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From Homes to Appliances and Autos: Hovnanian, Corning, GM, Ford, and Chrysler Each Must Manage Lower Demand

December 2008 Corporate, Pricing

It is no secret that our global economy is in a downward funk.  When will we get our groove back? A debate I will leave to the politicians.  But for now, durable goods companies such as Hovnanian and other housing suppliers, Corning and other home appliance suppliers, or GM, Ford, and Chrysler and other auto suppliers must manage the rapid shift towards lower demand.

The effect of shifting demand on price and quantity sold is covered in every first year economics course.  The exhibit below, a plot of price against quantity sold, represents the prior state of the economy in red and the future state of the economy in green.  For normal markets, the quantity consumers demand decreases as price increase, resulting in downward sloping demand curves.  In contrast, the willingness of producers to supply increases as price increase, resulting in upward sloping supply curves.

08-12-08-12-fromhomestoappliancesandautos_hovnaniancorninggmfordandchryslereachmustmanagelowerdemand_plot

In the old state of the economy (red curves), supply fulfilled demand at a market clearing price, PO.  Presumably the market clearing price was higher than the marginal cost to produce and companies maintained a level of profitability.

Recently consumer demand decreased precipitously, something economists would call a “shock to the system”.  On the new demand curve (green downward sloping curve), the quantity sold at any price is less than that which would have been sold on the old demand curve.

It takes time for suppliers to react to the new demand curve.  How much time?  This is subject to both the wisdom of the management of producing firms to reduce supply and the rate in which it takes to clear inventory.  While economics fails to predict timing, it succeeds in predicting market behavior.

The transitory term is the period during which demand has assumed its new lower position (green demand curve) while supply is still being held at its old, higher position (red supply curve) and the market temporarily rests in a transitory equilibrium.  Two disastrous effects plague producing firms during this transitory term.  First, the market clearing prices for their output will drop to PT damaging profits.  Second, the unit sales volumes will drop aggravating the need to clear inventory.

With falling prices and decreased demand, producing firms are temporarily facing expensive and idle production capacity that outstrips demand and the lack of pricing power to cover costs.

The rational managerial tactics to address this challenge are two-fold.  One, they must reduce production and production capacity sharply in order to reduce costs and adjust to the new supply curve (green curve).  And two, they may need to temporarily reduce prices to clear the market of excess inventory, perhaps even clearing it below its sunk marginal cost to produce in order to lower inventory carrying costs.

We see these actions within the market.

  • Between October 2005 and October 2008, US new home sales volume fell from approximately 1.1 million units to below 500 thousand units in seasonally adjusted annual rates.  The “fire sales” by Hovnanian Homes in the fall of 2007 can be understood as a rational approach to reducing inventory and curtailing further financial losses that would have resulted from the costs of financing and holding large stocks of unsold homes.
  • iSupply, a market research firm, has reduced its forecast for shipments of LCD TVs for 2008 from 99 million units to 93.4 million units.   The capacity reduction by Corning in the fall of 2008 can be understood as a rational approach to reducing the supply of glass for the LCD television market as consumers are “delaying” purchases of non-essential items.

We have also seen the failure of some firms to respond sufficiently.

  • Between 2000 and 2007 the yearly average of new car sales rested near 17 million units per year prior to plunging to below 12 M units annually for September 2008.  GM, Ford, and Chrysler have been brought to their knees with an unmanageable 30% drop in industry wide demand.

Firms in industries that adjust their demand rapidly and sufficiently will soon find themselves on a new supply curve (green upward sloping curve).  In the absence of technological or productivity advances, the willingness to supply at any quantity on the new supply curve will require the extraction of a higher price from the market.  Once firms adjust to the new supply curve, the market clearing price will re-establish itself at a new level which is likely to be higher than the old market clearing price.

While the laws of economics deliver a predictable trajectory for the market, economics neither foretells the duration of the transitory and recessionary market, nor does it indicate which companies will disappear during the transition and which will flourish in the future.  Both of these issues are subject to managerial wisdom and restrained actions by industry cohorts.

Until we reach the new equilibrium, there will be much gnashing of teeth.

During this transitory period, executive decisions to cut prices or use price promotions to clear inventory should be associated with clear market statements of their purpose and clear turning points where prices will resume to a more healthy position in order to avoid tipping off an unnecessary and industry destructive price war.  (Using price promotions to “maintain” volumes is likely to be a less than fruitful endeavor for durable goods suppliers during this tumultuous time.)  They should also mothball some production capacity and start producing in quantities appropriate to the new demand curve.  (New housing starts and chicken production have likely not been reduced sufficiently to match the next few quarters.)

If executives manage this process with thoughtful strategy and restraint, they will make it through to the next healthier stage of the economy.  A stage where the pursuit of creating value for customers and capturing prices in proportion to the value delivered once again delivers extraordinary results.

Anyone else looking forward to ditching this dirge and dancing a polka?

References



About the author

Tim J. Smith, PhD is the Managing Principal of Wiglaf Pricing, and an Adjunct Professor at DePaul University of Marketing and Economics. His most recent book is Pricing Strategy: Setting Price Levels, Managing Price Discounts, & Establishing Price Structures.

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