Characteristics of Contestable Markets:

1. Actual and Potential Competition: Contestable markets are characterized by the presence of both actual competitors and potential competitors. This means that even if there are only a few firms operating in the market, potential entrants can quickly and easily enter the market if they see an opportunity for profit.
2. Free Access to Production Techniques and Technology: Entrants to contestable markets have unrestricted access to the production techniques, technology, and knowledge used by existing firms. This means that there are no proprietary or exclusive technologies that give established firms an advantage.
3. Low Entry and Exit Barriers: Contestable markets have minimal barriers to entry or exit. There are no significant obstacles that prevent new firms from entering the market or existing firms from leaving. This includes low startup costs and no sunk costs, which are unrecoverable investments.
4. Low Consumer Loyalty: Consumers in contestable markets are not particularly loyal to any specific firm or brand. They are willing to switch to another provider if they perceive a better deal or service, making it easier for new entrants to attract customers.
5. Variable Number of Firms: The number of firms operating in a contestable market can vary over time. New firms can enter, and existing firms can exit, leading to changes in market structure.

Contestable markets are often associated with the theory of perfect competition because they share characteristics that promote competition and prevent firms from exploiting market power. In such markets, firms must constantly operate efficiently and provide competitive prices and services to avoid losing customers to potential entrants.

Implications of Contestable Markets for Firm Behavior:

1. Allocative and Productive Efficiency: In contestable markets, firms are incentivized to be allocatively efficient, meaning they produce the quantity of goods where price equals marginal cost (P = MC). This results in efficient resource allocation. Additionally, firms operate at the bottom of the average cost curve in the long run, achieving productive efficiency. These efficiency goals are pursued because the threat of new entrants keeps firms on their toes.
2. Threat of New Entrants: Firms in contestable markets are not only concerned about competition from existing rivals but also from potential new entrants. The low barriers to entry make it easy for new firms to join the market, compete for customers, and potentially take away supernormal profits. This threat affects firms' pricing and operating strategies.
3. Hit-and-Run Competition: The ease of entry and exit creates a phenomenon known as "hit-and-run competition." New entrants can quickly enter the market to take advantage of short-term supernormal profits and exit once the profits diminish. This dynamic competition keeps established firms vigilant and competitive.
4. Similarity to Perfect Competition: Highly contestable markets can resemble perfectly competitive markets. Existing firms act as if they face intense competition, striving for both allocative and productive efficiency. This competitive behavior benefits consumers in terms of lower prices and better service.
5. Short-Run Supernormal Profits and Long-Run Normal Profits: In the short run, firms in contestable markets may earn supernormal profits as a result of efficient and competitive behavior. However, in the long run, these profits tend to be eroded as new entrants seek opportunities. As a result, firms often earn only normal profits in the long run. The pursuit of normal profits acts as a deterrent to potential competition, even when barriers to entry and exit are low.
6. Incentive for New Firms: Supernormal profits in the short run can attract new entrants. However, in practice, firms may not earn supernormal profits for an extended period due to the competitive nature of the market. New firms can still enter, but their ability to sustain such profits may be limited.

Types of Barriers to Entry and Exit:

Barriers to entry and exit significantly affect the competitiveness and dynamics of markets. They encompass various factors and mechanisms that either prevent or discourage new firms from entering a market or existing firms from leaving it. Here are some types of barriers to entry and exit:

1. Economies of Scale: Firms that exploit economies of scale can produce goods or services more efficiently as they grow in size. This creates a barrier to entry for new, smaller firms that may find it challenging to compete on cost-effectiveness.

2. Legal Barriers: Legal barriers include factors like patents, copyrights, and exclusive rights to production, which can prevent other firms from entering the market. These legal protections offer a competitive advantage to the holder.

3. Licensing: In certain industries, firms need to obtain licenses or permits to operate legally. Acquiring these licenses can be time-consuming and costly, acting as a barrier to entry for new firms.