Corporate profits have own dynamic ( 338,89 KB )

 

Biggest adjustment in non-essential goods and services operating in very competitive environment

  As the financial crisis spilled over into the real economy many companies have seen a rapid drop in the demand for their products. In sectors such as motor vehicles, for example, this contraction is turning into an erosion of corporate profits and a reduction in workforce. Fortunately, not all sectors will have to face such sharp drops in demand nor will they make readjustments only through reductions in workforce. If we classify the various economic sectors according to the risk they face of a drop in demand and the competitive environment in which they operate, it is possible to provide some indication of the adjustments they may undertake in order to limit the impact of the crisis.

  Consider first the demand side. Demand largely depends on income and in this respect the biggest drops will take place among those consumers suffering most from the increase in unemployment, namely those under 25 years, adults with only secondary school record and immigrants. Nevertheless, the rest of the population may also depress their demand for goods and services. Negative expectations generated by the current situation regarding future income and the drop in prices in the real estate sector, which reduces wealth, would explain this behaviour. We should also point out the situation of those sectors linked to durable goods. In recent months, these sectors have had to face a particularly difficult situation because of the tightening of credit terms. For them, the good news is that the worst may already have passed given that the situation in consumer credit is beginning to reflect both the decrease in interest rates and the improved liquidity conditions of financial institutions.

  To assess how the demand for a product can respond to decreases in customer incomes it is useful to compute the income elasticity of demand. This measures the percentage change in the demand for a good due to a 1% change in consumer income. Demand for so-called «essential goods», whose elasticity is under 1, responds only moderately to changes in consumer income. This is the case with food and drink, energy and home goods. On the other hand, «luxury goods» (leisure products, holidays and domestic service and other home services) react more sharply. In the following table, the various sectors are arranged vertically from lower to higher income elasticity.

  With regard to the second classification variable, the competitive environment faced by companies within the same sector determines how they will share the drop in demand. In those sectors where there is strong competition, the drop in sales will be borne by the least efficient companies, that is to say, those showing the highest costs. This is because the characteristics of the sector are such that the market can be supplied only by those companies offering the lowest price. Many other sectors in fact show characteristics that allow those companies with higher costs to continue supplying part of the market. These companies are under less pressure to lower prices and are said to enjoy a certain degree of market power. In these cases, the drop in sectoral demand is borne by the companies according to criteria related to the origin of that market power and not based on production costs.

  The fact that a company enjoys a certain degree of market power may be due to various factors. For example, the existence of barriers to the entry of new companies, as in the case of the electrical power sector, limits the number of competitors and facilitates a certain coordination in order to prevent aggressive competition. Another possibility is that the products or services provided by the various companies show, in the view of consumers, some differentiation according to certain features. Just as one man’s meat is another man’s poison, each company may have its own market niche more or less isolated from other competitors. A result of this differentiation is the appearance of commercial brand names, which exist in such different sectors as food, footwear and telecommunications. In any case, companies in these sectors have at their disposal more variables to compete in a changing environment than simply prices.

  The competitive pressure faced by a company can be approximated by the so-called «Lerner Index», which is calculated as the contribution margin divided by price.(1) Higher indices thus correspond to greater market power. The above table shows the various economic sectors arranged horizontally according to this index.

  Those sectors located at the lower left-hand part of the table (travel agencies, manufacture of sports articles and audiovisual equipment) are exposed to a severe contraction of demand in a very competitive environment. Companies in those sectors must adjust themselves by means of major cost cuts if they want to stay in the market. In this respect, those companies with high fixed costs in relation to variable costs will have a hard time reducing them. The same applies to highly leveraged companies, given the financial charges they have to bear.

  Companies in the central section of the table could benefit from strategies such as improving their product differentiation or loyalty programmes for their customers, since both strategies would soften price competition. They could also benefit from greater customer segmentation, through the design of products or specific tariffs for particular groups. As in the case of «store brands» in supermarkets, the idea is to resort to tough price competition only for those consumers who are most sensitive to this variable. Telecommunications companies, for example, in spite of their market power, aim at this when they offer special tariffs for unemployed persons.

  To sum up, the biggest adjustment and perhaps the most distressing in terms of employment will have to be carried out by companies that produce goods or services that are non-essential and that operate in very competitive environments. Other companies have more margin for manoeuvre but will have to adopt diversification and differentiation strategies in order to minimize the effects of the recession.

  This box was prepared by Sandra Jódar

  Office of Economic Analysis, ”la Caixa” Research Department

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