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.

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5 Responses to IAN McAULEY. Reclaiming the ideas of economics: Competition 

  1. Alan Pears says:

    Ian’s point seems valid regarding electricity. The Thwaites review in Victoria showed that a large proportion of retailing costs were associated with ‘customer acquisition’ or marketing. Further, the duplication of IT systems, management structures etc meant economies of scale could not be captured. On the other hand, the vertically integrated monopoly model of public utilities certainly had its problems, and these utilities would exert their influence to block innovation – unless activist governments drove them. The Victorian government in the late 1980s had some success in forcing the SECV to pursue demand management to the extent that the SECV in 1992 published a paper showing how it could meet the Toronto Target (20% cut from 1988 carbon emissions by 2005!) at a reasonable cost. However, Labor’s deal with unions before the 1988 election to build Loy Yang B worked against achievement of climate targets. For me, what it comes down to is that no system is perfect, and that public scrutiny and limits on influence are essential. At present, it seems clear that energy is being disrupted by new models never imagined by most market players. Somehow we have to open up regulatory and policy models to new forms of competition while maintaining strong consumer rights and transparency. A core problem is that most debate ignores the reality that no-one actually wants energy for its own sake – it is a need derived from our desire for ‘valued services’ that can now be provided in many different ways, using much less energy than past solutions, and also distributed energy solutions that are still not well understood.

  2. Greg Bailey says:

    Another very good explanation of the subject, Ian. I have often wondered, when several new players come into a large market like electricity, whether the capital raising they are required to undertake negate the cost of retaining the industry in a regulated monopoly situation in order to achieve economies of scale.

  3. michael lacey says:

    In most markets competition drives cost reduction and innovation??

    Today we are witnessing the death of competition in industry after industry as the biggest corporations increasingly gobble up all of their competitors.

    The capitalist system has built into it mechanisms which we call competition. We like to talk about competition but we are hesitant most of the time to ask and pursue the question. Where does competition lead and it turns out that competition leads to its own extinction, competition wipes itself out and becomes instead monopolies.

    In other words if two or more companies compete, one of them makes a better product, or one of them lowers the price or, if they’re really good they can make a better product at a lower price. Those who do the best job at lowering the price and/or improving the quality of the work; they win and typically the winner in competition eats the loser; that is the loser goes out of business and the people who worked for the losing company now look for jobs.

    In the company that won the people who supplied the losing company look for customers in the companies that won and so the many becomes few .

    Capitalism leads to monopolies, by the way monopoly is not the only thing capitalism leads to in this way.
    It will often lead to a situation where there isn’t one company left standing to the point where they can get
    together legally or illegally, publicly or privately and work things out amongst themselves something much harder to do if there are hundreds let alone thousands
    of companies.

    So what’s the point the reason companies merge is it’s profitable it’s a way to be able to charge higher prices. Having merged with the company that might have competed with you, you control them and they will not compete with you anymore. You literally absorb them you’re now the decision-maker.

    Mergers like this reduce the number of people from the already small minority that control our economy to an even smaller one. The shareholders of the combined company will be richer; they will select a board of directors that will now preside over the lives and fortunes of many more people than either of the two boards of directors of AT&T and Time Warner separately had been able to do.
    This is the concentration of economic power in a society where economic power is already concentrated.

    The capitalist system always pushes in that direction is it happening across the board.

    When it happens with critical public infrastructure it drives up the cost of doing business

    Look at an important economist in the United States who discussed it. Simon Patten. He was the first economics professor at the first business school in the United States, the Wharton School at the University of Pennsylvania.
    Patten said that there are four factors of production. Classical economics talks about three factors of income — land, labor and capital. But there’s a fourth factor of production, and that’s public infrastructure. However, its function, Patten said – and this is a pro-capitalist saying it, this is the business school – the function of public infrastructure, roads and schools is not to make a profit, like a private investor would do. The public aim is to lower the cost of living and doing business, so as to make the economy more competitive.
    We have been given the snake oil !

  4. Michael Keating says:

    Sorry Ian but I don’t think this article is up to your usual standard.
    The assertion that all electricity retailers sell the same product does not mean there is no competition. The fact is that there are considerable cost differences between different generators of electricity, and the East Coast of Australia now has a very competitive wholesale electricity market. As both the Productivity Commission and the regulator have documented, electricity prices are lower as this competition has driven both efficiency improvements and innovation. If new generators could not enter the market, and we were stuck with a vertically integrated monopoly, like the State Electricity Commission of Victoria, do you really think that the take-up of renewable energy would have been as fast? Instead, I suggest that a monopoly will seek to prevent its existing assets being stranded, and the dirty brown coal burning Loy Yang generator would still be open.
    As we all know, retail electricity prices have increased in the last few years, but that is entirely due to an increase in the cost of transmission. The reason seems to be some gold-plating of delivery standards and over-investment, which can happen when as with transmission there is no competition, and we are forced to rely on price regulation.

    • Ian McAuley says:

      Thanks Mike.

      You’re right: competition between electricity generators has been brought benefits. No reasonable person would disagree with your points. At the beginning of the supply chain where all modes of technology are used to generate electricity, competition works.

      But my example is about the “retailers” at the other end of the supply chain – businesses that have virtually no connection with the physical product. Some of them have a look at your meter every quarter, but many of them don’t even do that – they contract that to the electricity distributors. A fifth to a quarter of our electricity bill is to pay for these “retailers”.

      If the National Energy Market had been designed by practical engineers and economists, they would have separated out generators from the state utilities, leaving those utilities with the traditional tasks of transmitting and distributing electricity, and collecting payments from customers. Government enterprises are reasonably good at running capital-intensive natural monopolies in industries with mature technologies. They don’t demand the outrageous profits that the privatised monopolies have cajoled out of government regulators, and they have no incentive to engage in “gold plating” to which Mike refers.

      But in their zeal for “structural separation” the architects of the NEM went way beyond a simple separation of generation, and spawned a huge new financial intermediary industry – electricity “retailers”. Perhaps they believed that competing retailers could bring some benefits to customers – particularly in the area of demand management. But for the most part they have behaved like the rest of the financial sector – competing for market share, imposing “loyalty taxes” on customers who do not switch, and making it difficult for people to shop around.

      Then there is another issue, the position of so-called “gentailers”, which are retailers owned by the large generating firms. That brings up a host of problems not foreseen by the NEM’s architects. That’s another story in its own right.

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