Shopping malls may seem far removed from hog farms. But hog producers and retail managers often face the same brutal reality: When push comes to shove, they must sell products for whatever price they can get.
An Associated Press story on Thanksgiving noted that many large retailers already had chosen to unload part of their holiday-season inventory directly to liquidators rather than waiting until after the New Year. They were doing this even before the traditional start of the shopping season on Black Friday.
Some reportedly “had cautiously planned their holiday inventories about 15 percent below last year’s levels” but now believed they still had too much inventory and hence were dumping some in bulk even though increased availability at liquidators’ outlets before Christmas potentially could cut into their own sales.
This hasty dumping illustrates a few economic principles.
First, a producer often must ignore sunk costs in pricing decisions. In introductory microeconomics courses, students learn that supply — producers’ willingness to sell different quantities of a product at different prices — depends on the marginal cost of producing the product.
The producer must ask: What does it cost me to produce one more unit of my product? How much can I sell it for? If the selling price exceeds the production cost, then produce another unit.
That introductory case assumes that the manager already knows exactly what price the product will bring at the time she must decide whether or not to produce the good. Such certainty is rare in the real world.
Instead, managers have to set production levels ahead of time based on their best estimate of what price they will get weeks or months or years down the road.
As long as the economy is stable, experience and competent market analysis usually lead to good decisions, but not always. And when the price has fallen below what was anticipated by the time the goods are ready to sell, things get dicey. This is particularly true in harshly competitive businesses like retailing and farming.
Ten years ago, hog prices plummeted to historically low levels — as low as 10 cents a pound (briefly) in some areas.
Deciding how many hogs to produce must take place nearly a year before the porkers go to slaughter. The sows must be bred, the pigs born and weaned and then fattened.
Moreover, unlike containers of Christmas merchandise, market-ready hogs cannot simply be stored in a warehouse. They are perishable. So once the farmer starts the production cycle, the quantity outcome is determined months in advance.
If many farmers make the same decision, there can be a glut of hogs when all are ready for market. Prices can fall sharply. But the cost of producing the hogs is a “sunk” one. The money already is spent and thus is as irrelevant as spilled milk. The farmer has to sell the hogs for whatever she can get, and the price declines can be gut-wrenching.
The same is true for a retailer who ordered holiday season merchandise many months ago. That purchase is a sunk cost. The management problem now is to sell it for as much as one can get. The acquisition cost is irrelevant.
The problem for retailers, as for farmers, is the extreme level of competition. If you as a retailer don’t cut prices, your competitors will and shoppers will throng to their stores, shunning yours. If competitors anticipate you in unloading their excess inventory to liquidators, they will get some revenue for that product. But you will share the cost of an even more competitive sales environment with them even if you are holding onto your own excess goods.
It is a classic “prisoner’s dilemma” — in which two crooks being interrogated separately by the police each know that if the other guy breaks first and confesses, the holdout will get a long jail sentence while the rat gets off easy.
If sellers can get together and agree on cutting output, or even destroying some goods already produced, as a group they may be able to increase market prices enough to get greater revenue even though they’re selling a smaller quantity.
But that requires some measure of coordination and coercion. That isn’t easy. Another recent news story headlined, “Taliban curtail poppy growth to bolster opium price” described exactly such an action. If you have AK-47s, you can bring producers into line.
But the fact that crude oil is now trading below $50 when it was near $150 this past summer shows that maintaining a cartel is not easy. OPEC has met repeatedly but has not been able to curtail output enough to halt the downward price plunge.
When a predetermined quantity of goods hit a market with sharply declining demand, the outcome can be messy. By Jan. 2, a lot of retailers may wish they were in a low-stress occupation like raising hogs.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.