Excess Capacity and Barter pricing

1- Overview

A value driver of reciprocal trade is the difference between marginal costs of production in different areas of economic activity. This marginal cost of production is the cost of mobilizing excess capacity. Different industries and different companies within industries will have different marginal costs at different times. The model outlined below will show that barter can produce value from industries that produce goods that can be easily sold for full cash value.

2- Model

Extractive and raw material producers generally have little or no difference between fixed costs and marginal costs relative to other goods producing and, especially, service industries. In other words, they have ( relatively) no excess capacity. Because of huge capital investments and time lags to bring new capacity on, an oil company will generally produce at full capacity all the time and sell its output for cash on the market. If prices move up, they cannot produce more and if prices go down, they cannot produce less (we ignore cartels here).

Manufacturers generally have some degree of excess capacity. They need the capacity to meet fluctuations in demand. Delaying delivery during a peak period could easily result in lost customers. Plant and equipment are discreet items and involve time lags to come on line. You cannot rent half a plant or 2/3 of a machine for 3 weeks to fill an order. If a printing firm has an idle machine their marginal cost to produce more output would consist of the electricity to run the machine, extra maintenance, hiring an extra shift. Costs excluded would include plant and equipment, administration, marketing and so on. The printer would be happy to sell the excess at anything more than say 50% of normal costs. Of course he can’t because it would disrupt the pricing of his regular production.

Other sectors have almost limitless excess capacity. Industries such as media, airlines, hotels have marginal costs of production that are very low. An empty airline seat or media time slot is worth nothing. An airline would be happy to fill that empty seat as long as it covered the administrative costs of issuing tickets, baggage handling and so on. Let’s assume this is 10% of regular costs.

In the cash market one unit of oil trades for one unit of printing which trades for one unit of media. In the reciprocal trade market, because of different costs associated with excess capacity, pricing is much different. In relation to the cash market, one unit of oil buys 10 units of media or 2 units of printing. Similarly one unit of printing buys 5 units of media. The analysis is somewhat simplistic in that there are a lot of moving parts that have been held constant to illustrate the point. The seller will have more knowledge of his own cost situation than the buyer will and situations will be different for different companies in different sectors at different times

Because of this scenario, an industry with virtually no excess capacity, in this case oil, could find reciprocal trade very advantageous for its corporate procurement. An oil company needs printing, media, travel, vehicles, consulting services and accounting services. With reciprocal trade, these products would be cheaper in terms of oil than in the cash market.

3-The Trade Unit

To facilitate transactions, lets introduce a common denominator for pricing called the Trade Unit. This is a unit of account and becomes money if people are willing to hold it, even briefly.

The market can determine the external value of the Trade Unit. How will this work? In the simplest situation, we would simply need to compare the price of the product in Trade Units with the external price and make a quick calculation. However, if this were the case, there would be no need for reciprocal trade since there would be no difference in the relative prices or goods and services between both markets. Driven by different costs of mobilizing excess capacity, maximizing asset yield and increasing sales, reciprocal trade produces very different relative prices (e.g. unit of media per unit of printing) than the cash markets

By applying our pricing models with existing accounting treatments and market practices, we can attempt to come with a theoretical external value for the Trade Unit. Let’s assume an economy with two entities. The first one is motivated by better prices on procurement. This company would typically be a primary product producer that has transparent cash markets for anything they produce (oil, gold etc.) Basically they cannot mobilize excess capacity at less than their average cost of production and consequently, would have little need for the extra markets provided by reciprocal trade. They would only be motivated to engage in reciprocal trade if there is a substantial saving in corporate procurement requirements.

The second entity is motivated by extra sales. A media company, for example, has a very low cost of mobilizing excess capacity. This company is attracted to reciprocal trade because they can discount their product to take advantage of the low cost of producing excess capacity without affecting their cash prices. The sales motivation is so strong that transactions currently take place in exchange for trade credits that sometimes have to be completely written off.

If the first company wants media at a discount then the second entity can fill that need. What is important for Trade Unit valuation is how this discount relative to cash shows up. Let’s consider two alternatives. First, The Trade Unit is valued at 25 Trade Units /barrel of oil which equals 25USD/barrel of oil. In this case the media would be sold at a discount to the cash market of, let’s say, 40%. The seller of media would receive 0.6 of a Trade Unit for a unit of media that sells normally for 1USD. However, the media seller does not want to book this sale at a discount. Current practice is to book these types of sales at full cash value. Now the system looks like this: 1 Trade Unit= one unit of media = 1 USD, 41.75 Trade Unit = one barrel of oil=25 USD. Hence 1USD = 1/0.6=1.67 Trade Units.

