Competitive arbitrage is fancy term, but it means something very simple. It is a pattern as common as business itself:
You discover a new business opportunity, and start a business to exploit it.
In the beginning this opportunity is underexploited, meaning that you make large profits for yourself.
The large returns attract copycats and competitors, who enter the market after you in pursuit of the same opportunity. They set prices to be lower than yours, in order to undercut you and take some share of the spoils for themselves. (This is the 'arbitrage' portion of the story).
The number of competitors increase, and the price cutting continues until everyone's margins are suitably destroyed, at which point capital that may have initially been invested in this particular opportunity goes elsewhere, since the returns have all been compressed down to nothing.
This is what is meant when finance folk say "supernormal returns attract competition, and excess competition drives profits down to the opportunity cost of capital."
Hamilton Helmer's book 7 Powers deals directly with this problem. It asserts that there are really only seven ways to resist competitive arbitrage; these are the eponymous '7 Powers'. In Commoncog's summary of the book 7 Powers, there is this section on how competitive arbitrage feels like in the introduction, which attempts to hammer home the importance of the topic. It goes:
Indeed, if you talk to anyone who has spent enough time in business, you’ll realise that they all eventually gain an intuitive grasp of ‘Power’. Even uneducated, traditional Chinese businessmen types are able to say “eh, that feels like a bad business” — and after awhile you’d realise that all they’re doing is a Valuation+Power calculation in their heads, even if they can’t articulate it as cogently as Helmer does.
Why is that the case? I think the answer is simple: bad businesses — the ones lack Power — feel different from good ones. Because competitive arbitrage slowly pushes margins downwards, operators of bad businesses will often feel like they have to run faster and faster each year in order to stay in the same place.
I don’t want to understate this point — an entrepreneur might grok what I am saying because they have a window into the business’s finances, but an employee wouldn’t normally have visibility into any of that, and would not know that Power affects them as well. To most people working in a bad company, you would simply feel that the company gets less and less nice to work at. You’d watch perks vanish, find that KPIs become ever more onerous year on year, and you’d think that maybe this is normal and reflects the natural state of the world, right up to the point where management gets so tightfisted it refuses to buy a new coffee machine to replace the one that Bob broke, and the old one sits mouldy and unused in the corner of the office kitchenette and serves as an ugly reminder of the state of the business.
But what does competitive arbitrage, experienced through a 'bad' business truly look like? How long can the process of competitive arbitrage take?
This concept sequence illustrates what that looks like.