Our intention with this economic note is to provide intuitive notions for our clients, using insights developed by the economic science that can help companies and entrepreneurs approach the economical crisis created by the COVID pandemic. The note is explained in general and didactic terms. For a specific note or report for your industry, don’t hesitate to contact us to get a quote.
Decrease in consumption
It is not controversial to say that during an economical crisis (like the one created by COVID), the overall consumption in a nation decreases. It could be controversial —or at least counterintuitive— to say that for some products consumption increases.
Overall consumption falls because during a crisis people have less income. Between unemployment, decrease in sales, fear, inflation, etc.; the overall result is that consumption falls. For example, if before a crisis a family spent $10’000 pesos every two weeks, it would be logical to think that during and for some time after the crisis such family will spend $8’000 pesos. When such behavior happens in most individuals, the national overall consumption falls.
This is also called a contraction of the aggregate consumption and it happens mostly because of a decrease in the individuals income. In Economy we call this the wealth effect, which can happen both because of a change in income (like being fired because a company closed or reduced employees) or because of a perception of having less income (like having fear due to the COVID pandemic and hence spending less).
But not all consumption decreases in a crisis. Some products (like canned tuna) increase their sales. This products are called by economist “inferior goods” and the reason their sales go up when income goes down is called income substitution effect. The premise is: when our income changes, our consumptions changes too.
For companies, the biggest insight the income substitution effect has in relation to the COVID crisis is that consumption won’t stop because of the resulting economical crisis or even because of the sanitary measures, it will only change. Pursuing the same sales strategy from before the crisis would be illogical. If consumption will change, the sales strategy needs to get in front of such change and even take advantage of it.
Substitution in segments
A big number of our clients offer products that are considered superior or high-end. A wrong interpretation of the substitution effect would be to think that companies need to pull away from high-end products and commercialize cheap ones.
Substitution effects are not the same between different income segments and in high-end markets substitution is usually not only or even not at all about price.
The best example we have is real state. Consumers with resources to buy high-end properties won’t start buying low-end properties after the crisis. But they will certainly choose with more care. Between an array of opportunities, they won’t choose the cheapest one but the one that offers better features and a higher ROI. The crisis will of course reduce demand of most of the high-end products, so for the consumer there will be more opportunities available in the market, which will allow this type of clients to have a stronger negotiating position in front of sellers.
In a nutshell: distinguishing factors, special features, good returns, exclusivity; there is so much more to the substitution effect than only lowering prices.
If we had three waterfalls in front of us, the three overflowing with water, and suddenly the flow in one of them was drastically reduced: from which one of the three would we want to get water from? Would it make any sense to spend time and effort to recuperate the flow of the decreased one? Of course there can be reasons to keep investing in a decreased flow —like having privileged information on a soon to come recovery of such flow—, though usually the practical action is to simply change of waterfall.
Economic flows are like waterfalls. Everyday, millions of products and services are exchanged. As an example, people going to the dentist or consumers buying detergent are both flows. Consumer expenditure is like an open faucet, every week people keep consuming. This is still true during a crisis, even if consumption falls. Some products consumption rates will decrease, but some others will remain the same, some might even increase and some might be completely new (like the new market for stylish face masks).
It’s not possible to give a prediction on economic flows that stands true for all sectors and industries, but the crisis will keep giving clues on market movements for each industry and sector.
As an example, newspaper El Pais released some weeks ago a report on infections in offices, buses and restaurants (link is to the english version). One of the key insights of such report was that natural ventilation seems to decrease chances of recirculation of infectious particles. I’m not claiming such insight is true —there is still a lot to know about COVID—, but for industries like restaurants there is clear indications that consumers are opting for open door venues because of their natural ventilation. This is an economic flow change, as well as a type of substitution effect related to health.
Our recommendation is for everyone to keep on the lookout in news, reports, government decrees, etc., for information that could indicate economic flow changes. This crisis, as any other, will keep giving us clues.
Competitiveness, productivity and innovation
This is the subject that we feel more passionate about. The economic notions here could be complex, so I will try to keep as didactical as possible.
Technology can make businesses more productive. This in Economy is known as the Total Factor Productivity (TFP). The most simple example I can think of is a shoemaker with no tools, making two pairs of shoes a day, and shoemaker with tools making five pairs a day. The first one has a lower TFP than the second one (the first one is less productive).
There are complex mathematical models which explain the TFP, but I think is better to only explain it’s most basic intuitions:
- If one company can produce more with the same resources than other similar company, the first one has a higher TFP (is more productive).
- When facing a crisis, the company with a higher TFP will be the one that prevails over the less productive one.
Is important to understand this last intuition: crisis are more difficult for less competitive companies and usually in a crisis the first companies to shutdown are the less competitive ones.
Some might think this means that companies who keep selling at the same price are the ones which shutdown first (competitiveness view as a lower price), but that is an over simplification. What actually happens is that companies with a lower TFP are the ones which exit the market first (shutdown).
The shoemaker is still a good example of why this happens. Let’s think that both shoemakers from the previous example pay themselves the same salary, their expenses are the same and both sell the shoes at the same price. Remember also that the one without tools can only make two pairs a day with the same expenses, whereas the one with tools can make five. This means the profit margin of the most productive shoemaker is higher (more than double). Of course then the most productive shoemaker can reduce his price to corner the first one out of the market (competitiveness as price). But he can also keep selling at the same price but enjoy higher returns and money flow from his higher productivity. Or he can compromise some of his productivity for a better quality product at the same price, to also corner the less productive shoemaker out of the market. Opportunities are always more and better for the most productive companies (the ones with higher TFP).
Technology impacts the performance of our companies. Investing in technologies or learning to use existing ones is not a whim but a business strategy. There are so many free and cheap technologies around for businesses and everyday transactions. This also means innovation will be a very important factor for companies in the post-COVID world. Productivity is pushed forward by innovation, by finding ways of doing things with more efficiency.
As a clear example, at our firm we’ve always proud ourselves of being fully on the cloud, using collaborative apps like Google Docs and having always our digital credentials for Federal Courts updated. This has proven very valuable during this COVID times and we can see that other legal firms are having big issues on implementing this type of technologies and digital processes now that things have changed.
Every company will have a different case, but there are now technologies for everything. A quick search in Google can give us light on the technologies available for our products and services, to become more productive and efficient. No other higher insight can we give at times like this.