It is important to note that at this point both parties will realize value relative to the cash market whether they are buying or selling.

If we bring in a third counterparty, say a printing company, a different value for the Trade Unit is derived. A printer will have higher costs than a media company in terms of mobilizing its excess capacity. These costs will extra labour, energy and maintenance and will restrict the company from discounting to 20%(as an example). At this level, the company is still making a profit on its excess capacity. The oil company is still getting a discount on its procurement of printing. In this case the Trade Unit is worth: 1USD=1/.08=1.25

Trade Units. Similarly, a transaction between the media firm and the printer would result in a Trade unit worth: 1USD=0.8/0.6=1.33 Trade Unit.

4- Conclusion

As long as sales are booked at full dollar value (1USD=1 Trade Unit), the Trade Unit will be at a discount to the USD.

- An overvalued Trade Unit will benefit those entities with low cost excess capacity (media, Telco) and an undervalued Trade Unit will attract firms with high cost excess capacity (gold, oil).

- The value of the Trade Unit will vary according to the nature of the transaction.

- Derivation of a single value of the Trade Unit will be very complex.

These concepts can be extended to sectors where there is no excess capacity.

Should Experts Manage your Money?

The assumption behind this question implies that someone else can do a better job at this than you can because financial markets and economics are so complex that you need specialized training and experience to make investment decisions. This is what the gurus keep feeding the general public. This is utter nonsense.

Finance, portfolio management and economics are pseudosciences that have more akin to phrenology than physics. Practitioners baffle you with concepts and terms only the initiates can understand. This is deliberate since this is the way they lull the public into paying their salaries fees and commissions.

Let me give you an example of what Nobel prizes are given out for in this field. A banana is twice the price of an apple until it isn’t. We can’t tell you what the absolute price of either is. For this- a Nobel Prize in portfolio theory and your mutual fund manager can use it as an excuse for underperformance while you get charged fees that eat into your retirement to pay big bonuses to fund managers.

These are the same people that created the economic mess we are in. They didn’t see this coming, lost 100 of billions of dollars and now they want to keep telling you how to manage your money.

Some people will say they invest conservatively because they do not want to worry about market fluctuations and want to sleep at night. This is an absolutely correct approach. Any investments that keep you awake normally should not be in your portfolio. You should be getting paid to worry about this stuff. Anyway, I wonder how these safe investors felt when their banks were being bailed out by their governments and their “safe” securities were selling for pennies to the dollar. To be really safe at the height of the crisis last winter you had to buy US T bills yielding nothing. Property is also a popular do nothing investment, of course that always goes up….

There is no such thing as a totally safe investment. And there is no return without risk. Buy and hold makes no sense- companies and countries go bankrupt. And timing is key.

Advisors and brokers have to make a living as well and I would suggest that this comes first in their priorities. Keep this in mind when you write them a Cheque. If you do go that way, just make sure you are not dealing with the next Bernie Madoff. Make sure your advisor has errors and omissions insurance ,is regulated and is part of an investor protection fund. If your advisor brags about how market savvy he or she is, move on. Similarly, one of the first questions you are asked should be- do you have a will? Advisors are a good solution for many people but you will need to be vigilant to ensure that your interests are met by a commission driven sales environment.

Dealing with money is a very personal thing and the reason that no one understands money is that no one understands this personal relationship. Only you can understand your own relationship with money… no one else can.

If you are a neophyte then that is probably a good thing since you don’t have to unlearn the nonsense that is written and spoken. If you do read and watch “business news” question everything (including this article).

There are no magic tools to investment and trading, no charts no portfolio models that you can turn to. If it’s easy, everyone does it and then it’s not so easy anymore. By all means, read up on markets and investments but do not listen to “experts” that tell you that they know better than you what to do. This is information that will distort your thinking. Ninety percent of relevant information is contained in the current price of the investment. The other 10 % is what all this punditry is about and is noise that can and should be deliberately ignored.

So the real secret to be successful in managing money is to tap into what is not in the public domain- you.