Competition: You can have too much of a good thing

Boosting competition is helpful only if accompanied by strong regulation and incentives to promote investment

January 11, 2011

Competition makes capitalism work. By forcing firms to improve on service and price lest they be undercut by rivals, and by discouraging firms from abusing workers lest they leave, it makes the price mechanism work for the people. Neoclassical economists take these facts to their logical conclusion and see competition as practically a panacea for the world’s ills.

Reality is rarely so simple. The limitations of competition as a force for good are well-known. Consumers can be inadequately informed, making it possible for firms to take advantage of them, and they exhibit a range of behavioural patterns that can be exploited by the marketing industry. Likewise, the intrinsic difficulty of matching skills to positions and the costs associated with moving job may cause workers to stay with abusive bosses.

What is less well-known is that there are cases where competition can do outright harm. Most basically, it is unlikely that firms will respond to competitive pressures purely by improving service and cutting costs and prices. In a world where people have imperfect information and workers can’t always leave their employer, firms may be able to respond by cutting corners and abusing consumers and workers.

Companies may also respond to competition by reducing rates of investment so as to cut costs and boost profits in the short term, at the expense of consumer and public interests in the long term. This may not be rational even from the perspective of the firm, but people are not perfectly rational – especially when they are managers of a company under pressure from short-termist stockmarket investors.

Such short-termist behaviour is evident in the differential economic performance of Australia and New Zealand since the early 1980s. Until then, the two countries had near-identical GDP per capita. But New Zealand liberalised its markets – giving competition a freer hand to a greater extent – than its neighbour. The result was lower rates of investment by companies in New Zealand and a GDP per capita that was twenty-five percent lower than Australia two decades later. (The benefits to Australia of exporting primary commodities to China were an additional boost that largely came after.)

Excessive competition can be especially dangerous in financial services. Banks under tight competitive pressures can cut borrowing costs to the point where it fuels speculation and they may make unwise lending decisions in pursuit of yield. Asset managers in a strongly rising market, meanwhile, face only limited competitive pressures and can charge fees that consume much of the additional return generated for investors. Such fees create proprietary capital to further fuel speculation. And, after a market bust, many financial firms will be dead or hobbled; reducing competitive pressures on the survivors and leaving them free to take excessive profits once more.

How should regulators respond to these observations? Firstly, they should recognise that intense competition is to be desired only where it is accompanied by a strong regulatory framework to constrain unacceptable behaviour. Second, any measures taken to boost competition should always be accompanied by targeted incentives to boost real investment. Finally, in the financial services industry, since competition is of limited use here anyway, regulatory measures to ensure stability and orderly function should take priority over maintaining competitive markets.