As indicated in our last post, the goal of this series is to bring economics to the forefront in Supply Management where it has been swept under the rug for far too long. Which is a travesty when you consider the three basic questions in economics revolve around what to produce, for whom, and how!

As a result of this, we decided we would introduce you to the economics of Supply Management (which is economics, after all), by going back to the basics (and all the way back to 1776 when Adam Smith published his treatise inquiring into the nature and causes of the wealth of nations and gave economics its independence from politics and moral philosophy).

We started by defining the production possibility curve and the concept of comparative advantage which give you the foundations required to figure out what you should be producing and what ratios are possible given the options at your disposal. Then, in our last post, we discussed the basic laws of supply and demand which ultimately tell you not only the quantities you should be producing, but for whom you should be producing them as production optimization centers around finding the optimal equilibrium between a corresponding supply and demand curve among all possible supply and demand curve pairings.

This just leaves us with the how. Classically, the answer was simple — either the goods were produced by the government or a private enterprise. But given the global nature of business, and trade, that exists today, the answer is no longer that simple. Today, the question is whether you produce the goods in house, whether you outsource production to a third party, or whether you produce them jointly (or in cooperation with) a third party.

And to answer this, you need to first get a grip on Total Cost. In economics, total cost is defined as the sum of all fixed costs, which are constant and independent of the number of units of the good (or service) produced, and variable costs, which vary depending on the number of units of the good (or service) produced. Fixed costs include rent, insurance premiums, depreciation on plant and equipment, and interest payments on bonds, to name a few. Variable Costs include wages of production workers, fuel, electricity, cost of material(s), and transportation. The Total Cost is the sum of all fixed and variable costs. And the how depends upon what option has the lowest total cost. Is it cheaper to produce the goods yourself, outsource to a third party (taking into account transportation and a profit margin for the outsourced producer), or produce the goods in a joint partnership with (one or more) manufacturer(s), where one party produces some of the components and another assembles them, for example. In basic modern economic theory, the answer is the option with the lowest cost.

And this concludes our introduction to the basics of economics for Supply Management, as we have now answered the three basic questions. But this isn’t the end. It’s only the beginning. First of all, since the answer for so many companies these days is to outsource, we have to understand the economics behind outsourcing so that a company can do a proper total cost analysis and make the right decision. But even more important, the value of an enterprise today is not measured solely on revenue, it’s measured on non-revenue producing components that are assigned a monetary value (such as brand equity, IP, etc.). After a hiatus, we’ll examine these issues and some of the economic theory that (in theory) underlies these decisions.

The goal of this series is to bring economics to the forefront in Supply Management where it has been swept under the rug for too long. How do I know this? When I look at any of the list of critical skills for Supply Management that have been produced by experts over the past few years, few, if any, mention economics (although many mention finance) and none give it any importance.

And this is wrong when you consider that economics is essentially a study of Supply Management. After all, the three basic questions revolved around what to produce, for whom, and how! If that isn’t Supply Management, what is? In Part II, we decided that we had to go back to the basics — back to 1776 when Adam Smith published An Inquiry into the Nature and Causes of the Wealth of Nations and gave modern economics its independence from politics and moral philosophy, where it was subservient ever since Aristotle embedded it in his Politics.

We went back to the basics by starting with the production possibility curve and the concept of comparative advantage, the two foundations you need when trying to figure out what to produce and in what ratio among the options at your disposal. In other words, we answered the what. The next question we need to answer is for whom?

To answer this, we turn to the basic laws of supply and demand and the supply vs. demand curves. Supply and demand is the classic microeconomic model of price determination in a market that attempts to find the economic equilibrium between price and quantity. There are four basic laws in this model:

1. The Law of Demand Increase
   If demand increases and supply remains unchanged,
   a shortage occurs and this leads to a higher equilibrium price.
2. The Law of Demand Decrease
   If demand decreases and supply remains unchanged,
   a surplus occurs and this leads to a lower equilibrium price.
3. The Law of Supply Increase
   If demand remains unchanged and supply increases,
   a surplus occurs and this leads to a lower equilibrium price.
4. The Law of Supply Decrease
   If demand remains unchanged and supply decreases,
   a shortage occurs and this leads to a higher equilibrium price.

In other words, demand increases and supply decreases can result in shortages and higher prices, while demand decreases and supply increases can result in surpluses and lower prices. In this theory, supply, under one set of assumptions, is modelled as a supply curve that relates price to quantity that can be supplied at that price and demand, under one set of assumptions, is modelled as a demand curve that relates price to the quantity that will be bought at that price. The equilibrium, or optimal production, is where the curves intersect.

So how does this help you with the “whom” question, as it looks like the answer is gives you is “how much”. It helps indirectly. You see, there is more than one supply curve and one demand curve. There is a supply curve for each potential product, and variant of the product, a corresponding demand curve for each of these product under current market assumptions, and a corresponding demand curve for each shift in the market that could occur as a result of changing tastes, market expectations, and/or total market size, just for starters. Some of these shifts will increase demand and others will decrease demand. As a result, it’s not just equilibrium that you’re after, but optimal equilibrium — defined as the intersection point between a supply curve and a corresponding demand curve that maximizes profit. So, if the result of your comparative advantage analysis says you should produce shoes as one of your product, and you can produce running shoes and walking shoes with equal advantage, and running shoes gives you a higher overall profit, than you produce running shoes and your market is running shoe buyers. In addition, if you can shift the demand curve in your favour by focussing on your ability to offer the extra support required by female runners (who have a wider Q-angle) and selling primarily to women, you sell women’s running shoes to women and the whom, after diving into the data, is women who are recreational runners and want extra support.

