Ceteris paribus, competition is king

Speakers: 
Mr Rod Sims, Chairman
Conference: 
2017 Annual Conference of Economists
21 July 2017

ACCC Chair Rod Sims has addressed the Australian Conference of Economists, where he outlined the case for why markets must work in favour of consumers, and the public must be convinced of the benefits of competition or distrust in the market mechanism can grow.

Transcript: 

Check against delivery

I would like to thank the Economics Society of Australia for inviting me to speak here today.

I speak at a lot of law and policy events, but as someone who trained as an economist I always particularly enjoy the opportunity to be in a room full of colleagues and to discuss economic issues specifically.

My role as the head of Australia’s competition regulator, the ACCC, puts me in an interesting position as an economist. The work of the ACCC is founded in the economic literature of industrial organisation and monopoly power.

We as an institution are charged with identifying and prosecuting cartels, opposing anti-competitive mergers and cracking down on businesses that mislead or deceive consumers. In short, we work to keep Australia’s market economy working for consumers.

We also have responsibilities for intervening in markets that are not likely to work well for consumers, such as regulating natural monopolies in infrastructure.

I find it fascinating, however, that the economics community has not always been supportive of competition law.

Modern competition law, or antitrust law, as we know it was first actively enforced in the US, with the 1890 Sherman Act.

Some economists viewed the Sherman Act as a violation of the prevailing Iaissez-faire principles at the time, or as nothing more than a populist measure intended to protect small agricultural producers from the large corporations that were coming to dominate late 19th century America.

We’re in the midst of a policy debate about Australia’s ‘misuse of market power’ laws, and similar concerns have been raised against the sensible changes proposed by the Harper Review. It is clear that some things never change.

Since then, the merits of competition law has been a matter of significant debate by many of the pillars of our profession. Probably the most famous sceptic is the Nobel laureate Milton Friedman. In 1999, Friedman stated:

My own views about the antitrust laws have changed greatly over time. When I started in this business, as a believer in competition, I was a great supporter of antitrust laws; I thought enforcing them was one of the few desirable things that the government could do to promote more competition. But as I watched what actually happened, I saw that, instead of promoting competition, antitrust laws tended to do exactly the opposite, because they tended, like so many government activities, to be taken over by the people they were supposed to regulate and control. And so over time I have gradually come to the conclusion that antitrust laws do far more harm than good and that we would be better off if we didn't have them at all ... [1]

Friedman’s colleague at the University of Chicago, fellow Nobel laureate F A Hayek became more supportive of antitrust laws as evidence for it accumulated. Hayek was a strong advocate for allowing markets to function relatively unhampered by government regulation. But Hayek recognised that markets function within a set of laws set out by government, and that some of these laws, such as those establishing property rights, are critical for markets to work properly.

For Hayek, the question was which laws foster effective markets, and which laws are impediments to the functioning of markets.  For example, while he was certainly more relaxed about monopolies than I am, he realised that it is necessary to have laws that prohibit monopolies from using their market power to block entry.  In Law, Legislation and Liberty, Hayek states:

What is harmful is …the ability of some monopolies to protect and preserve their monopolistic position after the original cause of their superiority has disappeared.[2]

Hayek’s thoughts on monopoly relate to his general views that society should be constructed to avoid the loss of individual freedoms, such as being coerced into actions one does not wish to do. Hayek famously outlined a scenario where people settle in a desert oasis under the assumption that water will be available at a reasonable price due to the existence of competing supplies of water.

However, if all but one of the springs dry up, the last remaining supplier may be, as Hayek noted, in a “position of being able to demand that the people do whatever he wishes”. It is this situation of economic dependence and loss of individual freedom that Hayek wished to avoid.

As Hayek observed in The Constitution of Liberty, this builds on an earlier observation by Trotsky:

In a country where the sole employer is the State, opposition means death by slow starvation. The old principle, who does not work shall not eat, has been replaced by a new one: who does not obey shall not eat.[3]

As good an argument against monopoly as you are likely to ever hear; and the first and last quotation of Trotsky I will probably ever use!

I have enjoyed debating whether Adam Smith would be a supporter of today’s competition laws. I am more than confident he would be a strong supporter. Smith argued that promoting competition was a key role of the State. And he also stated that:

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.[4]

One could take this as an endorsement of modern cartel prohibitions. However, Smith recognised the difficulty in implementing such prohibitions, noting that:

It is impossible indeed to prevent such meetings, by any law which either should be executed, or would be consistent with liberty and justice.[5]

To this day, we cannot “prevent such meetings” but through the cleverness of today’s immunity policies, where the first cartel member to “fess-up” gets immunity from prosecution, we have a better chance of limiting their detrimental impacts.

