Let’s start with a look at the difference between idiosyncratic risk and systemic risk.
Idiosyncratic risk only affects
your
company; systemic risk affects large groups of companies,
such as an industry, market, geography, or the world. The best way to solve a given problem will usually differ, depending on which type of risk you are faced with.
For example, when British Petroleum had its spectacular oil well disaster in the Gulf of Mexico, only BP and its drilling partner's debt and equity securities were directly impacted. That is idiosyncratic risk. Conversely, the global recession that was happening at the same time affected
all
securities — that is systemic risk.
Idiosyncratic vs systemic is a concept that applies to more than risk. It is a
lens
through which we can view situations, opportunities, and more.
So far, the challenges from Covid, supply chain disruptions, and labor shortages have affected just about everyone. But as we move into year three of these challenges, some companies will have developed solutions while others will have not. Those that haven’t present an
idiosyncratic
challenge to customers, suppliers, and creditors. At that point, the problem is management or ownership… in other words, you!
Further, while it’s true that if no solutions have emerged for your industry, market, etc., the problems are systemic, your company still isn’t off the hook. Why?
Because if customers, suppliers, and others think they will continue to be adversely affected, the era of workarounds ends and the search for permanent solutions begins.
That solution may be benign (e.g., your customers carry more inventory) or adverse to your interests. For example, if your costs are up and your prices rise —
and your customers think this is a permanent change
— they may substitute your product with another.
As shown above, there are really
two
things to look out for.
If your business doesn’t respond as well as competitors to systemic challenges, it becomes an
idiosyncratic
challenge for customers, vendors, and so forth. When that happens, the typical response is to limit or cease doing business with you.
Sometimes, however, no solutions to systemic problems arise from people in your industry, something that often leads to systemic solutions from suppliers and customers. These solutions may be harmful to your business or present an opportunity.
Here’s where price elasticity comes into play.
For example, if systemic problems means that your costs are up and you raise prices, the systemic response of your customers depends on their situation. Can they raise prices too? Are your prices rising faster or slower than changes in the overall price level (i.e., are your
real,
inflation-adjusted prices going up or down)?
The case to be concerned about is when real prices go up.
Price elasticity
If your company and industry is raising prices in
real
terms, then what your customer does is driven by what economists call the price elasticity of your product.
That is, the percentage volume change in customer purchases that results from a fixed percentage change in real prices to that customer.
A good or service is “price elastic” if a small change in price leads to a big change in demand. It is “price inelastic” if the opposite is true.
Gasoline is a product with price inelasticity; people can’t reduce their need for it in the short term. When prices go up, people keep buying because the alternatives are not good. Brands of bread, on the other hand, are highly price elastic. Raise the price of a branded sourdough bread idiosyncratically and customers will start switching to other brands or other types of bread almost immediately.
A Real World Example
One of my clients makes a product that is used by businesses that grow plants for resale.
A commodity that my client processes is by far my client’s biggest cost — the same is true for the entire industry. My client’s commodity cost has gone up for two reasons, both systemic. One is labor costs, which are quickly rising. The other is the cost of containers in which the commodity is imported — also quickly rising. At the same time, demand has increased substantially thanks to so many new home buyers purchasing plants.
So, what are the possible consequences of my client raising its prices?
First, and because this is a systemic problem, my client’s competitors are experiencing the same thing. Any member of my client’s industry that does
not
increase prices will go out of business. It will become the idiosyncratic company that struggles to ship product and pay its bills, all due to reduced profitability.
What will my client’s customers do?
In the short term, not much. They are price inelastic since the product is a small component of their overall costs. So, they will eat the
real
price increase.
But what happens over the long term? Well, that depends on what market segment my client’s customer is in:
-
Some sell to big box stores like Walmart, Costco, and Home Depot, a segment in which price reigns supreme.
Even though my client’s product is a minor cost component, its customers will look for alternatives in the longer term.
-
Others sell to nurseries, grocery stores, and the like.
My client’s product has a distinctive color in the soil mix and the retail customer considers this a sign of quality. These end customers want my client’s product, and it is not a big overall cost component. So not much will change. My client’s customers will therefore have to live with lower margins, find a way to reduce a different cost, or just raise prices.
My client’s dilemma, as with all players in their industry, is that they will have to raise prices or go out of business. One segment of customers may switch to alternatives; the other may not over the longer term. But there is increased demand for the end product so prices must rise and/or sales volume declines.
That is how a new equilibrium is reached — supply matches demand when costs and demand both go up.
Conclusion
It’s important to understand, on a case-by-case basis, whether the challenge you are facing is idiosyncratic, systemic, or some combination of both.
From there, and with a clear picture of the degree of your customers’ price elasticity, you can make informed pricing decisions in both the short and long term.
