The Role of Potential Competition in Industrial Organization

Abstract

Potential competition is important as a mechanism to control market power. I assess the strengths and limitations of alternative theories of potential competition by examining the available theoretical, empirical and institutional knowledge. I consider four major schools of thought: the traditional model of limit pricing, dynamic limit pricing, the theory of contestable markets, and the market efficiency model. Traditional limit pricing models rest on the assumption that firms respond to entry but are able to earn persistent profits when the structural characteristics of markets make entry difficult. Dynamic limit pricing is similar, but emphasizes that markets can only be temporarily protected from entry. Contestability theory, in its pure form, asserts that potential competition is as effective as actual competition in controlling market performance. The efficient markets hypothesis, broadly interpreted, states that markets are workably competitive and that the market structure reflects differential efficiency, not strategic behavior.