IAN McAULEY. Reclaiming the ideas of economics: Competition 

Competition generally brings tremendous benefits to consumers, but when it becomes an end in itself those benefits can be outweighed by the costs of competition.

If you lived in Melbourne in the old days, before Australia adopted competition policy in the 1990s, you had no choice but to buy your electricity from the state-owned State Electricity Commission of Victoria. Similarly in other states and cities – ETSA in Adelaide, the QEC in Brisbane and so on.

Now, in our brave new world of privatisation and competition, if you live in Melbourne you have the choice of at least nine electricity retailers.

They all sell exactly the same product

This choice is offered in the name of competition, but it isn’t the sort of choice we’re offered in choosing  makes and types of cars, clothes and cooktops, because all these firms are selling exactly the same commodity – a source of electrical energy at 50 cycles, single phase, 230 volts (some premises are wired for three-phase supply). It’s not as if the different firms are selling an identical commodity – as is the case with competing suppliers of gasoline. They are all offering exactly the same product – a product they buy from generators. You may be offered “green” energy, but if you do buy “green energy” the electricity that charges your vacuum cleaner and lights will be sourced from exactly the same combination of coal and renewable sources as that which supplies your environmentally indifferent neighbour.

In most markets competition drives cost reduction and innovation, but in electricity significant cost reduction occurs only at the generation end, where renewables are displacing high-cost thermal generators. But down the line, between the generator and your power plug, most technology is more than 100 years old, and one certainly does not want variety in supply: a vanilla 230 volt 50 cycle is just what we want. There can be some advances in metering, but our competing “retailers” tend to go more for marketing innovations (such as bundling electricity and gas) rather than process innovation. The electricity retailers do help consumers by smoothing out prices – the spot prices they pay varies tremendously over the curse of a day – but the old state monopolies had been providing simple and clear tariff structures without creating artificial markets.

Electricity supply is an extreme example of competition having become an end in itself, rather than a means to an end, that end being consumer benefits of lower prices and innovation.

It’s easy for those who have dabbled in a little economics, and those who have experienced or read about life in centrally-planned economies – the world of Trabant cars and Spreewaldgurken (made famous in Goodbye Lenin) – to believe that competition, in itself, brings tremendous benefits.

Competition brings costs as well as benefits, however. Each firm competing in a market bears its own fixed costs, meaning that scale economies cannot be realised. When it is difficult to engage in cost reduction or product innovation, as is the case of many financial services, firms tend to compete vigorously for market share, which is essentially a negative sum game.

Our 37 competing private health insurers illustrate the costs of competition.  Their administrative costs – the difference between funds received and benefits paid – amount to $4 billion a year. Of every dollar paid in premiums only 84 cents comes back as benefits paid. Even though that is better than most insurance (where payout may be as little as 50 cents), it is still expensive compared with Medicare, which, even after the cost of tax collection is taken into account, pays out 95 cents in the dollar. If there were innovation in health insurance that $4 billion may be worth it, but because the industry is necessarily so heavily regulated all health insurers offer essentially the same product. Customers are given “choice” but no real variety.

What competition zealots often overlook is the cost to consumers engaging in price comparisons. Collating price offers and calculating the benefits and costs of different rebates and incentives is time-consuming. The beneficiaries are those with time on their hands and the skills to construct spreadsheets – retired engineers perhaps. Their benefits come at a cost to all other consumers.

Economists – at least those who go beyond the simple models – call these costs “transaction costs’ and “search costs”.  As far as the consumer is concerned they are better called the costs of “confusopoly” (a term coined by Professor Joshua Gans). They don’t feature in basic economic texts, which assume, for the sake of simplicity, that all trades are frictionless and that knowledge is costless. But the costs are real, and if we must ration our shopping time we could probably spend it much more profitably by allocating it to markets where competition does work well.

In banking, transaction and search costs have spawned a whole new high-cost industry which, for a not always clearly-disclosed fee, does your shopping for you – the mortgage broking industry. As the Commission into the finance sector found, mortgage brokers have their own incentives which probably don’t align with the needs of their customers. Similarly many product comparison websites do not necessarily guide users to the best suppliers. (The only trustworthy comparison websites are operated by non-commercial entities such as Choice or by governments.)

Another cost, real but not easily quantified, is the intrusion into our lives of advertising – the visual pollution of billboards and advertising signs, the distracting advertisements on web pages, the din of TV and radio advertising.

It’s not only consumers who bear the costs of excessive competition. Small businesses supplying to government often have to go to tender for very small contracts. Tendering costs and the associated discontinuities in business can drive small and low-cost companies out of businesses, while their more expensive competitors, specialised in impression management and with more capacity to ride out the discontinuities of dealing with government. Some tendering processes produce absurd outcomes, such as the Optus cellphone service in Archer River in Queensland’s Cape York, when almost every other cellphone service in remote parts of Australia is provided by Telstra.

Perhaps the most absurd application of competition for competition’s sake was in the 1990s, when the Commonwealth allowed Telstra and Optus to provide competing pay TV services. Both firms ran their own cables along the streets, each cable capable of running both providers’ signals and more. All that Australians got was an expensive mess of under-utilised cables strung around some suburbs, while other regions, too lightly-populated to be of interest, got no pay TV service.

By now the reader of this essay may believe it to be arguing a case for central planning. But its point is that competition is costly, and in situations where those costs start to outweigh the benefits, as is the case in industries with simple, undifferentiated products using mature technologies, competition often imposes net costs to consumers.

In Australia public policy seems to be driven by the neoliberal idea that competition, in itself, is an adequate policy objective. So long as there is no collusion between suppliers and there are no insurmountable barriers to new players, Adam Smith’s “invisible hand” will do the rest. (Or is “competition” a convenient excuse for privatisation?)

A more pragmatic model, which largely explains the outstanding growth in postwar West Germany – their Wirtschaftswunder – is the economic philosophy of “ordoliberalism” (Ordoliberlismus). It is based on considering the theoretical outcomes of Smith’s model, and doing whatever is needed to achieve those outcomes. Maybe a reasonably unfettered free market, maybe a not-for-profit monopoly, maybe a regulated private firm – whatever works.

It’s uncommon to find Germans outdoing the Anglosphere on pragmatism, but in their microeconomic philosophy they seem to have achieved that crossover. Economic policy should be about achieving benefits for society, not about an obsession with “competition”. It’s a means, not an end.

 

This is the tenth of a series of articles in Pearls and Irritations  on reclaiming the ideas of economics. Others so far have been:

General introduction (September 19)

Aspiration (September 26)

Jobs and Growth (October 3)

Society, economy and the environment (October 10)

Regulation and deregulation (October 17)

Taxes (October 24)

Globalisation (October 31)

Debt and deficits (November 7)

Wealth (November 14)

 

Ian McAuley  is a retired lecturer in public finance at the University of Canberra and a Fellow of the Centre for Policy development.

print

Ian McAuley is a retired lecturer in public finance at the University of Canberra and a Fellow of the Centre for Policy Development.

This entry was posted in Economy. Bookmark the permalink.

Please keep your comments short and sharp and avoid entering links. For questions regarding our comment system please click here.
(Please note that we are unable to post comments on your behalf.)