In the theoretical world of homo economicus, the rational man without emotion, meritocracy may exist. In order for that to be the case, a person would have to continually contrast all options to find the technically superior solution, experience very little switching costs, and optimize for “performance.” This process would have to lead to a consistent outcome. If any company offered a superior product, they could expect market recognition and mass adoption. If they slipped from their pinnacle, they could expect a mass exodus. In this hypothetical world, the role of competition is well-defined.
This may be an economist’s dream, but it doesn’t exist in the real world. I won’t delve into the possible reasons why, but I think we can all agree that people are a bundle of sometimes conflicting emotions, and the fear of being wrong often prevents us from making changes in our preferences. Let’s look at a few examples.
The first example is Apple vs. Microsoft. It may be overused, but it should be fairly accessible to most people. Apple produces very good computers with software that works very well. For this package, they charge a premium. If Apple computers were technically superior in all ways to Microsoft-compatible computers, an economist would expect mass adoption. While the percentage of people choosing to buy a Mac is increasing, it is still a small percentage. Microsoft produces software that runs on a wide variety of computers. The quality of the machines built by their partners varies. However, when trying to determine value for money, many people will prefer a Microsoft-compatible computer. This introduces two problems. First, there is no one, objective, consistent product that is technically superior. Even when looking at value-for-money, people can’t necessarily make an objective determination. The result is that people rely on marketing. What are their friends and family buying? What feels more popular? Which choice do they feel better about? While Apple and Microsoft’s partners may be working to produce technically superior machines, they are also creating a marketing message that they hope will convince people to prefer their brand.
With computers, there is very little transaction cost. Investment managers, on the other hand, have much higher switching costs. It is possible to compare the track records of two investment managers. In fact, assuming that a manager’s skill remains consistent over time, it is also possible to factor out standard deviation to try to approximate a risk-adjusted return. This would allow a potential investor to compare the skill of two managers who work with different risk levels. Does this mean the more technically competent manager is always preferred? No, as Norrep handily proves. We were recently introduced at work to a local investment company with a family of mutual funds. Their performance is excellent, but they have gained little traction in the industry. It’s not for a lack of available information, since they were willing to send out portfolio managers to meet with anyone who had questions. However, without a sales team, not many investment advisors were familiar or comfortable with the company. They have decided to add a marketing function, and they are now beginning to gain some traction. However, many people will remain with the tried and true because switching costs are higher in this area.
Financial advisors have an added advantage: people usually aren’t looking around. We just brought on a new client who moved from their previous advisor years after the other members of their family. Take my word that their previous advisor offered service that was technically inferior to ours. But the client simply wasn’t constantly comparing their options. I’m sure they have other, more pressing issues in their life. Further, people sometimes don’t want to know that they may have made a mistake. So when the lack of service finally became flagrant, then this client looked to see what else is available. A family member had already chosen us, so I bet very little research was actually done about the various alternatives available. They will settle in with us for a long-term relationship and probably not re-evaluate their opportunities again unless something goes terribly wrong. I’m not saying that this is the best approach to a professional relationship, but it seems common.
Because of the costs of switching and the fact that most people aren’t constantly evaluating options, along with the difficulty in determining technical superiority, I don’t believe there’s such thing as a meritocracy. Competition doesn’t actually drive improvement, because people buy based on emotion and marketing messages, rather that an objective assessment of available options. That’s not to say that some companies don’t have an internal drive for excellence. But there’s nothing magical about competition that necessarily makes everyone better off. And beware of emotionally-hooked marketing messages.