The banking royal commission has many sub-plots. Did you notice the one where a couple of the banks blamed their decisions to keep doing things they knew were dodgy on the pressure of competition?
A chap from Westpac didn’t argue when one of the inquiry’s barristers criticised it for paying “flex commissions” to car dealers arranging loans for people buying cars. The higher the interest rate the dealers could get their customers to accept, the higher the (undisclosed) commission Westpac paid them.
The Australian Securities and Investments Commission has decided to prohibit this practice from November. So why was Westpac persisting with it until then? Because, if it simply stopped doing it off its own bat, it would lose most of its business to competitors.
Another chap, from the Commonwealth Bank, gave a similar explanation for it continuing to base its commissions to mortgage brokers on the size of the loans they organised. If it stopped doing the wrong thing, he said, its brokers would switch to dealing with other banks.
But since it’s a relaxing long weekend, let’s not persist with such a blood-pressure raising subject as the behaviour of our lovely banks. No, let’s just have a calming philosophical discussion about the complications of competition in markets.
Economists like to give us the impression competition is a fabulous thing in any market, all upside and no downside. Competition is something you can never have enough of, they imply.
Don’t believe it. It’s certainly true that a market with no competition – a monopoly – isn’t a great place. Prices are high, service is bad, and when you complain to the company, no one gives a rat’s.
But it doesn’t follow that all competition is wonderful, nor that more is always better. Far from it.
The simple “neo-classical” model of markets assumes a large number of small sellers. The competition between them is so fierce that none of them dares charge a price that’s a cent more than the minimum needed to cover their costs (including the cost of the capital invested in the business, aka profit).
All sellers charge the same price, and if you try selling for a bit more, you sell nothing and go bankrupt.
In the real world, it ain’t so simple. There are various reasons for this, but a big one is the presence of economies of scale – the more you produce, the lower the average cost of what you’re producing.
This allows you to lower your price – which is good for buyers – but, as a consequence, sell a lot more, which is also good for you.
It’s scale economies that explain why so many of our real-world markets are the opposite of what textbooks assume: a small number of large sellers – known as oligopoly. The big four banks are a good example.
When you look at the behaviour of oligopolies you see competition isn’t as wonderful as it’s cracked up to be. Oligopolists compete fiercely against each other, but they compete mainly for market share, and try to avoid competing on price.
According to the economists’ basic model, however, low prices are the key benefit competition brings us. In reality, oligopolists prefer to keep prices and profit margins high by competing via marketing and advertising, including by “differentiating” their products.
Occasionally a firm tries to steal a march on its competitors by innovation – coming up with a product that’s clearly better than the others. Mainly, however, product differentiation involves superficial differences.
Economists preach the virtues of competition because they assume it gives consumers a wider range of products to choose from, which must be a good thing.
But with only a few sellers, competition tends to do the reverse, limiting the choice available. Each firm will have a product range remarkably similar to the others.
This is because the few big firms focus on each other, not the customers. Their goal is not so much to find the magic product the punters will love, as to make sure their competitors don’t get ahead of them. So product ranges tend to be the same.
But how do we explain those two bankers claiming competition prevented them from ceasing dodgy practices? Why wouldn’t a bank want to get itself a reputation for being square with its customers?
Because of another weakness in the economists’ basic model: its assumption that both buyers and sellers know all they need to know about market conditions - an implicit assumption that gaining the knowledge you need to make good choices is easy and costless.
In reality, it costs time and money to be well-informed, which gives sellers (who tend always to be in the market) an inbuilt advantage over buyers, who tend to buy a new car, or change houses, only occasionally.
The first economists to starting thinking such thoughts just a few decades ago ended up winning Nobel prizes for realising that information is “asymmetric”, with sellers usually knowing a lot more than buyers.
In the two cases from the royal commission, the banks and their car dealers and mortgage brokers know about the conflicts of interest caused by their commission arrangements, but customers don’t.
Should one bank decide to stop playing that game, many of its dealers or brokers would have taken their business elsewhere long before the nation’s customers realised it was more trustworthy than its competitors.
Up-to-date economists see this as a class of “market failure” called a “collective action problem”: all the firms in a market realise they’re doing something wrong, or even profit-reducing, but no one’s game to be the first to stop.
The obvious solution is for the government to intervene and ban the practice, letting everyone off the hook at the same time - just as ASIC has decided to do in the case of flex commissions for car dealers. Sometimes competition needs help from a visible hand.
