The economy-wide bullwhip effect
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Illustration: Aïda Amer/Axios
To make sense of a confusing last few years in the economy, it is extremely helpful to look at a business school staple often taught with an in-class simulation involving beer.
The big picture: The "bullwhip effect," in which small fluctuations in demand ripple through supply chains to create huge shifts in output and inventories, is a core idea in operations management. It also describes many of the shifts unleashed by the pandemic that are still rippling through the economy.
- From manufacturing to housing to the labor market, the pandemic set off a series of shifts in both supply and demand four years ago, and companies are still grappling to find a new equilibrium.
- Different sectors are in different stages of that process, which is part of why it has been hard to get a handle on whether the economy as a whole is doing quite well or looks shaky.
Zoom in: In the aforementioned "beer game," often used in business school operations classes (sometimes substituting a less intoxicating product like candy), different teams represent different points in the beer supply chain — retailers, distributors, manufacturers and so on.
- The upshot is that because each node on the chain seeks to maintain adequate inventories and has limited information on what is going on at other points in the chain, huge swings in supply occur until the teams figure out how to find a steady equilibrium.
- In the real-life economy, companies have spent decades learning those lessons and adopting technologies and practices to mitigate the bullwhip effect — but the pandemic blew them up.
Flashback: In 2020, companies saw collapsing demand and reacted accordingly — slashing orders for their inputs, laying off workers, and girding themselves for the economic storm.
- In 2021, demand surged back faster than most were expecting, so they overcorrected in trying to accommodate that demand — fueling inflation and the tightest job market in generations.
Between the lines: Many of the negative business headlines of recent days look less like an incipient recession and more like continued efforts to adjust to what steady-state demand might look like.
- General Motors this week said it was laying off 1,000 people in its software and service division, not because of cratering demand but because, as a spokesperson told CNBC, "we must simplify for speed and excellence, make bold choices, and prioritize the investments that will have the greatest impact."
- The number of housing units started in July fell to an annualized 1.24 million, the lowest since May 2020 but on par with 2019 housing construction.
The bottom line: The pandemic unleashed a shock on the economy that has continued reverberations — but with each month that passes, companies make more progress working through them.
Hat tip: Thanks to John Lettieri of the Economic Innovation Group, from whom we're borrowing this idea.
