Penny-sucking economics – part 1

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The comic books of my youth often had a section in the back advertising the opportunity to purchase something wondrous for only one dollar plus a self-addressed, stamped envelope. While these offers were usually disappointing once received, I remember my first get-rich idea was to try to get one million people to send me a dollar. It turns out that I should have been thinking much smaller.

We have largely underestimated the significant effects of economic activity in the range of one penny per transaction, multiplied millions or even billions of times, or what I call penny-sucking economics. This first part of the discussion will look at the business side of this “niche,” while a subsequent post will consider what is the mostly-unseen consumer side of the equation, the effects of which show up in the data for income inequality.

Walmart and penny profits

Whether you love or hate Walmart, Sam Walton clearly revolutionized American retailing through a “penny-sucking” strategy. Walton intentionally shot for as low a net income margin as was sustainable, a number that settled in around 3 cents per dollar of net sales in recent years (although it has been trending even lower recently). By keeping this percentage low and steady, Walmart forces competitors to “fly too low,” often “crashing” in unprofitability as a result (for example Sears and KMart in a self-destructive business combination).

This strategy also exacts a huge amount of pain on suppliers and employees, who quickly learn that every penny of cost and compensation is fought over by Walmart managers. Walmart’s profitability, and the Walton family’s great wealth, literally comes from sucking billions of pennies from even more billions of individual retail transactions, as well small amounts on a per-sale basis coming as from local and state governments, who yield back pennies in taxes on each sales dollar and in other tax subsidies in order to get a new store built in their city.

Gambling casinos are another great example. The most successful casinos keep the average profit from each dollar inserted into the slot machines down to just a couple of cents, knowing that the trick is to entice people to keep inserting the beginning stack of coins, plus any winnings, back into the machine over and over again. Occasionally the machine yields some coins back, with lights and bells, until it the initial money stake is gone, given to the casino one probabilistic penny at a time.

Jeff Bezos and penny cashflows

Jeff Bezos took the Walton penny-sucking strategy one important step further in creating Amazon. Recognizing that accounting profits are often just a “convenient fiction,” Bezos extended the Walton idea back to the basic business cashflow itself. Who needs “net profit” when you can process billions of dollars of sales via the internet, sucking a penny or two from each dollar of that cashflow out of the system yet without showing a visible accounting profit, or especially a taxable profit? As long as the bills are paid through that cashflow, the business keeps going and growing, and Bezos gets very rich. Amazon eventually could not hide its profitability, but it held to that accounting no- or low-profit strategy for a very long time.

In a sense, this is a localized version of the concept of the velocity of money, and perhaps the true secret behind Amazon Prime. The faster an Amazon transaction is completed end-to-end, the faster cash flows to from Amazon to suppliers and shippers and their employees, who in turn spend more of their collective salaries shopping through Amazon Prime and other online retailers. And more pennies thus get sucked out of the same cashflow with each iteration.

A similar example is the high-frequency stock trader. Their benefits and risks to the larger capital market are hotly debated, but the strategy is brilliant. Each stock trade may earn only a few pennies, but repeated millions of times per day through self-learning artificial intelligence algorithms and with computer-generated speed, the pennies quickly add up to huge profits.

High-frequency stock traders work on the very edge of the concept of the marginal investor. It is interesting to contemplate that my own usual “diversify, buy and hold” strategy has little effect on the valuation of the capital markets, because that investment strategy generates relatively little new economic activity. Stock market valuations are primarily driven by the high-frequency buy-and-sell cashflow of marginal investors, those active in the market at any given moment. And increasingly those marginal investors are computers.

And so, at the breakneck speed of consumer and financial transactions, the most “profitable” companies “suck a few pennies” out of the consumer economy with each transaction, with the bulk of the dollar quickly plugged back into the economy for another round through the “slot machine.” What is the impact of this business strategy on ordinary consumers? That will be the subject of an upcoming post.

When I worked in the auto industry over 40 years ago, a key statistic watched was the average number of days between sales for regular car buyers. If that number was trending toward 30 days slower, forecasters were looking at an 8% to 10% decline in new car sales. It might be interesting to determine the average number of “penny transactions” from major retailers per minute as a forecast of economic trends.

Part Two of this series, which looks at the consumer spending side of “penny-sucking economics,” has now been published.

For an update tying penny-sucking to corporate tax reform, click here.

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4 thoughts on “Penny-sucking economics – part 1

  1. Pingback: Penny-sucking economics – part 2 – When God Plays Dice

  2. Pingback: Penny sucking and corporate tax reform – When God Plays Dice

  3. Pingback: Bleeding Heartland

  4. Pingback: Iowa rent-seekers meet Adam Smith – When God Plays Dice

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