The ACCC has had substantial successes in this area with penalties in the tens of millions of dollars against cartels and trade limiting behaviour across almost every facet of life: washing powder, automotive parts, aviation transport, medical services – to name a few in a long and ever-expanding list.

I am aware that I am yet to quote a living economist. Yet criticism of competition law is still common both in Australian policy circles, as well as in global economic discussions.

Today, there are three themes in these debates I’d like to address.

The first is what I would call the naïve faith many economists appear to have in the welfare-enhancing consequences of firms maximising profits.  Don’t get me wrong. I expect firms to behave in ways to maximise their profits. And in the vast majority of circumstances this promotes economic welfare. However I feel that economists would be wise to incorporate some of the lessons of corporate strategy into their thinking. Corporate strategy is often more about firms attempting to increase their profits by handicapping their competitors as it is about out-competing them.

The second is a more nuanced issue, and perhaps reflects that the debate about competition law has evolved from whether it should exist at all, to what it should be aiming to achieve.

Many economists argue competition agencies like the ACCC should intervene in a market only if that intervention is likely to increase total economic welfare (a total welfare standard). Much of Australia’s competition law aims to deter conduct that is likely to ‘substantially lessen competition’, commonly considered to be closer to a ‘consumer welfare’ standard.

I think protecting the process of competition is the appropriate goal for a competition agency. Competitive markets are the most effective mechanism known to encourage the efficient use of resources. While there are exceptions, protecting the competitive process is the most effective way of maximising total economic welfare.

Finally, I will reflect that economists need to be very careful when their themes and advice get way out of line with community thinking.

1. Competition and corporate strategy: an inverse relationship

Since coming to my current position in 2011 I have often heard competition lawyers and economists say “companies only succeed if they best satisfy the needs of consumers”.

While there is much truth in this, as I have already indicated, the use of the word “only” betrays surprising naivety and is a cause for concern.

Before I go on I want to clarify that I am a committed capitalist. For me, the profit motive is the most powerful tool for enhancing social welfare. It provides businesses with the incentives to produce the goods and services consumers need and want, and to do so as efficiently as possible. It rewards the businesses who do it best and ensures that they are the ones who survive; it also encourages innovation and progress in the long term.

However, it is simply naive not to recognise that the profit motive can also cause great harm if it is not channelled towards productive ends.

In prosecuting this argument it is appropriate to cite Harvard Business School economist Michael Porter and his hugely influential 1979 paper “How competitive forces shape strategy”[6].

What Adam Smith is to economics, Michael Porter is to commercial strategy.

Over time variations of Porter’s diagram have dominated commercial corporate strategy thinking and practice.

The five forces of commercial success: erect high entry barriers, keep suppliers weak and dispersed, reduce competition, curb buyer power and reduce likelihood of substitutes

In essence, Michael Porter demonstrated that firms can attain commercial success by reducing competition, by erecting high entry barriers, by keeping suppliers dispersed and weak, by creating strong consumer loyalty, and by reducing the likelihood of other firms being able to offer your customers products that they see as substitutable for your product.

In promoting a reprint of this article, the Harvard Business Review said:

The five forces govern the profit structure of an industry by determining how the economic value it creates is apportioned. That value may be drained away through the rivalry of competitors … through the power of suppliers or the power of consumers or be constrained by the threat of new entrants or the threat of substitutes. Strategy can be viewed as building defences against the competitive forces or as finding a position in an industry where the forces are weaker. Changes in the strength of the forces signal changes in the competitive landscape critical to ongoing strategy formulation.

As anyone with any commercial experience knows, businesses are at least as much focussed on reducing these competitive pressures as they are on “satisfying the needs of consumers”.

When I left public policy 23 years ago and joined a commercial corporate strategy firm I quickly invented the following equation:

            Corporate strategy = Competition policy x (-1)

That is, corporate strategy is often trying to achieve the opposite of competition policy.

I remember in late 1994, six months into my new role in the private sector, encountering a friend who was working in the then prime minister’s office. She asked: “After six months out of the public service if you met the Prime Minister today what would be your key message to him?” With no hesitation I said: “Double the size of the ACCC.”

