Mickey Kim: MIT’s ‘Beer Game’ explains panic’s impact

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INVESTING: Mickey KimA long time ago in a land far, far away, you could walk into a grocery store and be tempted by shelves overflowing with a seemingly endless variety and unlimited quantity of goods to satisfy your every whim.

This describes the happy state of the U.S. economy as recently as early 2020, as the well-choregraphed “dance” involving the various links in the global supply chain made sure the right quantity of goods arrived when needed. When the supply chain is running smoothly, it’s like breathing air; it operates without a thought.

Fast forward to today, and you’ll find seemingly random grocery shelves stripped bare. COVID revealed the fragility of the global supply chain; when it’s broken, it’s all over the headlines. When you can’t get what you want, it’s all you think about.

Supply-chain management was a low-profile profession that gained visibility in the early 1970s as Toyota introduced “just in time,” a manufacturing philosophy that prized “maximum efficiency,” where suppliers delivered parts to the factory floor exactly when needed. This profession is poised to become more high-profile, as the pandemic demonstrated the wisdom of having “just in case” safety stocks to protect against future supply chain disruptions.

Professor John Sterman of the Massachusetts Institute of Technology’s Sloan School of Management has been using the “Beer Distribution Game” as a “management flight simulator” for four decades. The BDG simulates supply and demand across the industry, from Brewery (B) to Distributor (D) to Wholesaler (W) to Retailer (R).

Each team competes against all the others and is broken down into BDWR groups, which are not allowed to communicate outside their group. Customers buy from the retailer, who then orders from the wholesaler, who in turn orders from the distributor, who acquires beer from the brewery. The brewery makes the beer, which is then shipped down the chain to the retailer and finally bought by the customer.

The game consists of 40 rounds. It costs 50 cents to hold a case of beer in inventory and $1 for each case the group is unable to deliver. Each team vies to minimize its total cost across its supply chain.

Sterman and Gokhan Dogan presented their observations of the BDG and theories on how students with so much intellectual wattage could get it so wrong in a scholarly paper: “‘I’m not hoarding. I’m just stocking up before the hoarders get here.’ Behavioral causes of phantom ordering in supply chains.”

The authors define hoarding as “attempts to accumulate large private stocks of goods when people perceive threats to supply.” Hoarding goes hand-in-hand with “phantom ordering,” where “people react to uncertain supply by ordering more than they actually desire, or ordering from multiple suppliers, then planning to cancel their excess orders once they get what they desire.”

In their experiment, all players learn at the start that customer demand is constant at four cases per week. There are no random shocks: no machine breakdowns, materials or labor shortages, or transportation glitches. With demand constant and supply assured, you don’t have to go to MIT to know there’s no rational need for hoarding or phantom orders. Everyone should order four cases a week, every week.

Behavioral finance tells us investors are more like the irrational Homer Simpson than the coldly logical Mr. Spock and must overcome all sorts of bad instincts and biases. The amygdala is the “fear center” of the brain where our prehistoric “fight or flight” survival instinct resides and screams at us to, “DO SOMETHING!”

Whether it’s the fear of loss that causes us to panic and sell when stocks are plunging or the fear of missing out (“FOMO”) that causes us to chase meme stocks or cryptocurrencies, the damage is real.

As it turns out, it’s the same with supply chain managers, as the amygdala responds to scarcity, real or imagined. In the BDG, tiny changes in people’s orders led to huge cycles in production, a phenomenon known as the “bullwhip effect.” Indeed, the authors noted 22% of the groups placed orders of 100 cases a week, or 25 times the known, constant customer demand of four cases a week.

The shortages, hoarding and boom-bust cycles in the game were completely self-inflicted.

While we can’t predict a pandemic or a container ship getting stuck in the Suez Canal, we need to understand the causes of panic and avoid it. Until we do, expect the fear of running out (“FORO”?) to prevail and lead to more hoarding and phantom ordering, not less.•


Kim is Kirr Marbach & Co.’s chief operating officer and chief compliance officer. He can be reached at 812-376-9444 or mickey@kirrmar.com.

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