In last month's edition of InSight, I suggested that the notion that more choice is always better can be taken too far. Too much choice can overload our capacity to choose wisely, and there are markets, such as education, where expanding choice for some means constraining choice for others. There are other markets, such as electricity and health insurance, where there is "choice" without variety.

Expanded choice results, in part, from our economy having opened up to expanded competition - an expansion resulting from deliberate public policy. It is useful, therefore, to ask whether competition policy has been pushed past the point where it confers net benefits.

Older Australians remember an era of much less competition. Buying a washing machine or a television didn't require much search, for all retailers offered the same price - a price set by the manufacturer or importer, with the threat of refusal to supply retailers who discounted. International airfares were set by the International Air Transport Association, while domestic fares were set within the Two Airline Policy. The Commonwealth Government, armed with tariffs and import quotas, was vigilant in protecting us from access to cheap clothing, cars and electronics. And to make sure we didn't shop around too much, state governments enforced restricted trading hours; anyone with a full-time job had a window of two and a half hours on a Saturday morning to do a whole week's shopping.

Image: Thomas Hawk

It was not until 1974 that Australia got its first Trade Practices Act, outlawing, among other practices, collusive pricing and retail price maintenance. In 1995 the Commonwealth and states got together to endorse a national competition policy, which committed governments to remove most remaining constraints on competition. It is notable that both these moves, aimed at promoting market competition, were the initiatives of Labor governments.

There is no question that we have benefited from these reforms. But have they gone to the point that there are diminishing, or even negative returns? Does all competition bring benefits, or are there some areas where the costs outweigh the benefits?

Competition policies, enforced by Commonwealth and state regulators, can outlaw practices such as collusion and overt deception, but these safeguards, in themselves, do not ensure consumers enjoy all the benefits competition is supposed to bring. These regulations are aimed mainly at ensuring suppliers compete with one another and that they are truthful in their claims - but there are many other conditions to be met before consumers enjoy the full benefits of competition.

The main demand side condition to be satisfied is that buyers are well-informed as to the price and quality of goods on offer. In some markets this happens with only a little nudging from the regulators. In supermarkets prices are posted, foods have ingredient labelling, and a poor purchase is not very costly; one can switch brands on the next visit. A product like superannuation presents a different situation: prices (mainly agents' and fund managers' commissions) are opaque; comparisons are difficult, and by the time one realizes a bad decision has been made, it is usually too late. In these markets regulators can (and do) require firms to disclose information, but that in itself is problematic, for the more information is provided, the more difficult it is for people to compare offerings.

Competition authorities, such as the Australian Competition and Consumer Commission (ACCC), generally prohibit false claims by suppliers. A company cannot lie about its products, and there are prohibitions on deliberately misleading claims, but there are many grey areas where suppliers can exploit known consumer biases.

For example, a "98% fat-free" claim carries a different message from "2% fat". A $100 cashback offer on a $900 appliance is more attractive than a straight offer of $800. Fear is used to sell insurance - often far more insurance than consumers need. Marketing experts know the efficacity of immediately attractive offers with later costs pushed into the background - "teaser" rates on credit cards and repayment holidays for major appliances. Competition policy in Australia, as in many other countries, has tended to focus on ensuring firms are competing and are not engaging in outright deception, but they have been slow to intervene where firms deliberately exploit consumer biases.

Sometimes the wrong sort of competition thrives in markets. In the financial services sector, for example, firms often use commission-based selling. The salesperson (glorified with names such as "financial planner" or "insurance broker") is rewarded on the basis of the value of product he or she sells, rather than the quality of the transaction. In large part such overselling has been responsible for the present subprime mortgage problems. Mortgage brokers competed vigorously to transact mortgages; they were concerned simply to sell as much as they could, rather than to sell profitable business. Banks and other financial institutions had taken their eyes off the road, for they were seeking growth ahead of profit. In the economists' pure model, firms compete to sustain profitability, but when firms compete to maximize market share, to grow, or to benefit from political favours, consumers are usually worse off.

In some cases vigorous competition can deliver price reductions, but with sacrifices in quality. Airlines provide a case in point. In the US, ever since the Carter Administration deregulated airlines in 1978, there has been intense competition in the industry, and, on some routes at least, there have been steep price reductions. But over the last twenty years indicators of customer dissatisfaction - number of complaints, number of passengers bumped, lost bags, cancelled flights, delays - have risen steeply.

In most competitive markets poor quality suppliers are weeded out by consumers switching to other suppliers, but this is difficult in airlines. Most people do not fly often enough to establish reliable experience, and even frequent travellers find it hard to judge - "was that five hour delay at Dallas due to weather, mismanagement by the airport or was it because of slack maintenance?" Also, intense competition results in airlines going out of business and new airlines replacing them - hardly helpful for establishing a sound base of experience. As Nobel Prize winning economist George Akerlof points out, when customers cannot judge quality, poor quality tends to dominate; even if consumers are willing to pay a premium for quality, competitive pressures force a race to the bottom.

Poor supplier behaviour is also found in industries where customers do not have an ongoing relationship with suppliers. Dealings with used car yards, package holiday operators, real estate agents and undertakers are generally "once off". They contrast with the more enduring relationships consumers establish with local stores and regularly used tradespeople.

In fact, the more firms there are in a market, the harder it becomes for firms and consumers to form ongoing relations. Research by David Laibson of Harvard University suggests that the benefits of competition rapidly diminish as the number of firms in an industry increases. The benefit of a fourth or fifth supplier in a market is much less than the benefit of a second or third supplier. In other industries, firms compete strongly for new customers but once customers make a choice they become locked in to one supplier. If switching is difficult, the supplier enjoys a degree of monopoly power. Consider the difficulty in changing a bank (with mortgages, periodic payments and deposits) or an internet service provider (changing all those addresses).

Governments and competition authorities can become fixated on situations where only slight gains can be made from improving an industry's competitive structure. As a case in point there is presently a huge emphasis on competition in gasoline, but even the most rigorous application of competition policy will deliver benefits of only a few cents a litre, or about $100 a year. In the meantime consumers are paying dearly for financial services, spending too much on health and general insurance, and are facing high prices for privatized toll roads, electricity and water.

The Organization for Economic Cooperation and Development (OECD) has been examining the question of whether traditional competition policies are adequate to ensure consumer welfare. In Australia the Productivity Commission has recently released a report on Australia's consumer policy framework, which, among other recommendations, suggests more useful disclosure of information, improved consumer education and more consumer input into policy making.

These steps are cautious, however, for there is still a strong belief among policymakers, particularly in treasury departments, that competition, having delivered so many benefits, is the be all and end all of public policy. And politicians are adept at raising distractions, such as gasoline prices, while leaving untouched many areas where businesses are enjoying significant privileges. We need to be on the lookout for those distractions.