Let me hasten to add that the vast majority of what companies do is to the benefit of consumers. They spend a lot of time reducing costs, improving their products and opening new stores or facilities. This is why free market economies are so successful.

Even their efforts to raise entry barriers or lock in consumers can benefit consumers; think Microsoft or Apple or Google. But, as with each of these companies, they will also seek to create shareholder value by excluding competitors, anti-competitive bundling or deceiving consumers. Google has recently attracted the interest of the European Commission and, in the past, the ACCC.

Economists may wish to counter here and point out that the profits generated by anti-competitive conduct will eventually be eroded by the process of competition itself. Perhaps, but for how long does a cartel have to go on, charging higher prices to consumers, before a big enough competitor is able to knock them over?

Some cartels, like the global vitamins cartels in the 1990s, have lasted a decade or more. This is despite the prices of some vitamins more than doubling.[7]

It is not enough, therefore, to assert that the profit motive will always drive progress. Destructive, anti-competitive business practices must be discouraged so profits are not sought at the expense of long-term economic welfare.

It is heartening to see other strong advocates of free markets also support competition laws. The Economist magazine, my favourite newspaper, earlier this year lamented the rise of short-termism. To rouse big firms “wallow[ing] in lucrative stagnation”, the magazine suggested that:

Competition policy needs to weaken the entrenched position of established firms and help new entrants. That would make the economy more dynamic, boost wages and end the era of surplus profits that are put to no use. It’s not a message many powerful CEOs are keen on.[8]

In this context, “competition policy” would not mean giving new entrants an unfair advantage to become competitors; rather, it would involve removing impediments to new entrants, including regulatory capture and other anti-competitive benefits of incumbency.

Our colleagues at the University of Chicago, after decades of driving the laissez-faire approach to anti-trust, recently held a summit on whether market concentration is a problem in America. Again I quote The Economist magazine:

Until recently, convening a conference supporting antitrust concerns in the Windy City was like holding a symposium on sobriety in New Orleans ... But the mood is changing. There is an emerging consensus among economists that competition in the economy has weakened significantly.[9]

2.Welfare economics and antitrust; competition as a beacon

Economists, like everyone else, also occasionally add to the debate on what competition agencies should be trying to achieve.

The basic questions we at the ACCC ask are anything but basic:

  • Should a merger between two competitors be allowed to proceed or is it likely to substantially lessen competition?
  • Is a proposed agreement between businesses likely to be anti-competitive?
  • Is a large company restricting competition by abusing its dominant position?

The answer to these questions often depends on the frame through which they are assessed. For example, a merger that reduces choice and increases prices will hurt buyers and reduce consumer welfare. For the merger parties, however, the same merger may allow significant gains in efficiency and profits, increasing producer surplus.

Many economists nowadays would advocate that competition agencies should apply a total welfare standard to antitrust decisions. That is, a test that determines outcomes based on their effect on the sum of both consumer and producer surplus.

The tension that often arises in this context is that competition agencies are intended to work to protect consumers from the power of businesses. But a pure total welfare standard does not prioritise consumer welfare over producer welfare; it is agnostic between the two.

For the ACCC this tension is further complicated by the language of the competition tests we apply. In the Competition and Consumer Act (CCA), which is the legislation that the ACCC enforces, many of the thresholds for intervention by the ACCC are expressed in terms of ‘substantially lessening competition’. For example the CCA prohibits mergers or agreements that have or would have the effect, or are likely to have the effect, of substantially lessening competition in a market[10].    

A test that focuses on protecting competitive forces may not to some immediately seem to have much connection with economic ideas of welfare maximisation, but in fact the two are very closely related.

As you would all agree, in the vast majority of circumstances a competitive market is the superior market structure for generating efficient outcomes. In particular, competitive markets encourage:

  • firms to produce and offer products most valued by consumers (allocative efficiency)
  • the most productive firms to prosper and see inefficient firms decline (productive efficiency), and
  • firms to innovate and invest to build productive capacity (dynamic efficiency).

So by preserving competition, the test we apply has an extremely strong link to preserving and promoting economic welfare.

You might ask then why not simply apply the economic welfare test directly instead of tackling these issues through a competition test?

The answer is as follows: merger reviews, or investigations into business conduct, are not neat exercises where market boundaries are clearly defined and participants are easily and exhaustively identified. Consideration of these matters is inherently done with incomplete information from which we must extrapolate competitive dynamics, causal relationships and a broad understanding of how the market has evolved, and where it is likely to be headed.

