Shaulablog

Most people know the basic theory of capitalism: supply and demand. They can name Adam Smith, maybe have heard of the invisible hand. But it has long frustrated me that most people seem to believe that the real world is somehow that simple. Competition will drive prices down. But wait, the theory is actually that competition will drive prices down to cost, and that’s not sustainable because then everybody goes out of business. Oops, well, there’s also “what the market will bear” so economics as the layman seems to perceive it is the intersection between two curves: “what the market will bear” and “competition drives prices down”.
MBAs however read Michael Porter, who did fundamental studies of competition in business in the 70s. Of course businesses don’t want their prices driven down by direct competition, that cuts into profits! Your goal as a business is to avoid that situation, and to help us Porter developed a model of the 5 competitive forces that pull on a company: 1) the negotiating power of your customers 2) the negotiating power of your suppliers 3) barriers to entry to new competitors 4) substitute products that effectively compete with yours and 5) your direct competitors. Wikipedia notes that some argue that a 6th force of “other stakeholders” like regulators and activists could be added, but I see this as a list of stakeholders already – stakeholders that can fight you for a piece of your profit pie.

Of these let’s draw our attention back to number 3 – barriers to entry for new competitors. New competitors are hungry and willing to give up profits to gain market share which forces you to lower your price (classic theory of capitalism!) and then they become part of number 5 – direct competitors that can take business away from you. So to keep that competitive pricing in the theory books, what businesses want to actually do in practice is choose an “Entry Deterring Price”. You don’t price your goods just below your direct competitors’ because then you have a price war, and as someone said to me recently: you win by going out of business. Instead you price your goods just below the price at which a small new competitor could enter the business. If you have a capital-intensive business like some kind of manufacturing or need expensive infrastructure to get started, then you have lots of room to price high. If you have a service business with low barriers to entry, you’ll need to lower your price to a point where someone can’t bootstrap a new business on a low volume of sales at your price.

So aha! I knew it, and now here it is in B-school cannon: competition should not drive prices down. Since Michael Porter and certainly before, direct competitors focus on differentiation: it is innovation that disrupts markets and pricing. Not all businesses are run by MBAs, so there’s still the occasional price war, but since the days I summered at 7-11 and watched Coke and Pepsi magically alternate weeks on-sale I’ve known the markets are not nearly as competitive as some anti-intervention dear friends would like to believe. Invisible hand? How ‘bout the invisible handshake?