MBA DL: Economics of the Business Environment: Vulnerability WBS Live June 2010

John Old

University of Warwick

The 3 basic concepts in EBE

VulnerabilityExposureProtection and Mediation

These are the 3 central concepts in EBE which we use to explain the events in the organisation you choose to analyse for the final assignment

April 8, 2023

Short Run Vulnerability (Lesson 1)

Vulnerability is about the ‘hurt’ that can be done to a business’s costs and its profits by the market and the macroeconomy

Exposure

a) in the marketplace (Lessons 2 and 3) Market Exposure is about whether a business is actually ‘hurt’

or ‘helped’ by the markets where it sells goods and/or services and also where it buys its inputs. Is it in ‘Strategic Hell’ ?

b) in the global economy (Lessons 4 - 8 )

Macro exposure is about whether a business is actually ‘hurt’ or ‘helped’ by changes in the local and global macroeconomy, which are totally outside its control

Some key accounting identities

Total Profit = (Price – Average Total Cost) x Volume of Output/Sales

The object of the firm…

Not to minimise total costNot even to minimise average costNor to maximise priceOr even revenueIt’s to make profits – which requires balancing price (and revenue) with cost

An assumption in a lot of economic analysis – “Profit Maximisation”?...

This does not mean that firms will set out to squeeze every last penny out of their poor workers and customersBut , faced with two alternatives – one which makes money, and one which loses it – they will choose the first.In economic terms this means comparing the marginal revenue (the extra earned from an extra unit of output) with the marginal cost (the extra cost of producing it)If we assume that as output increases MC is constant (CR) or increases (DR)And MR is constant or falls (you can’t normally raise the price as you increase output)If MC<MR then it’s worth increasing outputIf MC>MR then output should be cutAnd “profit maximisation” occurs where MC=MRSo profit maximisation occurs where MC=MRAnd firms will tend to move towards this level of outputEspecially where competition is intense

“Profit Maximisation”?...This does not mean that firms will set out to squeeze every last penny out of their poor workers and customersBut , faced with two alternatives – one which makes money, and one which loses it – they will choose the first.In extreme competitive conditions (“perfect competition” or “strategic hell”) firms have to behave as if they were “profit maximisers” In economic terms this means that in this market situation they have to continually look for cost savings, etc, otherwise they will be driven out of business by othersThe maximum profit achievable is the minimum required for survival

Some key accounting identities

Total Profit = (Price – Average Total Cost) x Volume of Output/SalesSo profits fall as output and sales fall(Price – Average Total Cost) is the “profit margin”And this will also fall if Average Total Cost rises

When economic conditions change, why are some firms affected more than others?

“Vulnerability”…the ‘hurt’ that can be done to a business’s costs and its profits by the market and the macroeconomyWhat do a firm’s cost conditions look like?

Economists typically classify costs as

“Long run” – where the organisation can vary all the inputs, or “factors of production”eg when building on a “green field site”, or entering a totally new industry and market“Short run” – one or more significant factors can’t be variedOur focus here is essentially short-run

Economists also classify costs as

Fixed – don’t vary with the level of outputexamples?capital costs, R&D, (some) advertising and marketing, Variable – vary with the level of outputexamples?Materials and components, energy, labour?In the long run, all costs are variable

In reality, it’s not as clear cut

Some costs are “quasi-fixed”especially some types of labourfirms may have invested in trainingemployees have firm-specific knowledge“permanent” employees may have greater commitment, “motivation” etc (see OB!)

Key determinants of the AC curve

How large are “fixed” costs – ones that will be the same irrespective of output?What happens to variable costs as output increases? Will these rise or fall? “Increasing”, “constant” or “diminishing” returns?

The “Fixed cost” effect

Suppose a firm has FC of €10 million If it produces 1 million units, then average fixed cost (AFC) = (€10 million/I million) = €10 per unitIf it produces 5 million, then AFC = €2 per unitIf 10 million, AFC = €1 per unitAnd so on

This alone would produce a downward sloping “short-run” average cost curve

But can be reinforced by increasing returns (eg division of labour effects)These will reduce average variable costSo average total cost falls even more as output is increasedBut eventually the firm is probably going to run into diminishing returnsWhich push up average variable cost, and, if they are strong enough, average total cost

Cost

Output (Q)

AC

0 Q1 Q0

AC1 AC0

Hence the “text-book” “U-shaped” average cost curve

Cost/ Price

€

Output (Q) 0

AC1 “flute”

AC

“Type 1 Vulnerability”

Cost/ Price

€

Output (Q) 0

D1

AC1 “flute”

AC

“Type 1 Vulnerability”

Cost/ Price

€

Output (Q) 0 Q0

€0

D1

AC1 “flute”

AC

“Type 1 Vulnerability”