Focusing on the competitive process is a good way of simplifying welfare analysis and maintaining the economic integrity of decision making.

A competition test is also likely to be particularly adept in assessing dynamic issues.

I have been asked would I oppose a merger to monopoly if the new monopolist presented evidence that it could perfectly price discriminate. Under the scenario posed, the monopolist would win and buyers would lose. However, output would not change and there would be no efficiency loss.

My answer to this question is “Yes”, I would oppose such a merger under the “SLC” test for a number of reasons.

First, perfect price discrimination only occurs in textbooks; and while it is a useful teaching tool, the information required to extract the willingness to pay of each customer is never known to the seller. Price increases resulting from the exercise of market power will, in the real world, almost always cause a deadweight loss.

Second, there are important dynamic issues at play. Monopolies do not have the same commercial imperatives to be as vigilant over costs or adapt to the changing needs of its customers as firms facing competition. While monopolists have some incentive to do these things, firms facing effective competition have greater incentive to do so. Nothing sharpens the mind of a businessperson more than the threat of customers crossing the street and buying from his or her competitors.

Focusing on the process of competition directs the analysis to key threshold questions such as:

are there barriers to entry in this market that inhibit the effective entry of competitors, and allow monopoly pricing to go on unimpeded? Or,

will this merger create a company large enough that it will be able to act unconstrained by its rivals?

To me, these are particularly important questions to consider.

The impact on dynamic efficiencies arising from anticompetitive behaviour is a live issue for the ACCC at the moment.

In November 2015 the National Competition Council (NCC), which is the body that advises the government on whether infrastructure assets should be subject to regulation, recommended that the Port of Newcastle not be regulated.

The Port of Newcastle was sold by the NSW government in 2014. The port is the sole export gateway for many coal mines in the Hunter valley. Soon after acquiring the port, the new owner increased usage charges by around 50%. In response to this, major coal producers in the Hunter Valley sought for the port’s charges to be regulated.

In its recommendation that the port not be regulated, the NCC explicitly stated that the port is able to price discriminate between coal miners, and therefore that even if prices are increased, there will not be any effect on the quantity of coal extracted and exported by the coal miners.

In economic terms, the NCC concluded that the port can price discriminate in a way to cause no deadweight loss and therefore there is no loss in efficiency or welfare. There is only a transfer of economic rents from the miners to the port owners.

The Minister accepted the NCC’s recommendation and decided not to declare the port as a regulated service.

One of the coal miners, Glencore, appealed this decision to the Australian Competition Tribunal. The Tribunal reversed the Minister’s decision and declared the port.  The port is currently a regulated service and there have been no further increases in port charges.

However, the Port of Newcastle has now appealed to the Full Federal Court and we are awaiting judgment, which we expect to receive later this year.

The ACCC was granted leave to participate in the Court hearing. We argued that the Port ought to be regulated.

Our reasoning for doing so was two-fold:

First, as noted above, it seems incredibly unlikely that the Port of Newcastle can price discriminate without causing some changes in output.

Second, there is a broader dynamic issue at stake. Coal producers in the Hunter Valley own long-lived sunk assets. These are investments made when the port was publicly owned, and which may not have gone ahead if they knew the port would become an unfettered monopolist.

Privatising the port without a regulatory regime in place has provided the new owner with the opportunity to expropriate the value of these assets through higher port usage charges.

This raises the question of why would these coal mines invest in future expansion or to increase their efficiency? The economic rent from doing so will likely go to the port owner.

The prospect of this happening at other government-owned ports also adds to the risk of investing in assets that have no alternative but to use those ports. The broader dynamic impacts from transferring publicly owned utilities to an unregulated profit-maximising monopolist do not appear to be considered in this form of welfare analysis.

3.The importance of the “pub test”

I have long held the view that if economists cannot convince the man or woman in the street of the correctness of their views then they are either very poor communicators, or wrong.

The alternative view, that the public is too silly to understand economic arguments, is arrogant at the very best.

I have also long held the view that the economics profession is, among all professions, best placed to guide public policy. 

Economics is, in many ways, the language of public policy. The study of individual incentives and actions, and how they sum to be great forces of social and financial change, provide a foundation for public policy. Concepts such as opportunity cost, economic rent and partial or full equilibrium analysis are often fundamental to assessing public policy proposals. And importantly for public policy, we as a profession are concerned not just with what is happening, but also with what should be happening.

It is somewhat disappointing then that the economics profession has not been more influential in public policy debates in recent times.

