Friday, January 30, 2009

Starbucks vs. Harley Davidson: What you see and what you don't

We live in a consumer-driven economy, liberals often say, and how much more can we produce until we’re too chock-full of gadgets and gizmos? This concern is easily manifested in a company like Starbucks: How can they grow when they’re already located on every street corner in every city? Such concerns, like so many misunderstandings about the economy, come back to Henry Hazlitt’s single lesson about economics: What you don’t see is often more important than what you see. We’ll begin by talking about what we see, which is too many Starbucks stores.

What you See

Starbucks originally hooked me on coffee. I was in 8th grade and a location next to my school was giving out samples of their new Frapuccino with brownie bits. Since around that time, Starbucks expanded to over 16,000 locations worldwide. Its horizons seemed endless, as numerous books popped up about the genius idea behind the business, no doubt perhaps conceived in the cozy intellectual confines of the coffee shop’s atmosphere.

But in 2006, way before our current recession, it was clear that Starbucks had over-expanded itself. Since then, it’s closed over almost 1,000 stores and has plans to close hundreds more. In the meanwhile, Starbucks has certainly lost its edge. The issue seems simple enough, and the conversation almost one-dimensional: They need to open more stores. More stores means more money. But the economy - maybe even the world - isn’t big enough. They can only open so many stores in the same city before there’s no room left to expand. Companies rely on growth. What are they to do? In the meanwhile, they’re worried that the Starbucks brand has become stale and too expensive for a society in recession.

What you Don't

The solution to the path that Starbucks should have taken struck me while I was reading about The Harley Davidson Company in Motley Fool’s recent book, Million Dollar Portfolio. The following quote summarizes a bit of the history of Harley Davidson before getting into their success:
In 1901, a 21-year-old William Harley designed a motor to put onto a bicycle. He was soon joined by his good friend Arthur Davidson, and together they started a company that would eventually build motorcycles. Over the next 70 years, the company was private, surviving the ups and downs of the American economy, with major contributions to the war efforts of both World I and World War II. By the 1950’s and 1960’s, though, the company saw its reputation diminished, as it was associated with the Hell’s Angels and other less savory characters.

In 1967, the company was bought by American Machinery and Foundry (AMF), which produced leisure equipment such as snow skis, golf clubs, and bowling balls. AMF mismanaged the company to the point of near death, and sold it for $80 million in 1981 to a group of private investors, including Willie Davidson, a descendant of the original Davidson family. They rebuilt the company, placing a new emphasis on quality that had gotten away from them for decades. Customers returned. In 1987, Davidson and Friends took the company public.

That was the beginning of a spectacular ride. Shares of Harley at the end of 2007 were worth roughly 110 times what they traded for when the maker of the Fat Boy first went public…(p. 85-6)

What was responsible for this turnaround?
For the better part of two decades, Harley had the opportunity to do the right thing with its profits – sink them back into the business, making new and better products, and reaching out to loyal customers. In fact, the true glory years for Harley’s stock were those when management limited how fast the company made bikes. Rather than make all the hogs it could sell, Harley increased production at a rate of only %10 a year, lower than what the marketplace could bear. The ensuing scarcity of bikes raised the value of those machines that did make it to the market. For the better part of a decade, customers were willing to pay more than the manufacturer’s recommended price. (p. 86)
Something clicked when I read this, as I realized that Starbucks’ problem was not over-expansion, but a lopsided view on the meaning of growth.

Certainly more locations is one way to increase profit, but did it never occur to them to improve their product, similar to Harley Davidson? Starbucks' extra cash placed them in a position to improve their product, or at least to make it more efficiently. Or they could have experimented with real cappuccinos, which are generally thicker and have less foam, rather than switching to automated machines. Or they could have lowered the price of their products, which would have enabled them to compete more effectively with McDonalds and Dunkin Donuts. Instead, they’re stuck with too many stores which need to charge an arm and a leg for a cup of coffee in order to make a profit.

None of these strategies were guaranteed to work, but they get at a very basic aspect of economics: Differentiating between what you see and what you don’t see. Starbucks chose to err on the former by expanding everywhere, rather than the latter. However, the alternative strategies – which err on what you don’t see – were certainly viable, as seen in the success of Dunkin Donuts. In a very real sense, both were strategies behind growth. Yet do you hear liberals decry that Dunkin Donuts is taking over the world with their expansion of quality and lowering of price?

As Harley Davidson’s history shows, companies don’t just grow by getting physically bigger and taking up more space. As Hazlitt proclaimed in 1946, growth in areas that you don’t physically see right in front of you are often the most important types of growth.

The More Important

I want to end on this concept because I’m entranced by it.

Mankind necessarily begins with the concrete and what’s right in front of him, and over generations he forms laws of nature, which get at what Plato called underlying forms. Plato believed that the forms behind the manifestation of reality are inherently more important than physical objects, because the forms govern their existence. In other words, the law of gravitation is more important than the objects which are being gravitated, because the law allows us to understand the objects.

