Monopoly rents in contestable markets

- We analyze a contestable market using a model with pricing and entry decisions.
- Only one firm enters the market, and randomizes over multiple prices.
- The other firm stays out of the market in equilibrium.
- Undercutting is not profitable because of randomization.
- The entrant is able to charge high prices and collect positive rent.

Random choices of prices and product characteristics can be used by a contestable monopolist to deter entry and fully extract the monopoly rent. We develop this idea in a model of Bertrand price competition. In equilibrium, one firm enters the market and makes choices that are unpredictable to its competitors. This prevents price undercuts and keeps other firms out of the market. The entrant firm collects the monopoly rent despite the existence of potential competitors. This result raises an alert for regulatory practices based on the conventional wisdom that contestability is associated with low prices and profits.