While we digest the royal commission’s evidence of shocking misconduct by the banks and insurance companies, there’s another unpalatable truth to swallow: they have no monopoly on bad behaviour.
It seems almost everywhere you look you see examples of companies behaving badly. In a major speech he gave a few months ago, the chairman of the Australian Competition and Consumer Commission, Rod Sims, offered a remarkable list of business household names the commission was taking proceedings against, as I noted at the time.
Commissioner Kenneth Hayne has given us a lawyer’s explanation of why the banks misbehave, but Sims’ speech offers an economist’s explanation.
It’s an important, though sensitive, question for economists since their simple “neo-classical” model of markets predicts firms won’t mistreat their customers because, if they did, they’d lose them to a competitor.
Sims offers seven reasons for this evident “market failure” – a term economists use to acknowledge when real world markets fail to deliver the benefits the textbook model promises.
First, he says, meeting customer needs may not be the main way companies succeed.
On the supply side, markets and economies are driven by the desire of firms to earn and grow profits. (On the demand side, markets are driven by the self-interest of consumers seeking the best deal they can get.)
“However”, Sims concedes, “being the best at meeting the needs of consumers is not the only, or even the dominant, way firms succeed. Staying ahead of rivals through continual improvement is a difficult task for most companies; eventually, someone [else] works out how to do things better and cheaper.”
“Commercial strategy therefore is largely about building defences against the forces of competition. To make it more difficult for other firms to develop a better product. Or, if they do, to limit their access to customers.” Much of this is perfectly legal.
Michael Porter, the doyen of corporate strategists, from Harvard Business School, demonstrated that firms can best attain commercial success by reducing the number of competitors, by erecting high barriers to new firms entering the market, by keeping suppliers dispersed and weak, by using brands or the bundling of products to create strong consumer loyalty, and by reducing the likelihood of other firms being able to offer your customers products those customers see as substitutable for your product (that is, by “product differentiation”).
Sims’ second reason customers may not get treated well is that executives are under considerable sharemarket pressure to increase short-term profits, so as to increase share prices. Executives’ bonuses are often geared to achieving this.
Many companies set a sales or profit target higher than the growth in nominal gross domestic product, meaning not all of them can achieve it. This can induce some executives to push the boundaries and ignore the risk of reputational damage over the longer term.
Third, in some markets poor firm behaviour goes unpunished by customers. This can be so because customers don’t see what’s been done to them – that they’re being misled, or that firms have formed an (illegal) cartel to keep prices high.
Or it can happen because customers don’t have viable alternative products to turn to. Or switching to another provider may be too difficult or costly. Firms may deliberately make it hard to compare their product with their competitors’.
Fifth, companies may give their staff financial incentives without adequate safeguards to prevent mistreatment of customers.
Companies can establish poor business models, such as arrangements that leave franchisees little room to achieve a return on their investment while paying their workers award wages.
Sixth, customers can consider themselves badly treated when firms (including banks and power companies) engage in “price dispersion” – charging new customers a lower price than existing customers – which is a common practice and perfectly legal.
Economists have often judged this to be a good thing – “welfare enhancing”. But Sims notes that such behaviour imposes extra search costs (spending leisure time checking to see that companies you deal with aren’t taking advantage of you) which are a loss to society.
(He could have added than the economists’ simple model assumes away all search costs – an example of “model blindness”, by which economists mislead themselves.)
Finally, customers can suffer if executives’ loyalty to their company leads them to sail closer to the edge of what’s legal than they would in their private lives. If some lawyer tells you it’s not illegal, does that make it honest?
Not surprisingly, the economist’s explanation of why businesses behave badly is very different to the judge’s. But when it comes to what we can do about it, Sims and Hayne aren’t far apart.
Commissioner Hayne’s answer is not to pass new laws outlawing conduct that’s already illegal, but to increase penalties so as to make them a realistic deterrent to big businesses whose size means their misconduct in just one area can earn them huge sums, and then police the law with far more vigour and diligence that so far shown by the financial regulators, including Treasury.
Sims has several suggestions. Increase the “private cost” of bad behaviour by identifying and shining a light on bad behaviour, increasing penalties and continually looking for new ways to increase regulators’ ability to identify and pursue bad behaviour.
Markets will never be as competitive as the textbook model assumes, but Sims says governments should ensure they’re as competitive as possible.
And they should bolster competition on the consumer side by taking measures to lower customers’ search costs – the time and effort needed to find the best deal.
Ross Gittins is the Herald’s economics editor