178.307 Markets, Firms and Consumers

1. 178.307 Markets, Firms and Consumers Lecture 5- Investment

2. Prediction Prediction is difficult, especially of the future. Neils Bohr Danish Physicist and Nobel Prize Winner

3. Scenario Planning involves two common elements: First- it is based on a heterodox view of risk and uncertainty. Second- it is a management approach to deal with uncertainties. It is an approach that increases manager’s awareness of uncertainty. It can minimise the costs of adverse surprises. It can allow managers to take advantage of opportunities, otherwise not foreseen. Introduction

4. Stems from two distinct pressures: The failure of orthodox planning and forecasting techniques in many instances. The recognition that human systems are complex, not simple. Three core issues are: Describing or predicting future events. Developing management or strategic responses to these. Limited capacity to forecast or manage future events. Scenario Planning

5. Predicting Future

6. Predicting Singapore’s GNP • Growth path of Singapore seems largely smooth • How easy is it to predict the GNP for Singapore? • Consider the following graph

7. Singapore GNP- Analysis • On average, my predictions are 92.9% accurate. • BUT • I did not predict the 1985 recession • I under-estimated growth during the 1990s • I did not predict the 1997 Asian crisis • I over-estimated growth since then.

8. Annual Changes in GNP show big swings Changes are largely unpredictable Achieving a ‘smooth’ rate of change is difficult. Sustaining high growth rates is challenging- especially as GNP grows. Complex systems don’t follow straight lines. They are characterised by: Unpredictable turning points Sudden shifts Feedbacks Spillovers Gaming behaviour Complex systems can’t easily be predicted

9. A Complex System

10. “The greatest danger in times of turbulence is not the turbulence; it is to act with yesterday’s logic” Peter Drucker Why did US Car Manufacturer’s “fail” in the 70-80s? Market share was lost to Japanese automobile manufacturers Investment Failure

11. Firm Failures • Why did US Car Manufacturer’s “fail” in the 70-80s? • Market share was lost to Japanese automobile manufacturers • Losses were huge- Chrysler obtained a Government bail-out. • Prototypes failed to make it to production. • Consumer dissatisfaction with product.

12. Background- US Market in 60s was dominated by oligopoly of 3 firms: General Motors (GM) Ford Chrysler Foreign competition had little impact. Fuel prices low. External Factors Steady economic growth, stable demand. Insulated from competition Low oil prices, biasing production and design towards large cars. US Car Industry

13. Corporate culture uninterested in Japanese technology. Inefficient management (concealed by steady growth in industry). High wages- a Union ‘monopoly’ sharing ‘dividends’ Ignored Factors Demand for small cars Production-efficiency of Japanese manufacturing-plants. Tight oil-market Middle-East instability. Other Factors

14. Oil prices rose in response to the two oil-shocks of the 70s. Consumer demand switched away from large-cars to small-cars. This move reinforced by US new environmental regulations. Lack of prototypes limited reaction by US car-manufacturers. Oil-shock seen as temporary Oligopolies were traditionally seen as unstable. Market dominance considered unassailable. What went wrong?

15. How many uncertainties did US Car manufacturers ignore? Possibility of oil-shock Response of consumer demand to oil-shocks. Demand for small cars Competitor’s response to new situation New regulatory environment US Car Industry

16. Senior Managers Uncertainty is a complex problem. People adopt simplifying procedures. Procedures that are successful are reused. Poor procedures tend to be dropped. …many managers developed their skills in the 1950s and 1960s, an era characterized by an unusually high level of economic predictability…it was considered incompetent or unprofessional to say, ”Things could go this way – or that.” Pierre Wack, 1985. Internal Factors

17. Adopt similar strategies that ‘worked’ in the past. Look for similarities to past, discount differences. Result- poor performing investments E.g. Ford’s large engine plant. Anticipating surprises facing a firm is hindered by ‘perceptions of stability’. Internal coalitions can prevent timely responses. The longer a period of stability, the more likely a shift will occur. Senior Managers

18. Scenario Planning • Makes managers more aware of uncertainties. • Challenges perceptions of stability. • Identifies signals of a forthcoming switch. • As a corporate activity, can help bring about agreement on need for change. • Scenario planning is prudent- not timid.

19. Many formal planning tools are based on orthodox economic theory. Risky events are those that: Occur with predictable frequency Similar to historical events Can be assigned probabilities. Risk and Uncertainty distinguished by Knight. Uncertain events occur: Infrequently May be completely novel Impact is varied- dissimilar to historical events. Probabilities difficult to assign- E.g. insuring space rockets against accidental destruction. Risk and Uncertainty

20. The core problem is that conventional planning has led to managers making expensive mistakes. Example: Mexican Debt Crisis Unlike the 70s, most forecaster's predicted that oil prices would rise through the eighties Some forecasters (Club of Rome, Global 2000) extrapolated exhaustion of oil reserves. Club of Rome- Oil reserves would be exhausted by 1992. Conventional Planning

21. Oil Demand • Mid-point case was oil averaging $50 a barrel in the 1990s. • Even low-price case had oil averaging around $35 per barrel. • Oil companies and governments responded with synthetic fuel factories. • This turned natural gas or coal into gasoline.

