Market Failures: The Foundation of Strategy

Market failures, for all their negative connotations, can lead to business strategies aimed at innovation, product differentiation, and superior value creation. Harvard Business School professor Michael Porter, through his seminal 1979 article in Harvard Business Review, essentially reversed the logic of public policy and helped create the business policy (strategy) discipline – by recommending strategies for maximizing monopoly power and company profits.

To explore how market failures could benefit business, we must first define market failure and how it happens. Let us start at the very beginning—market structures. In economics, there are four kinds of market structures: perfect competition, monopolistic competition, oligopoly, and monopoly. Each one has specific characteristics and market outcomes. For the purpose at hand, we will be concerned with only the perfect competition structure. To learn more about market structures, follow this link.

Perfect Competition

The key characteristics of a perfectly competitive market are the existence of many sellers and many buyers, identical products being sold by different sellers, no barriers to entry or exit, and complete information about products, pricing, etc., available to all market participants.

The key conditions for perfect competition include:

• All companies sell an identical product.
• Every market participant has complete information about products, availability, and prices.
• There are no barriers to entry or exit, allowing companies to enter or exit the market without incurring costs.

Entrepreneurs who see excessive profits in a market can jump into it and take some of the profit away from incumbents. If many such entrepreneurs enter the market, profits will begin to decline, and some will decide to exit the market – since entering and exiting a perfectly competitive market can be done at no cost.

No single seller or buyer can dictate pricing and output decisions in a perfectly competitive market. Every market participant is a price taker, thus ensuring efficiency and optimal resource allocation. Perfect competition leads to prices that reflect the true societal costs of production. It represents an idealized form of market functioning that maximizes societal welfare. This is generally also the fundamental objective of public policy.

Market Failure

A market failure occurs if any of the preconditions for perfect competition does not hold for a specific market. For instance, if there is information asymmetry in a market, i.e., when not everyone has complete information, it’s a case of market failure and may lead to sub-optimal outcomes. A buyer without complete information on who is selling at what price could end up buying from a higher-priced seller. Similarly, entry barriers created by incumbents with market power, competitive advantage, or access to valuable resources present cases of market failure. If some sellers have differentiated products or strong brand names, that is another situation for market failure.

In reality, no markets are perfectly competitive; most have some imperfections (market failures). Perfect competition is a theoretical construct designed to guide regulators and public policymakers in improving social welfare by minimizing market failures.

Reversing the Logic

Researchers working in the public policy domain in the late 1970s reversed the logic of public policy and created the business policy (or strategy) discipline as practiced today. While public policies aim to foster market forces that produce perfect competition, strategists seek to leverage existing market failures for competitive advantage. Michael Porter of the Harvard Business School pioneered the study of market forces, such as entry barriers and the threat of substitute products and services, to develop strategies for maximizing monopoly power.

Market Failures Are the Foundation of Strategy

Market failure can occur in one or more of several situations, each offering opportunities for strategists to leverage the market failure for benefit:

Many Sellers and Many Buyers:

• Dominant companies can set prices, expand or limit their output, and even set different prices for different customers.
• Sellers with market power can even control supply, thus sustaining their market power.

Identical or Homogeneous Products:

• A company can differentiate its product based on quality, product features, IP patents, or customer experience to stand out from competitors. ?
• Established companies with brand loyalty or economies of scale can deter new entrants and continue to maximize profits.

Complete Information:

• Most companies have certain proprietary information that can be the source of their competitive advantage and, hence, superior profits.
• Companies can benefit from not releasing their proprietary information publicly.

Ease of Entry and Exit:

• A company can thwart prospective entry into its market by leveraging any preexisting entry barriers, such as the high cost of entering the market, established products or brand names, or regulation.
• A company can create entry barriers for competitors through advantages such as differentiated products, intellectual property protection, and a distribution system.
• Companies can try and create high switching costs for their customers if they have products or services well integrated into customers’ operations.

Ethical and Legal Perspectives

While strategists see market failures as opportunities, they must not lose sight of the ethical and legal dimensions of their decisions. Profiting from market failures without addressing the market’s core inefficiencies can harm society and even attract regulatory scrutiny. Companies should not engage in practices that are clearly illegal and unethical, such as predatory pricing or excluding competitors from a market.

Predatory pricing involves selling goods or services below cost to eliminate competitors and create barriers for new entrants.?Amazon has been accused of selling printed books and eBooks at prices significantly lower than those offered by competitors, such as traditional bookstores. Predatory pricing is often used to drive rivals out of the market or set them up for takeover.

Most recently, on May 23, a complaint was filed against Live Nation-Ticketmaster for unlawfully exercising its monopoly power over performers, venues, and independent promoters in ways that harm competition. The complaint alleged that Live Nation-Ticketmaster engaged in anticompetitive practices to strengthen its dominance of the live concert market and act as a gatekeeper for an entire industry. Such anti-competitive behavior disadvantages consumers, workers, and businesses of all kinds.

In 2004, the European Commission fined Microsoft €497 million for bundling its Windows Media Player with the Windows operating system. The Windows O.S. at the time had a 95% market share in the computer industry. Bundling Windows Media Player gave Microsoft an unfair advantage over competing media player brands because it came pre-installed on nearly all personal computers, thus excluding them from the market. The fine was increased to €860 million in 2008 for Microsoft’s failure to comply with the earlier ruling. In 2013, Microsoft was again fined €561 million for not offering consumers a choice of browser during setup; the Internet Explorer browser was being bundled with its Windows operating system, thus excluding other browser makers from the market.

Conclusions

For businesses, market failures present numerous opportunities. By identifying where market failures exist, they can legitimately carve out unique value propositions and differentiate themselves from others. In some situations, a business might even create market failures and benefit, for example, by creating entry barriers to discourage prospective new entrants by investing in innovation and brand building. However, if not carefully considered, such a course of action can prove to be a slippery slope leading to regulatory intervention. Refer to my article on forbes.com about how tech companies can keep from being cited for uncompetitive actions.

Companies must balance their strategic actions with ethical considerations and the potential long-term societal impact. Sustainable success often requires navigating the fine line between leveraging market failures for competitive advantage and ensuring fair competition to avoid legal repercussions and maintain a positive reputation. Ultimately, the most successful businesses are those that can innovate and grow while contributing to the overall efficiency and fairness of the market.

Citation:

Jain, Vinod K. “Market Failures: The Foundation of Strategy.” Business Reboot Newsletter, July 28, 2024. https://www.dhirubhai.net/pulse/market-failures-foundation-strategy-vinod-k-jain-pegle/?trackingId=x9UGnFEOTzieXGS6WKf3oQ%3D%3D

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A Recent Article in Forbes.com

Competition and Antitrust in the Digital Age

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