Friday, December 8, 2017

Producing at a loss

One of the paradoxes of the business cycle is that companies will often produce products and services at a loss.

Classical Economics
In the absence of competition, firms will choose the production model that makes the most profit given the anticipated demand.

Small demand will drive the firm toward low fixed cost and higher variable costs.  Think boutiques and artisans.

Large demand will drive firms toward high fixed cost and lower variable costs.  Picture highly automated factories.

Firms do not exist in the absence of competition nor is demand constant.

Consider an economy that hosts a universe of firms that have chosen different paths.  Some are artisan producers and others are low variable cost producers.  What happens when demand collapses? Do the producers whose production model most appropriately matches the the new demand prevail?


What happens is that all producers continues to produce as long as the price exceeds the variable cost.  Even though they are losing money they are losing less money by producing than by idling.  Since the highly automated plants have lower variable costs they continue to flood the market even though they are producing at a loss.  That cuts the bungee cord that tethers price-discovery to reality and amplifies price excursions.  The artisan firms are monkey hammered as the highly automated factories continue to flood the market long after the artisan firms idled.

How can Uber be losing money?  Really?  What are their costs?  They have mature code and apps.  They have brand recognition.  They have revenue.  Their variable costs are almost zero.  Their fixed cost are purely optional.  How can Uber be losing money?


Well, they are looking over their shoulders at the competition.  Uber's business is not technically difficult.  There are other firms who want a piece of the action.  Firms with brand recognition in other areas.  Every social media company can replicate Uber.  Google/Alphabet can replicated it.  The auto companies can replicate it. They all have the programming expertise and  they all can leverage other strengths.

An example:  Social media collects GPS coordinates of users through-out the day.  After a while they can pattern any individual just like a hunter tries to pattern a trophy buck.  Do you suppose that would be useful in scheduling and routing of drivers?

Uber is losing money because they are in a race for their lives.  They are trying to code work-arounds and strengthen brand loyalty.  They are losing money because the last firm standing in the event of demand collapse is the firm with the lowest variable costs.

Even if the last firm standing hemorrhaged profit through 3/4 of the business cycle they will attract recapitalization if there are no other alternatives.  Because with no alternatives the last firm standing will have much pricing power.

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