Published in La Jaune et La Rouge, Ecole Polytechnique, Oct. 2012
Commodity industries are experiencing spectacular progress. Given the amount of capital invested, often measured in billions of dollars, the impact of the supply/demand balance on pricing and the small number of competing players, capacity investment strategy (i.e. size, location and timing) cannot ignore the fundamentals of competition dynamics, therefore constituting a perfect field to apply the theories of imperfect competition.
— Out of fashion since the 1980s, the raw materials and basic products industries (other than gas and oil) have made a progressive comeback in the last twenty years due to the strong increase of demand in developing countries, notably China. However, financial risks may be as high as future expected incomes. Indeed, over-investments in production capacities, unexpected slowdowns in demand growth and price wars are never far away: once capacity has expanded, pressure on utilization rates can lead to price drops down to the level of operating costs. Therefore, when deciding the size and location of new capacities and the timing of those billions of dollars to invest, understanding the fundamentals of competition dynamics becomes the “cornerstone” of renewed prosperity for the heavy industry.
> Financial risks could be as high as future expected returns
Of course, questions may vary according to products and market conditions. Nevertheless, the idea will always be to use, maintain and/or create market imperfections – under the strict respect of anti-trust policies – which origins lie in the scarcity of resources and barriers to entry inferred, in particular, by the colossal cost of investments. So when forecasting market prices and industrial utilization rates, interactions between a limited number of players cannot be ignored.
A commodity is an indispensable basic product with clearly standardized qualities that buyers are perfectly aware of, like construction materials (cement, flat glass, concrete reinforcing bars, etc.), raw materials (coal, minerals, foodstuffs, fertilizers, etc.), metals, basic chemical products, paper pulp, etc. Differentiation between competing products is therefore linked to their composition (mineral content) or production / transportation costs.
Commodities industries are highly capitalistic and need irreversible investments to erect specific operating assets with long lifespan (often more than 20 years). They’re characterized by non-adjustable capacities without additional investments, a small share of variable costs (vs. fixed costs) and, in some cases, a significant weight of logistical costs (heavy and voluminous products, raw material quarries/reserves structurally far from markets).
LACK OF REALISM
The industry cost curve has been broadly used, to answer the question of market allocation when delivered costs’ positions or utilization rates vary from one market to another – while capacity constraint globally applies. Once more, the industry efficiency principle is retained, thus mimicking perfect competition. Although easily quantifiable via linear programming, these market allocations very often disappoint experienced decision makers because unrealistic. Indeed, they do not explain certain observed price levels or certain market shares where the co-existence of more or less competitive units is often the rule.
Even standard models of imperfect competition do not take into account some frequently observed behaviors: these models, while acknowledging the oligopolistic* characteristic of markets, focus either on price or on volume as a strategic variable (Bertrand or Cournot competition models). *Wherein several sellers monopolize the market
It can be shown that the deserved market share of each player is proportional to their individual price-cost spread. Demand allocations can then be calculated by broadening this kind of behavior to N players and M markets and integrating production capacity constraints. Stemming from these theoretical results, YKems has developed SVA™ model which allows assessing both market shares and prices according to capacity / demand balance and players relative competitiveness on geographical markets.
The good anticipation of investments however does not constitute the end of the game. Prices must be monitored and adjusted permanently to avoid encouraging new entrants while ensuring investment profitability and discouraging aggressive behaviors from existing players.