About the prof

Prof of Economics, Wms School of Commerce, Washington and Lee University, Lexington VA

China’s Auto Industry Shakeout

I have a (Google blogspot) blog called Autos and Economics. My latest post (of a few minutes ago) is on a pending shakeout in the Chinese auto industry. The origins of the industry’s excess capacity include the government’s “import substitution industrialization” policies of the 1980s and 1990s, and – since 2001 – a rush by global producers to establish a foothold in what is now (by a significant margin) the world’s biggest market. But despite its size China has too many firms, too many brands, too many factories and too many models. There will be a bloodbath. What is unclear is who will survive. All but 2-3 Chinese domestic brands and the most recent global entrants are in my analysis all at risk. While we’ll focus this term on case studies of the beer and steel industries, my post on Chinese autos has in the background the application of a host of standard economics of strategy models. Read, and if you could, publicize among classmates, friends, workmates, relatives….

Texts for Winter 2016

Aside

Texts are the same as for the Fall 2015 section.

  • Warrian, Peter. A Profile of the Steel Industry. Business Expert Press, 2012. ISBN: 978-1606494172
  • Ogle, Maureen. Ambitious Brew. Mariner Books, 2007. ISBN: 978-0156033596
  • Martin, Stephen. Industrial Organization In Context. Oxford University Press, 2010. ISBN: 978-0199291199
  • Tremblay, Victor & Tremblay, Carol. The US Brewing Industry. The MIT Press, 2009. ISBN: 978-0262512633

Beer and survival

… that is, survival of breweries during Prohibition. This is the topic of a “job paper” (what an economics PhD job candidate sends out with their application) from UCLA, “Product Switching, Adaptation and Firm Survival in the Brewing Industry during Prohibition” by Carlos Eduardo Hernández. Here is an abbreviated version of his abstract:

… states and counties chose to prohibit the sale and production of alcohol in the years leading up to the 1919 federal prohibition. Because of high transportation costs, local prohibition in nearby markets [thus] reduced the demand for beer production for some breweries more than others. Using novel micro-data at the brewery level, I show that breweries adapted to this first shock … produce[d] alternative products like soft drinks. … [such] breweries … were 12 percent more likely to survive the entire prohibition period (local + federal) …

Organizational theory encompasses two “pure” models. The first is that, once founded, organizations don’t change. This underlies the population ecology approach of Carroll and Hannan. The other is that firms continuously adapt to their environment, resource dependency which I associate with Scott, Powell, Pfeffer and others. So Hernández’ dissertation framework appears to me to be close to that of Carroll and Hannan, that organizations don’t readily change. Hence those that had a head start in developing non-beer products did better.

Oddly, there’s no reference to this literature in the job paper. I ought not be surprised: I wrote a paper years ago that played with these ideas, albeit in a different context (can firms – in my case Japanese firms – “borrow” technology). I found that while sociologists referenced the economics literature, economists didn’t read sociologists. (Carroll and Hannan are an exception.) Examples include:

  • Dimaggio, Paul J., and Walter W. Powell. 1991. “Introduction.” In The New Institutionalism in Organizational Analysis, edited by Walter W. Powell and Paul J Dimaggio, 1–38. Chicago: University of Chicago Press.

  • Pfeffer, Jeffrey. 1982. Organizations and Organization Theory. Boston: Pitman Publishing.

  • Powell, Walter W. 1990. “The Transformation of Organizational Forms: How Useful Is Organization Theory in Accounting for Social Change?” In Beyond the Marketplace: Rethinking Economy and Society, edited by Roger Friedland and Alexander Robertson. New York: Aldine de Gruyter.

  • Scott, W. Richard. 1987. “The Adolescence of Institutional Theory.” Administrative Science Quarterly, no. Dec.: 493–511.

  • Scott, W. Richard. 1995. Institutions and Organizations. Thousand Oaks, CA: Sage Publications.

  • Swaminathan, Anand, and Glenn R. Carroll. 1995. “Beer Brewers.” In Organizations in Industry: Strategy, Structure and Selection, edited by Glenn R. Carroll and Michael T. Hannan, 223–43. New York: Oxford University Press.

Global Steel, China Steel

Industries have industry associations. Nine of those for steel jointly claim:

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Estimates from the OECD Steel Committee indicate that there is almost 700 million metric tons of excess steel capacity globally today. China’s overwhelmingly state-owned and state-supported steel industry has an overcapacity ranging from 336 to 425 million metric tons and it is expected to grow in the coming years. This situation, together with a declining steel consumption, has resulted in record levels of steel exports from China to the rest of the world in 2014 – and which are on track to exceed 100 million metric tons this year.

What does this say of the nature of the industry? Why large swings in prices? Is this a Bertrand market with occasional price wars?

Additional query: what was the ECSC?

Bud + Miller = spinoff?