One reason for this may be that economists are more highly rewarded or regarded for contributing to economic theory rather than economic policy. Or that those that do contribute have been unable to get their message across.

But getting one’s message across is also a matter of understanding your audience. While I wouldn’t replace our competition laws with the ‘pub test’, it is important to recognise that there is some wisdom to be gained by occasionally consulting the pub (if not in person, at least in your mind!).

For example, returning to the competition law questions posed earlier in this speech:

Would the man or woman in the street be happy with a merger to monopoly that saw prices rise to consumers, but be comforted that shareholders are receiving higher dividends from the more profitable merged entity?

Or…

Would the man or woman in the street agree that it is OK to allow an unregulated owner of a monopoly infrastructure asset to expropriate the economic rent from the existing users of that asset?

The answer would be “no” to both questions. Yet applying a pure economic efficiency standard in the abstract may give an answer of “yes”.

I feel that this incompatibility between pure and often abstract economic theory and the everyday world cannot be sustainable for the profession of economics. In practice, economics needs to be able to recognise the truth in statements such as ‘markets must work for consumers’.

If for no other reason, this is a truth because consumers are also voters. We have all watched as countries like the US and UK, which have traditionally pushed for free and open markets, have recently shifted focus. There are many reasons for those shifts, but one strand that resonates throughout is a feeling that the economic paradigm of open markets and competition has not worked for the average man and woman on the street. That they have been left behind.

This loss of faith in market economics is a great frustration for me. I have been, and remain, a passionate believer in the power of free markets. I have seen firsthand, from work in developing countries early in my career, to working in public policy and then corporate strategy, the positive change countries and institutions are capable of if they embrace an open market system. I have also seen the speed at which countries that resist the power of markets can fall behind.

I feel strongly that we will all be considerably worse off if this increasing disillusion in the market economy continues to grow unchecked.  Today, more than ever, economists are needed who can effectively communicate the wisdom of free markets and the power of competitive forces to do good in society.

I see the ACCC as an advocate of competition and the market economy.  Part of this is convincing the public of the benefits of competition. Markets should work in the favour of consumers. As we have seen, if markets do not work in the favour of consumers, or are not seen to do so, distrust in the market mechanism can grow and people are likely to agitate for other mechanisms to allocate resources.

I applaud the economists who wade into the public sphere and who ground their contributions in the facts of everyday life, particularly when that means relaxing the often abstract assumptions of theory.  Economists who make this step will find, I think, an audience more willing to listen. And we, as a society, will greatly benefit from more contributions to public policy from talented economic minds.

Concluding remarks

Perhaps my key message today is as follows.

It is often said that promoting competition is not an end in itself. We may well improve public policy outcomes if we were to treat it as such.

 

[1] Friedman, M., 'The Business Community’s Suicidal Impulse', Cato Policy Report, Vol. 21, No 2, March/April 1999. pp. 6-7

[2] Hayek, F.A., Law, Legislation and Liberty, vol. 3 (The Political Order of a Free People). Chicago: University of Chicago Press, 1979. Pg. 84

[3] Hayek, F A,. The Constitution of Liberty, Routledge, 2014. Page 120.

[4] Smith, A.  An Inquiry Into the Nature and Causes of the Wealth Of Nations, Book I, Chapter II, para 82.

[5] Ibid.

[6] Porter, M., ‘How Competitive Forces Shape Strategy’, Harvard Business Review, March 1979. https://hbr.org/1979/03/how-competitive-forces-shape-strategy.

[7] Mitsuru Igami & Takuo Sugaya, 'Measuring the Incentive to Collude: The Vitamin Cartels, 1990-1999', March 9, 2017 http://economics.yale.edu/sites/default/files/igamisugaya_170309_vitamincartels.pdf.

[8The Economist , Schumpeter column, “Corporate short-termism is a frustratingly slippery idea”, 16 February 2017. Available at: http://www.economist.com/news/business/21717069-firms-are-increasingly-accused-failing-look-ahead-misdiagnosis-corporate.

[9The Economist , Schumpeter column, “The University of Chicago worries about a lack of competition”, 12 April 2017.  Available at: http://www.economist.com/news/business/21720657-its-economists-used-champion-big-firms-mood-has-shifted-university-chicago.

[10] In the following discussion, I am focussing on this “SLC” test, and not the authorisation process where detriment from lessening of competition  is weighed against public benefit, which involves application of a modified total welfare standard.