By the Numbers: The Wal-Mart Dilemma, File Sharing and Lousy Service

The other day I was challenged to explain some of the economic phenomena I’ve written about on this blog, like the Wal-Mart Dilemma, file sharing and the end of affordable personal service, in terms of classical economic models. I was a little rusty, but here is how I replied:

In the ideal, ‘perfect’ marketplace (if we should ever find one), the amount of a product that is sold, and the price at which it is sold is determined by the intersection between the supply and demand curves, as illustrated in Fig. 1 at right. The black dot, which corresponds to the point at which y units of the product are sold at price x apiece, is that intersection: If a vendor charged more than x, the drop in demand would more than offset their improved margin, and some competitor would eventually step in at price x.

What Wal-Mart has done is shown in Fig. 2. They bully their suppliers to lower their wholesale prices to the point that Wal-Mart can sell for less (and less each year). Customers accordingly buy a lot more of each product, often more than they need, either to stock up or because they can get more of the product from Wal-Mart than from other vendor for less money, so even if they throw the extra away they’re still ahead. Much has been written about this practice, which is analogous to what, in international markets, is called ‘dumping’ — clearing out a product at a loss to force smaller competitors out of business. Much has been written, also, about the devastation this has wrought in the name of ‘productivity’: Vlasic pickles chased the Wal-Mart business to the point they produced almost half the US’s total pickle volume, but at margins so small they were unsustainable, and they became insolvent. The only way Levi Strauss could meet the price-cutting demands of Wal-Mart, upon whose business they quickly became dependent, was to close all of the company’s once-proud Made in America facilities, outsource everything to Asian sweatshops, and lay off all American production staff. The competitors of Vlasic and Levi Strauss (and many more companies like them), in the meantime, lost so much market share to the discounters that some of them, particularly small local vendors, disappeared as well, taking small local retailers with them. The Wal-Mart Dilemma has arisen as a result: The laid-off US workers can now only afford to buy from the same deep-discount retailer who put their employers in receivership or forced them to offshore their domestic operations. It’s a grim irony and socially devastating to millions, but to the shareholders of Wal-Mart it makes perfect sense. And, what’s worse, in most cases, the foreign crap that Wal-Mart sold was so inferior in quality that buyers found the ‘low prices’ weren’t even a bargain — their products had to be replaced much sooner and the absolute cost to the consumer (and to the society in energy waste and landfill garbage) was actually higher. Only when customers wake up and realize that they’re actually getting less value for money (and/or when Asian currencies are revaluated) will this aberration in the healthy supply/demand curve some to an end.

In industries where oligopolies use their size and domination of the market to crush or buy out small competitors, and hence jack up prices and margins to exorbitant levels, you get a picture like Fig. 3. In this case, the high prices drive customer demand to near zero, to the point where there is essentially no intersection of the supply and demand curves. We’ve seen this in the CD market, where the oligopoly dramatically reduced the number of titles it produced, jacked up margins to sky-high levels, and saw unit sales plummet for a decade as a result. While the oligopoly blames the sales drop on P2P suppliers (file-sharing), the P2P phenomenon is actually a result, not a cause, of exorbitant pricing and falling product diversity. The ‘market’ worked around both the excessive pricing of the oligopoly, and the lack of variety and quality of their product — consumers simply traded music with each other (as they in fact have always done, but on a much smaller scale), and welcomed independent online artists who offered the quality and variety they wanted at a reasonable price. Here the irony is working in the opposite direction than it does in the Wal-Mart case: The music oligopoly cannot afford to lower its prices, broaden supply or improve quality to recapture lost market share because their shareholders will not let them — this would at least temporarily hurt profits and share prices. So instead the oligopoly is simultaneously suing file-sharers and squeezing artists to try to find a way to sustain profits without capitulating to the market that its own greed has created — a losing game.

