable are here still of a kind which may well produce the opposite of what they promise”.

Caroline Colton is a PhD candidate at the University of Wollongong and a contributor to the Australian Institute of International Affairs’  Australian Journal of International Affairs.

This article is an extract from Colton’s article published on 29 November 2016 in the Australian Journal of International Affairs titled ‘Contestability ‘theory’, its links with Australia’s competition policy, and recent international trade and investment agreements. It is republished with permission.

Published February 19, 2017