Hazlitt was saying something very similar, only in relation to economics: What we don’t see is often more important than what we see. We visually see Starbucks everywhere, but we don’t visually see the quality of coffee increasing. Hazlitt elaborated with an analogy to a broken shop window: If a shop’s window breaks, we see extra business go to the repair man. Judging just from what we see, broken windows are good because they produce business. What we don’t see, however, is more important. We don't see the foregone opportunities given up by shop owner. Perhaps he now has to make his goods more expensive, or he can’t expand his business. Economist John Maynard Keynes - whose influence has exceeded Marx in determining liberal economic policy - was notorious in his inability to grasp Hazlitt's law. He once famously suggested that we should bury money under ground, so that industries can form by digging holes to get them out.

I’m fond of intellectualizing issues, often to a fault (see this post and every other). For this reason, though, I’m often amazed at how intellectual liberals fail to grasp anything about the economy that's not in plain sight in front of their eyes; because Hazlitt’s law is the bare essence of intellectualization, by moving the discussion to the underlying principles, rather than just what’s out there in front of you. How can you be intellectual and fail to grasp that there’s more to the world than just what you see?

Nonetheless, liberals often chide at attempts to get at the underlying forms of the economy, such as Adam Smith's notion of the invisible hand, under the presumption that it's an oversimplified attempt to avoid reality. On the contrary, however, discussing physical economic things without reference their underlying economic form is like trying to move a rotating object without thinking about gravitational forces. Stated more succintly, its easy to change something's outward physical appearance, like an item's price, but its not easy to alter the form, like the information that a price conveys.

Of course, applied to the economy, this mistake is not specific to intellectual liberals. Many economists and politicians, in the tradition of Keynes, overemphasize consumer goods and end-products, which we see, over investments and savings, which we don't see. One instance of this was when former President Bush urged Americans to go shopping after 9/11 upon the assumption that this would stimulate the economy. Contrary to Bush's intention, buying random things when you don’t need them is pointless, and spending beyond your means is in fact harmful for the economy. When you buy a product that you need and can afford, you’re signaling to the manufacturer – along with anyone involved in its profit – that the product is valuable. You're telling them that you enjoy their product more than you would have enjoyed your extra money somewhere else. You're signaling them to make more of that product, or to keep doing what they were doing. Buying useless products that you can’t afford just adds noise to that signal, and it depletes from your savings. Savings again represent what you don’t see: They don’t just sit in a bank vault. They’re loaned to businesses or people, or are reinvested into the economy. That money is given a purpose, and in line with Hazlitt, that purpose is arguably more important than your consumption, particularly if you don’t need or want that consumption.

This misconception is magnified in the use of GDP – gross domestic product – to measure the macroeconomy. GDP is the total measure of exactly what you see: product. It doesn’t include what you don’t see, particularly savings and investment. When a window breaks, or another Starbucks opens, GDP increases, regardless of any depletion in savings; when a company like Harley Davidson focuses on making better motorcycles (and spends on R&D), GDP suffers.

Economist Mark Skousen, among a few others, hotly debates the usefulness of GDP. Using a statistic called gross output, he estimates that end-product consumer goods account for only a third of the economy. And this makes sense, because changes in the GDP usually lag behind changes in the stock market by a few months. It takes money to make money, and it also takes money in the right hands as well. That's why savings and investments are more important than consumption.

Right now most every company is in trouble, although to varying degrees. Starbucks used one strategy for expansion, though it certainly wasn’t the only strategy, and in hindsight it probably wasn’t the wisest. Harley Davidson management has recently turned south as well, as they’ve somehow managed to pile on a huge amount of debt while being aware of their shrinking baby-boomer customer base. But the important lesson is that these companies had options, as growth doesn’t always occur in areas that you see. Often the best things in life – love, joy, happiness – you can't see directly at all.


Media (in order of appearance):

Photo: (1) Careful, 11/10/2006, by Carlos Aldana; (2) Fuel, 09/30/2006, by Nathan Makan; (3) 1907 Harley Davidson, photo by Rmhermen; (4) Harley Davidson Heritage Model 2004; (5) DUNKIN' DONUTS, 12/03/2006, by Paul Downey; (6) Concave modular origami : collection so far, 11/17/2008, by fdecomite; (7) Shattered Lens, 03/06/2006, by kandyjaxx; (8) Westfield White City, 11/25/2008, by Manuel.
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  1. Holy cow! I see you've been busy writing. I've got to find the time to catch up on all these posts.

  2. Hey Jake, yeah insight for me comes in spurts and stops. Hope you enjoy whatever you read, certainly take your time or don't feel obligated. And feel free to discuss any old post for whatever reason (as any new comment is shown on the sidebar) - partly b/c I always feel starved for a new post idea until I start writing one.


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