Fig. 4 shows yet another market anomaly: The unaffordability of decent customer service. The industrial model of the West is based on high margins (from oligopoly practices and automation) and high volume of identical products to sustain the absurdly high ROIs that shareholders demand of public companies. This leverage is much harder to achieve in services than it is in products. Vendors want customers whose products are obsolete or broken to throw them out and buy new ones — as often as possible. A market for durable used products would disrupt that consumer pattern, and the fact that companies like Amazon and eBay are meeting the exploding demand for quality second-hand products is alarming and threatening to all the companies that depend on the Western industrial model. It’s like the file-sharing nightmare, except now people are trading everything used, not just music, videos and software. Likewise a huge gap has opened up between the supply of and demand for quality customer service — another area where ROIs are constrained by lack of leverage: Service is hard to automate, usually dreadful when it’s offshored, and offers lousy margins compared to products to boot. Every segment of the customer population, from corporations and the rich to the poorest individuals, is dissatisfied with the quality and value-for-money (and sometimes the absolute unavailability) of quality customer service. Providing good service is expensive, and large corporations are trying everything they can to force customers to a ‘self-service’ (i.e. no service) model. Those in industries where they can’t just tell the consumer “Throw it out and buy a new one” are in especially deep trouble. Examples: the news media, professional services (legal, medical, financial etc.) are all under fire for their skyrocketing prices for less and less service time and value.

The curves in Fig. 4 are not sustainable. Customer demand is not going to yield — the need for quality service will never just go away, most people will never adapt to ‘self-serve’ models (the digital divide just keeps widening), and thanks to the Wal-Marts of the world customers’ ability to pay for quality service is going to decrease, not increase (especially when the stock market and housing market bubbles burst). This will widen the gulf in Fig. 4 even further. There are three possible scenarios, and we’re likely to see a mixture of all of them:

1. New low-price, high-quality service suppliers will enter the market. If this happens (and it’s already started), expect a bloody battle from the incumbents who will do everything they can to prevent it — getting governments to ban ‘unlicensed’ (by the incumbents) service providers, rendering warranties invalid if service is done by ‘unauthorized’ personnel, and, of course, suing the new entrants. Credit unions, Internet banks and insurance companies, independent Sarbanes-Oxley ‘compliance consultants’, alternative media, paraprofessionals, alternative medicine practitioners, healthcare offshorers, self-publishers, investment clubs, alternative disputes settlement forums, and other ‘peer assist’ offerings are just some of the examples of alternative offerings eating into the ‘customer service’ establishment in many industries, and trying to close the gap in Fig. 4.
2. The price ‘bubble’ for services will collapse, just as it has for products and just as it will for stocks and real estate. This will also be bloody. Public corporations in service industries will be crucified by shareholders as those incumbent service providers who break ranks drive service industry ROIs down to more reasonable levels. Large-firm ‘professionals’ who would faint at the unheard-of idea of salary cuts will see cuts in double-digits, which, on top of the incredible hours they already work, will probably lead to massive strikes by people you would never expect to see striking. Companies which make shoddy products and which try to shove off all service to outsourcers or offshorers, like the big computer hardware and software makers, construction companies and lawn tractor makers (according to Consumers’ Union, these industries’ products have the highest failure, repair and complaint rates, and none provides quality service) will face a consumer revolt, and demands for government regulation to improve or offer free replacement for defective products and work — which these industries will fiercely lobby against.
3. Peer-to-peer service models will emerge. This could be fascinating, because there’s a precedent for it in just about every country that has ever suffered through an economic collapse. The next generation may start by working their way through university fixing computers inexpensively for the big, sloppy computer manufacturers. But why would they stop there? Once they become expert at repairing your piece-of-shit Dell computer, why wouldn’t they start building their own, and offering much more customization, better upgrade capability, lots of free, Open Source software bundled in, and friendly, reliable, knowledgeable local service? At a fraction of the price. Yes, at first some of them may be pretty crappy themselves, but the market will work that out, just as it did with the Japanese manufacturers when they first entered the Western market (remember when Made in Japan was synonymous with poor quality?)  And if you buy your next computer from your neighbour’s son’s upstart enterprise, why not do your banking through your niece’s new community bank, part of a huge peer-to-peer network of community banks all helping each other out? And why not a new industry comprised of young legal students (or retired lawyers) offering alternative dispute resolution services for $20/hour instead of the $200 the lawyer charges? Lots more examples spring to mind.

It’s hard to say where this could end: Whether customers will be content with a rectification of corporatists’ market-distorting abuses, by simply ‘working around’ the dysfunctional giants; or whether this trend could usher in, especially with the pending retirement of half a billion baby-boomers in the next decade, an early evolution of a new and entrepreneurial Gift Economy. If it should turn out to be the latter, we’ll need to find a replacement for the classic supply/demand curves that I’ve used in this article. When x=0, all the time, y by definition becomes infinitely large, and a world of scarcity becomes a world of incredible abundance. I’m not sure the Gloomy Profession is ready for that.