One of my favorite debating points in my MBA class is the limited usefulness of regulation to promote fair competition and stimulate economic growth at the same time. While competition is a good thing, achieving it through regulation usually stifles innovation. Of course, this is a complex area of economic policy that stirs up very intense reactions from people. In fact, when I quoted UK economic policy adviser and Professor of Economics, Stan Metcalfe when he says that “the best competition policy is innovation policy”, I had one MBA student tell me about Microsoft urgently needing to be regulated or software innovation would be severely inhibited. The student quit the course but as far as I can tell, five years later, open source software is sorting out Microsoft very nicely.

I’m sympathetic to Metcalfe’s view on the relationship between innovation and competition. Of course it’s an idea that can be traced back to Schumpeter and other Austrian economists but Stan’s views are more than just theoretical. During the 1970s he was an economic policy adviser to the UK government and a large part of this work involved regulating competition, particularly prices of goods and services. If Metcalfe is emphatic about innovation being the solution to fair competition it is because he has seen first hand how the command economy stymies innovation and growth. In his excellent book “Commanding Heights”, Daniel Yergin describes the extremes of regulation by governments in the 1970s. My particular favorite is the sandwich inspectors on US airlines who would measure size and fillings to make sure that “fair competition” was happening.

Every now and then I come across an industry where my gut reaction is to say “why doesn’t government do something about this!”. However, what initially appears to be a form of market failure is usually fertile ground for innovation.

I have been trying to move house recently, which has brought me into contact with the strange world of the real estate industry. If I detach myself a little from the stress of buying and selling and put my academic’s hat on, it’s another example of where innovation will succeed in reforming the industry where regulation would fail.

To start with, writing about this industry makes me a bit nervous. They definitely don’t like criticism. I’ll explain..

The Sydney Morning Herald hosted an online forum on peoples’ experience with financial planners a few months ago. Of course, the negative comments rolled in and the financial planning association protested. However, the SMH saw that the forum was getting a lot of clicks and consequently kept it going.

The next week the SMH thought it could generate more clicks with a similar forum on real estate agents. The response from SMH readers was even more vitriolic but by the late afternoon, the forum and the story had been removed from the website. Media Watch investigated this strange decision and it turned out that the real estate institute had told the SMH to kill the story, and they did!

The reason why the SMH had responded to the request of the real estate industry and not the financial planners is obvious. Real estate classifieds are one of the last solid revenue sources for newspapers. Freedom of the press is a nice idea, but it comes a distant second to the principle of “don’t bite the hand…”. If anyone can tell me of an industry that has more power over the Australian press, then please let me know.

After my initial surprise at the industry’s ability to control the press, I started thinking about why real estate classifieds were so important to newspapers. Surely the web had taken this market, along with every other section of the classifieds and newspaper advertising. I don’t actually know anybody who regularly reads a physical newspaper. So what’s the story with realestate.com.au (the dominant website for property listings)?

Well, it turns that realestate.com.au (REA) is 60% owned by News Limited with real estate agent businesses being the second largest group of shareholders. The ACCC actually approved a takeover of realestate.com.au by News in 2005. The decision cites the low barriers to internet advertising as one of the main reasons for approving the takeover. This decision looks a bit misguided to me. The trouble is that first mover advantage with internet aggregation is very powerful and there are increasing returns to scale. It’s a bit like Wotif.com. The bigger it gets, the higher the barriers to competition. The result is a fairly cozy relationship between the real estate industry and the print media. I have looked at Realestate.com.au and as far as I can tell there is no way that I can list my house independently from the real estate agent. The same is true with Domain.com.au , owned by Fairfax. If I want to have my house on realestate.com then I have to wear the 15k in commission fees. With the majority of buyers now exclusively relying on realestate.com.au and domain.com.au, its a goldmine to an industry where commissions are tied to rising house prices in a country that has one of the highest house price to income ratios in the world. Nice work if you can get it!

In return, the real estate industry continues to place ads with the newspapers. In particular, the little local newspapers (Westside News in my part of town-which arrives on my driveway every week whether I want it or not), also owned by News Limited, are about 25% real estate classifieds. The only reason why I can think that agents tell clients to write cheques to place advertisements in these suburban newspapers is that it promotes the agency to people who might list their house some time in the future. I just can’t imagine someone flicking through the free newspaper and deciding to buy a house in the local area as an impulse decision. Serious buyers go to the two dominant web sites because that’s where everything is!

But where there are people making money, there is money to be made. The reason why the real estate industry is so lucrative is that barriers to entry, in the form of internet advertising, have stopped competition.

In theory, what happened to the stockbroking industry in the last 10 years could also happen to the real estate industry, with new business models driving down costs. I can buy shares on the internet now for under $20 and it takes me about 30 seconds. About ten years ago I remember paying $80 for the same service where I had to phone a broker, go into an office and sign paperwork.

The temptation here is to say that government should force News Limited to sell realestate.com.au and prevent ownership by real estate agencies. That might work, but a better idea is to let innovation sort this out.

The best response to a monopoly internet aggregator position is to encourage a business with even greater potential to be an aggregator. Watch out for Google! In fact, Google is already listing properties on Google Maps- and private vendors can list their properties without agents getting involved. Predictably, the response from Fairfax and News Limited has been to threaten to not buy key search terms from Google. Good luck to News and Fairfax – they will need it! The difference is that Google has a viable business model, Fairfax doesn’t and News Limited’s newspaper business is looking for one. It’s just Schumpeter’s creative destruction in action. Incidentally, a major real estate shareholder sold their shareholding in REA (owners of realestate.com.au) the day before Google announced its entry into the real-estate advertising business. Something comes to mind about rodents and sea-going vessels….