The Porter Legacy

Governments should take a leaf out of corporate strategy books and remove barriers to competition instead of trying to mandate it.

Human beings are self interested, and instead of trying to re-engineer humanity, policy makers should recognise this fact and use it for the greater good. As Adam Smith says in one of his most-quoted passages, we do not rely on the baker’s, butcher’s or green grocer’s benevolence to get our bread, meat or fruit; rather, we rely on their self-interest to provide for themselves, and through that self-interest, us.

To followers of Adam Smith, a perfect market has an infinite number of buyers and sellers that can enter and leave the market freely. This ability to enter and exit a market with few or no barriers was critical to Smith’s analysis. Prices reach an equilibrium at which companies do not make ‘super’ profits, and buyers pay no more or less than a product is worth. Imagine buying an apple at the Flemington fruit market: sellers are plentiful, buyers find price discovery relatively easy; the market establishes an equilibrium price at which everyone buys and sells fruit.

This is an efficient, and not necessarily very profitable, market.

Of course in the real world this is not always possible. There are some products and services that people simply can’t live without. And there are some markets where the barriers to entry are, by necessity, high. Take electricity: buyers can choose not to use it, but not very effectively, and there are not many other substitutes besides candles.

On the other side a producer of electricity has a number of barriers that protect it from competition: the cost of building a power station, stringing up distribution wires, and securing raw material supplies. Each of these present massive upfront costs for a new entrant, protecting any incumbent company from competition. Producers of electricity are therefore able to charge a much higher price for their products then they would receive in a perfect market because these barriers to entry prevent potential competitors from entering the market to take advantage of higher than normal profits.

In short, the electricity market has captured consumers and significant barriers to entry – an imperfect market.

If you run a company, and want to make higher profits, find an imperfect market. If you are a consumer, stay away from such imperfect markets. Michael Porter recognised this and put together the five forces theory. This theory is a how-to guide for companies trying to create barriers to entry, thereby allowing them to charge higher prices, and get better returns for their shareholders – all at the consumers’ expense.

In Australia, in industry after industry, we have seen the outcome of Porter’s legacy. Where once twelve retail banks stood, there are five. In retail insurance, less than five years ago, there were twelve insurance companies, now, in effect, there are three. Supermarkets, toll roads, financial services, freighters, ship forwarders, nursing homes, private hospitals etc. In industry after industry where there were once a multitude of competitors there are now five or less.

The losers from this consolidation are consumers. Government’s reaction to this has been to exacerbate the situation by introducing a bewildering number of laws to ‘protect’ consumers. In doing so governments have made it more difficult for new competitors to enter markets and make them less imperfect. It is almost as though Porter’s analysis was only read by management, but no one in government.

The aim of government should be to bring down the barriers to entry, rather than trying to recreate competition through law and regulation.

In the end choice is the ultimate friend of consumers, not government regulation. And no matter how hard they try, governments cannot replicate through regulation the same sort of benefits that a free market can provide. They do however seem perfectly able to inflict a whole number of unintended costs and consequences.

If governments concentrate on removing barriers to entry, ensuring that any market is contestable, then companies and consumers, left to their own devices, will work things out for the best. Let that be Porter’s real legacy.

Porter M (1985) The Competitive Advantage of Nations