This just leaves the how.

In Part I, we noted that, as far as the doctor can see, the topic of Economics is too often swept under the rug where Supply Management is concerned. Why? Hard to say, but the recent failure of Macro Economics to predict the biggest downturn since the Great Depression and its continual inability to explain the tortoise-pace of the recovery is certainly a major factor.

But, reasons aside, the reality is that you can’t ignore economics. Not only will you be unable to judge a supply market strategy without a solid understanding of basic economic principles, but when you get down to the basics, as pointed out by Adam Smith in 1776, real wealth is resources and the goods and services produced with them. In other words, all wealth, and economics, revolves around Supply Management.

Remembering that the three basic questions of economics are what to produce, for whom, and how, we need a good understanding of the basics. The first understanding is the production possibility curve/frontier. This is a graph that compares the production rates of two commodities that use the same fixed total of the factors of production. The curve shows the maximum specified level of one commodity that results given the production level of the other. In other words, with fixed resources, there is a trade-off between how many units of each product can be produced. This is the basic theory that underlies your manufacturing planning.

The next understanding we need is that of comparative advantage. This is the ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another. This is the basis of trade. This is because it’s advantageous to produce goods you can produce more efficiently than someone else and trade them for goods that you can produce less efficiently than someone else. In a more complex way, this is not only the basis for trade between nations but the consumer economy we have now.

To see this, we simply add IOUs into the equation. Let’s say you need shoes, but your skills are bookkeeping. Let’s also say that the shoemaker doesn’t need bookkeeping, but needs a hammer from the ironsmith. The ironsmith is poor with numbers and needs bookkeeping skills to keep the taxman off his back. In this case, the shoemaker can accept your IOU in exchange for the shoes and give it to the ironsmith who needs your skills. In this way, neither you nor the shoemaker have to fumble around for days trying to procure a hammer you don’t know where to get or produce one you don’t have the skills for, and the ironsmith doesn’t need to worry about the taxman as he can quickly produce the hammer the shoemaker needs who can quickly produce the shoes you need to walk to the ironsmith’s forge where you quickly do his books to keep the taxman away. When everyone does what they do best, and trade it, all parties profit. The only difference is that, today, instead of negotiating complex multi-party trades or passing around IOUs, we just use paper money issue by banks, which represent the value of the goods and services we trade.

In other words, when we understand the (multivariate equivalent of the) production possibilities curve and the concept of comparative advantage (which tells us that even if we can’t produce anything better than our competition, we can still profit as long as we produce something of value, although we will do better if there is something we are better at than anyone else), we understand how to determine what we should produce and in what quantity. And that’s the first step to successful Supply Management.

One of the goals of SI is to continually educate its readers on topics that other blogs miss or ignore. One of those topics that continually gets brushed under the rug is that of Supply Management Economics. For a while the doctor has been trying to figure out why. Is it because economics is not that important? Is it because economics is assumed to be implicitly conveyed in the topics covered? Or is it because there is no firm grasp of economics where Supply Management is concerned?

The answer is still up in the air, but part of the problem is obviously due to a lack of understanding, which should not be surprised when one considers that where the economy is concerned in general, there is a lack of understanding. Consider this recent article from the economist on A Brief History of Macro: How We Got Here about macroeconomics and its poor reputation these days due to its continual failure to answer why America’s post-crisis recovery has been so slow and, more importantly, its inability to predict the biggest and most powerful downturn since the Great Depression. (Epic Fail!)

Basically, despite all of economists’ grandiose claims to the contrary, when it comes to large-scale national and international economics, modern macroeconomic theory just doesn’t have a good enough grip on reality, so how can you be sure standard Supply Management economics is right either, even if you understand it? You can’t. But that doesn’t mean that you should ignore it either. There are a number of principles that hold up well and provide insight into the market dynamics that impact your organization on a daily basis. And without a solid understanding of the basics, how will you judge market-based sourcing strategies presented to you by consultants and experts? Before you can judge a supply market strategy, you have to know how much confidence you can put it in, and that requires an understanding of economics, the solidity of the underlying principles that are being assumed, and the assumptions that are unsupported.

In this series we going to cover a bit of the basics, as well as a few recent advancements in Supply Management Economic theory that may advance your understanding of strategic supply (relationship) management and inject more value into your value chain. We don’t know all the answers, but those who do not seek never find.

So where do we begin? At the beginning, or at least close to it. Back in 1776, when America was declaring its independence, Adam Smith, a moral philosopher and Scottish economist published An Inquiry into the Nature and Causes of the Wealth of Nations which offers one of the world’s first collected descriptions of what builds nations’ wealth. (Source: Wikipedia) In this fundamental work of classical economics, Smith essentially states that real wealth is resources and the goods and services produced with them.

Based on this, we are led to the three basic questions of economics:

1. What to Produce.
2. For Whom to Produce it For? And
3. How to Produce It?

Which brings us back to my question of why economics continually gets brushed under the rug when Supply Management IS Economics!