The hot news item (here) is the $106 billion agreement for AB InBev NV [a Belgian firm] to acquire SABMiller Plc [a UK firm]. The proposed venture will control 1/3rd of the global beer market and 50% of global beer profits. This is the latest in a cumulative $90 billion in acquisitions following the buyout of a group of Brazilian investors of Brahma beer.

The final form of the firm will be a function of antitrust rulings in the US [surely MillerCoors and Budweiser won’t be allowed to merge] and in China [Snow Beer, partially owned by SABMiller, is by far the largest firm, but AB InBev has 14 breweries there, too].

A big question: why (if at all) can a merger of this sort add value? At first glance, all it does is rearrange who owns which brand. Will this allow higher prices? Are there breweries that are poorly utilized so that this can produce operating efficiencies? or large sales forces that overlap and can be pared? But unless they kill brands, there are no savings on advertising. So no gains to beer operations, no gains to shareholders, only one group of execs grabbing the bonuses of another. For the lucky few, that is a big chunk of income.

Now don’t forget that 1/3rd figure. Here’s an infographic from an Oct 12, 2015 Bloomberg article on markets where neither is dominant:

http://www.bloomberg.com/news/articles/2015-10-12/forget-inbev-and-sabmiller-here-are-the-markets-where-local-beers-rule

Managerial Markets

We focus on firms as profit maximizers; for our purposes the details of the goals of a firm aren’t critical, and πmax offers simplicity.

Then there’s the real world of stock buybacks. This is a triangle trade that creates fees and riches. But is that because firms are profitable, or because it’s a complex shell game?

See details in this post on the Wolf Street blog (of Wolf Richter). The basic story is that execs are typically granted stock options that are priced to be “in the money.” They cash in their options, which increases the number of shares outstanding and thus dilutes the value of those held by regular shareholders. So the firm buys the shares back. Begin again.

Oh, and there’s one modest fillip: at present buybacks are of sufficient scale that firms are borrowing to undertake them. That’s right, profits aren’t sufficient. The accounting is sufficiently complex that shareholders don’t complain, and boards are just following industry norms and so aren’t guilty of ignoring their fiduciary duties. But then why should executives worry about profits at all? – it looks as though they can run this shell game for a very long time, long enough to retire.

So maybe our “innocuous” assumption that firms pay attention to costs and profits will prove less useful than in the past.

Strategic Options: Saudi Arabia isn’t engaged in deterrence

Thinking about strategy requires assessing one’s role in the overall market. For Saudi Arabia, that’s not what it used to be. While their output of crude oil in 2013 at 9.9 mil bbl / day is about what it was in 1980 (and is just shy of the peak over the period 1980-2013), their market share is distinctly lower, falling from 17% (of global output of 59.4 mil bbl/day) to under 13% (of 75.2 mil bbl/day). That limits their pricing power.Petroleum

Elasticities tell the story. The short-term price elasticity of demand is about -0.2, the medium-term one of course is more elastic at -0.5 or greater. [In most energy markets the income elasticity of demand is roughly 1.] So if the Saudis cut output by 10%, global output falls about 1%. That means prices rise 5%. Unfortunately for the Saudis that means their income would fall by 5%. With a population burgeoning in numbers and expectations, and as the ideological seat of the Wahhabi sect that fuels radical Islam but so far has not seen cause to bite the hand that feeds them, they can’t afford a large hit.

Now if OPEC (or at least the Middle East subset) was a true cartel, the Saudis could count on others cutting back as well. That changes the arithmetic in favor of cutting output. But Iraq needs to pump every barrel they can, and Libya and Iran as well. Such lack of discipline is reflected in the history of OPEC: in the past, whenever prices were low, attempts by the Saudis to drive up prices were offset by rampant cheating by other OPEC members. There’s no reason to think today would be different. But in the past the Saudis were big enough to go it alone; today they’re not.

One other bit of economic logic reinforces this argument: when interest rates are low and prices are low, it makes sense to leave oil in the ground rather than to pump and sell it. Selling turns oil into bank deposits, and those earn nothing. Leaving oil in the ground also provides the option tot benefit from future price rises [though the option loses its value if prices fall further]. So do you want to store your oil in the ground, or store your oil in the bank? (Those with finance acumen can do the corresponding net present value calculation, and maybe even put a valuation on the option.)

In sum, we should be highly skeptical of the claim that the Saudis are pumping a lot of oil to try to drive new producers (particularly US frackers) out of business. If nothing else, there’s no reason such producers won’t jump back in with higher prices. Chapter 11 bankruptcy hurts creditors but leaves the underlying business in place, and the distribution pipelines will remain as well. Low prices may curtail additional drilling today, but that’s scant help to Saudis in keeping prices high tomorrow and the day after. In other words, basic economics indicates we don’t have to resort to nefarious, anti-American conspiracies to explain Saudi behavior.

This term we will play with many concepts, including market power and cartel stability. We’ll use examples from the iron & steel industry and the beer industry on a regular basis. But if you delve into details, you’ll find that product differentiation matters in petroleum markets (not all “crude” is alike). That limits the options further for producers of undesirable (heavy, sour) crude.