22. Mexico • Mexico was a “special case”— • A member of OPEC • Used oil receipts to fund public projects. • Borrowing programme based on projections of oil increases. • Encouraged by low international interest rates and favourable terms of trade in 70s.

23. Unplanned Problems: Recession in OECD in 1980-1 Faltering oil prices Rises in interest rates Fall in terms of trade Capital flight, requiring more borrowing By 1982, Mexico unable to sustain debt-repayments. Debt-crisis began Exacerbated by the collapse in oil prices by mid-1985. Trade policies limited ability to earn foreign exchange. Mexico

24. Defining set of all possible outcomes not feasible. Addition of new events causes probabilities to be adjusted. Unsurprising events become ‘unlikely’. We weight events that don’t occur in the decision. Expected payoffs depend on winning on ‘average’. BUT- some ‘losses’ may be so catastrophic, there is no chance to rebuild profitability. Unanticipated events- or incorrect probabilities- will distort decisions. Expected payoffs work best in stable- not turbulent environment. Shackle’s Critique

25. Scenario Planning is derived from Shackle’s theory of surprise. Shackle proposed a different metric for uncertain events. This would be the level of surprise attached to a future event. Key differences: As you imagine more events, the surprise attached to each event does not change. We keep ‘losses’ and ‘gains’ separate– rather than aggregating them as a net benefit. We don’t give events ‘probabilities’. Theory of Surprise

26. A number of scenarios are proposed. Scenarios may be generated in two ways: Experts can suggest a number of cases (Brainstorming). Surveys (and similar) can be used to generate events. These events are grouped into a number of scenarios. Use of Experts Experts have to be drawn from a broad field. Experts can still have blind spots— Shell failed to generate any “Egalitarian” scenarios. Out-maneuvered by Greenpeace over the Brent Spar. Theory of Scenario Planning

27. Can be efficient- captures a lot of pre-existing knowledge. Can exclude other stake-holders. Harder to get others involved. Can create elegant, elaborate and detailed scenarios– impenetrable to anyone… Surveys Self-interest can affect responses. It is biased in favour of conservative standpoints. Responses can be difficult to verify. Drop-outs can distort the final conclusion. Delphi method penalises unorthodox answers. Experts and Surveys

28. Scenarios are not forecasts or predictions. They are more like a story. Each story is in some sense plausible. Because they are plausible, no scenario is regarded as astonishing in prospect. Catastropic scenarios are rarely considered. E.g. an asteroid crashes into Earth, flattening Singapore’s CBD. The scenario is plausible. The scenario would have a dramatic effect on Singapore What are Scenarios?

29. Planning options are very circumscribed. It is an event that is difficult to manage. Most organizations can do little to insulate themselves from the catastrophe. It is too small a probability to divert resources to deal with. How Many Scenarios? According to Miller’s Rule, most people can only consider 7+/- 2 “things” at a time. Catastrophes and Scenario Numbers

30. Some organisations have gone down to 2 or 3. E.g. British Airways in mid-90s created 2 scenarios. Generally this is not recommended. What are the dangers of too few scenarios? Two scenarios lend themselves to ‘optimistic’ and ‘pessimistic’ spins. Depending on whether people who use scenarios are pessimists or optimists, one scenario ends up being treated as a forecast. The other scenario is discounted- even though it is equally valid. Too few?

31. The problem with three scenarios is one is one can be interpreted as the mid-point scenario. This scenario then becomes (in the employer’s mind) the ‘forecast’ and the others are discounted as ‘outliers’. Four scenarios have no natural mid-point. Can be easily presented (e.g. graphs) and interpreted by people who use them. Three or Four Scenarios?

32. Scenarios are developed and described. Both quantitative tools (mathematical models) and qualitative tools (logical arguments) used. Scenario planning is less reliant on mathematical tools. Exploratory scenarios are useful to alert people to uncertainties. By challenging current perceptions, people can be more alert. This lessens the surprise-effect of the future. Some suggest this is the major benefit of scenario planning. Scenarios

33. Strategic Scenarios • Strategic scenarios integrate management decisions (strategies) with scenarios. • Strategies are identified that are appropriate for each scenario. • Strategies are then selected that meet two criteria.

34. Robustness • A strategy is robust if it generates a satisfactory result in many scenarios. • For instance, Singapore’s high savings rate is a robust macro-economic strategy. • It helps balance the current account. • It has (historically) permitted high growth rates. • It provides a buffer against shocks.

35. Robustness • Robust strategies may not generate the best outcome. • They generate satisfactory outcomes in a wide range of circumstances. • This means they are prudent strategies- they are risk averse. • They are not timid.

36. Adaptable • Adaptable strategies are ones that are easily switched. • If they are recognised as inappropriate, they can easily be reversed. • The flip to this is avoiding getting locked into costly courses of action. • Another aspect is contingency planning.