A contestable market is characterized by free entry and free exit. By free exit, we mean that there are no sunk or irrecoverable costs; on leaving the industry, a firm can fully recoup its previous investment expenditure, including money spent on building up knowledge and goodwill. A contestable market allows hit-and run entry. If the incumbent firms, however few, are not behaving as if they were a perfectly competitive industry at long-run equilibrium (p 5 MC 5 minimum AC), an entrant can step in, undercut them, and make a temporary profit before quitting again.
The theory of contestable markets is controversial. There are many industries in which sunk costs are hard to recover or where the initial expertise may take an entrant some time to acquire, placing it at a temporary disadvantage against incumbent firms. Nor, as we shall shortly see, is it safe to assume that incumbents will not change their behaviour when threatened by entry. But the theory does vividly illustrate that market structure and incumbent behaviour cannot be deduced simply by counting the number of firms in the industry.