Case 095Industry structure and moatsCore
Soda ash is priced off the industry cost curve. The lowest-cost producer makes it for Rs 18,000 a tonne and the marginal producer for Rs 26,000. A new low-cost entrant adds 10% capacity. What happens to price and to the low-cost producer's margin?
1The situation
Chembora Soda Ash is the lowest-cost producer in a regional soda ash market, with 12 lakh tonnes of capacity and a cash cost of Rs 18,000 a tonne thanks to captive salt and limestone. Five rivals make up the rest of the 60 lakh tonnes of capacity, with cash costs of Rs 20,000, 22,000, 24,000, 26,000 and 29,000 a tonne. Demand is 45 lakh tonnes a year, growing about 3% a year.
A new plant with 6 lakh tonnes of capacity, 10% of the industry, will start next year at a cash cost of Rs 17,000 a tonne. Soda ash is a commodity: buyers switch for a small price difference.
2Your task
Where does price settle before and after the entrant, what happens to Chembora's margin, and for how long?
Quick check
Chembora is the low-cost producer. Is it safe from the entrant?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
Price drops from about Rs 26,000 to about Rs 24,000 a tonne, and Chembora's margin falls a quarter, from Rs 8,000 to Rs 6,000 a tonne. Price is set by the highest-cost producer still needed. Before the entrant that is producer D; the new 6 lakh tonnes push D out and producer C becomes the marginal supplier. Chembora's EBITDA falls from about Rs 960 crore to Rs 720 crore. At 3% demand growth, the gap closes in about 2.2 years.
Step 1Who sets the price in a commodity market?
The last producer the market needs. Think of a vegetable market late in the day: the price settles where the last seller whose stock is still needed will accept. Price is set by the highest-cost producer still needed to meet demand, because below that price the market would be short of supply. Line producers up from cheapest to dearest and walk right until capacity covers the 45 lakh tonnes of demand: Chembora, A, B and C together make 42, so producer D, at Rs 26,000, is needed and sets the price. This line-up is the cost curveEvery producer ranked from lowest to highest cash cost, drawn as blocks whose width is capacity and height is cost per tonne..
Step 2What does the entrant do to the curve?
It slides in at the cheap end and pushes every other producer to the right. With 6 more lakh tonnes ahead of them, the first five producers now cover 48 lakh tonnes, so producer C at Rs 24,000 is the last one needed and D is priced out. Nobody's costs changed; the marginal producer did. Chembora sells the same 12 lakh tonnes at Rs 2,000 a tonne less: EBITDA falls from Rs 960 crore to Rs 720 crore, 25% lower.
| Item | Before | After the entrant |
|---|---|---|
| Marginal producer | D | C |
| Price, Rs a tonne | 26,000 | 24,000 |
| Chembora cost, Rs a tonne | 18,000 | 18,000 |
| Chembora margin, Rs a tonne | 8,000 | 6,000 |
| Chembora EBITDA, Rs crore | 960 | 720 |
| Producer D output, lakh tonnes | 3 of 9 | 0 of 9 |
Step 3How long does the pain last?
Until demand grows back into producer D. At 3% a year, demand passes the 48 lakh tonnes the cheaper producers can supply in about 2.2 years, and price climbs back towards Rs 26,000. So the entrant costs Chembora about two years of lower margin, not its franchise. Being lowest on the curve still matters: Chembora keeps a margin in every scenario, while producer D has none.
Say the limits. Real prices often sit above the marginal producer's cash cost when capacity is tight and below it in a glut, when producers keep running to cover fixed costs. Imports can also cap price if landed import cost sits below domestic marginal cost. And watch for a second entrant: two plants in quick succession can hold price at the lower step for much longer.
Where candidates lose it
The common error is saying the low-cost producer is protected because its own costs have not moved. In a commodity, the lowest-cost producer earns the gap between its cost and the marginal producer's, and the entrant shrinks that gap.
The second miss is pricing off average cost, or off the entrant's cost. Neither sets the price; the last producer the market needs does.
What the interviewer asks next
- Demand falls 5% in a slowdown. Where does price go before the entrant arrives?
- Would Chembora gain by adding its own 6 lakh tonnes instead of letting the entrant do it?
- How would a 10% import duty cut change the curve?
Company names and figures are illustrative.