Here’s how BHP Billiton Limited and Rio Tinto Limited are changing the face of the iron ore market

In what has become a heated war of words between executives in Australia’s three largest iron miners, the chairman of Fortescue Metals Group Limited (ASX: FMG) has accused BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO) of conducting a ‘scorched earth’ strategy by increasing production in an attempt to reduce prices and force other miners out of the market.

The accusation might be right on, but along with WA premier Colin Barnett’s threat to increase royalties to compensate for a drop in state revenues, Fortescue’s attack on BHP and Rio makes very little sense.

All three of the world’s major miners – including Vale SA (NYSE: VALE) in Brazil – are increasing production and reducing costs in order to improve their competitiveness and of course deliver returns to shareholders, which is a major imperative of publicly-traded companies.

This is exactly the same strategy currently employed by Fortescue and a number of other smaller Australian miners; very few are battening down the hatches to wait out the storm.

Presumably the alternative is for all parties to reduce production in order to maintain the price of iron ore which, given that Australia is the world’s largest producer of the steel-making ingredient, sounds a lot like collusion.

Coincidentally world oil producers are in a very similar situation to Fortescue, as prices drop and OPEC nations say there is no need to cut production to support prices.

The most overlooked fact in both industries is that you can have either a competitive free market or a self-interested protected one, but not both.

In a ‘free’ market, if a producer can somehow achieve an advantage such as lower costs or a more desirable product, it will of course be more successful and lower-quality competitors will be put at a disadvantage or pushed out of the market.

Over a number of years the effect is cumulative and evolutionary, and the overall quality of product available to the market and cost of delivering it improves.

That’s exactly how Wesfarmers Ltd (ASX: WES) and Woolworths Limited (ASX: WOW) have successfully driven such significant improvements in their grocery businesses to consumers over the past decade or more.

A ‘protected’ market is a useful economic measure at times but generally results in a less competitive industry because better companies with lower costs subsidise the performance of worse ones.

In the oil world, OPEC generally helps conduct a protected market with the price of oil supported by adjustments in production quotas.

While this has worked for many decades, the net effect is detrimental since OPEC now produces a decreasing proportion of the world’s oil production – exactly because continued high prices (and political disputes) have inspired competition in the US and elsewhere.

Rio Tinto and BHP are thankfully heading down a more competitive route, improving their offering in order to best serve the market and assure their success.

It puts companies like Fortescue in an unfortunate position, but that’s exactly why the free market delivers such good returns to consumers over time – because those who can’t compete are pushed out.

It’s also why you need to make sure you invest in companies with natural advantages over their competition, because buying the ASX equivalent of ‘Joe Ordinary’ is too risky when it’s your hard earned cash at stake.

The Motley Fool has identified one company which, although it’s not an iron miner, has competitive advantages and market dominance fit to make even BHP and Rio seethe with envy.

It’s no coincidence that this sexy tech stock has been named the Motley Fool’s Top ASX Stock Pick for 2015.

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Motley Fool contributor Sean O'Neill owns shares in Rio Tinto.

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