Cost/ Price

€

Output (Q) 0 Q1 Q0

€1

€0

D1

AC1 “flute”

D2

AC

“Type 1 Vulnerability”

Cost/ Price

€

Output (Q) 0 Q1 Q0

€1

€0

D1

AC2 “saucer” “saucer”

AC1 “flute”

D2

AC

“Type 1 Vulnerability”

Cost/ Price

€

Output (Q) 0 Q1 Q0

€1 €2

€0

D1

AC2 “saucer” “saucer”

AC1 “flute”

D2

AC

“Type 1 Vulnerability”

Last year in the UK…

Setanta TVSold (sports) subscription TV in the UK Major contract - £392m pa for Premier League footballMajor (but not only) source of revenue – subscriptionsNeeded 1.9m subscribers to break evenOnly had 1.2m!

Type 2 Vulnerability

is caused by a shift in the cost curve so costs rise at all levels of outputis important in an upturn (costs of inputs “bid up”)High type 2 Vulnerability is caused by high input cost intensityeg cost of construction materials for builders(Wembley stadium???)

“Type 2 Vulnerability”

Cost

Output (Q)

AC1

0

“Type 2 Vulnerability”

Cost

Output (Q)

AC1

0

AC2

Prices and Recession

Global Composite Carbon Steel Price(source: worldsteelprices.com)

0

200400

600

800

10001200

1400

Month

$/t

CEMEX reports fourth-quarter and full-year 2009 results

MONTERREY, MEXICO. January 26, 2010 - CEMEX, S.A.B. de C.V. (NYSE: CX), announced today that consolidated net sales decreased 17% in the fourth quarter of 2009, to US$3.4 billion, and decreased 28% for the full year, to US$14.5 billion, versus the comparable periods in 2008. Adjusting for the exclusion of our Venezuelan operations, the sale of our assets in Australia and the Canary Islands, and currency fluctuations, net sales decreased 20% in the fourth quarter and decreased 19% for the full year of 2009.

EBITDA fell 37% in the fourth quarter of 2009 to US$474 million and decreased 35% for the full year to US$2.7 billion. On a like-to-like basis, EBITDA decreased 39% in the fourth quarter and decreased 25% for the full year of 2009.

http://www.cemex.com/qr/mc_qr_012610.asp

What does the AC curve look like in practice?

Cost

Output (Q)

AC

0 Q1 Q* (MES)

AC1 AC0

AC1

“MES”?

The “Minimum Efficient Scale” (or “Minimum Efficient Size”) of operationsHow big is this relative to the market?How much cost disadvantage is a firm at if it produces significantly less than MES?

What does the AC curve look like in practice?

Cost

Output (Q)

AC

0 Q1 Q* (MES)

AC1 AC0

AC1

What does the AC curve look like in practice?

Cost

Output (Q)

AC

0 Q1 Q* (MES)

AC1 AC0

AC2

AC1

What does the AC curve look like in practice?

Cost

Output (Q)

AC

0 Q1 Q* (MES)

AC1 AC0

AC2

AC3

AC1

What does the AC curve look like in practice?

Cost

Output (Q)

AC

0 Q1 Q* (MES)

AC1 AC0

AC2

AC3

AC1

AC4

You can infer the shape of AC various ways

Eg studying past accounts of the firmsBut there are other waysOther published information“engineering estimates”Published economic estimatesThe key point is that you make sensible inferences from whatever data is available

For example

Fixed and variable costsWhat proportion of the firm’s costs are really fixed (or “quasi-fixed”?) →“Type 1 vulnerability”“Internal” and “external” costs“Type 2 vulnerability” will be greater, the more of a firm’s costs are “bought in”

Economic Vulnerability in Practice : The Case of Nippon Steel

Steel Production Costs in 2009 ( Source : SteelontheNet )

%Internal Costs as a % of Total Costs 28%Fixed costs as a % of Internal Costs 85% ( high type 1 )External ( Bought-in) Costs as a % of Total Costs 72% ( high type 2 )Iron Ore as a % of Total Costs 25%Coal as % of Total Costs 34%Other external costs ( scrap, oxygen,energy etc ) 13%

To summarise - Vulnerability…

Shows how much the firm could be “hurt” by changes in its product market (because sales volumes fall)And in its input markets (because input prices rise)

Another key question is

How exposed is the firm to such markets?For example, in its product market does the firm simply have to take the “going market price”?Or can it have an “active pricing strategy”?Does it have some control, or discretion over input prices?

In economic terms, this is about how competitive the product and input markets areLessons 2 and 3 deal with this.

At the seminar in September

We’ll be developing the concept of “exposure”…to the firm’s product and input markets…and to the wider macroeconomy…and looking at some of the implications of all this for strategy

Anything else?