by Donald V. Potter

After a short spell of low inflation, American business is being barraged with forecasts of an impending return to the price spirals of the late 1970s. The financial markets seem to have built into the cost of money a higher level of long-term inflation than they have in recent years. The differences between interest rates and current underlying inflation are at levels unseen in a generation. “The Return of Inflation,” warned a recent cover of The Economist, which was designed to resemble a horror movie poster. “Coming Soon to a Country Near You. Starring ‘Uncle’ Sam Spendthrift.”

This threat of inflation may create jitters among consumers and many investors, but it breeds hope among strategic planners. That’s because nothing bails out a difficult strategic plan, with its escalating costs and falling margins, like the forecast of a price increase. Even a strenuous cost-reduction effort is no match for the immediate, direct boost to earnings that a price increase can provide.

Little wonder then, that most U.S. business plans this fall will foresee some kind of price increase, making this our annual autumn ritual on the altar of hope. Yet we know, with the benefit of perfect hindsight, that the differences between forecast and actual prices account for more shortfalls in budgeted corporate returns than any other factor.

Before a company, a division or a product management team commits itself to a price increase forecast, it should answer two critical questions. First, what marginal costs of the marginal producers are due to rise? Second, can current low-cost producers expand at the current price?

Forecasting prices is obviously a risky business. Economics 101 teaches us that the unit price just balances supply and demand. Price clears the market. In practice, though, it seems like the market never gets properly cleared. Companies are plagued either by inventory accumulations or by shortages of production capacity as prices and customer demand forecasts miss their marks. In the practical world, these problems are not going away. But price forecasts would be more accurate if planners kept in mind several lessons drawn from price behavior in the real world.

LESSON ONE: Most prices are set by suppliers’ costs, rather than by “what the market will bear.” Most of us would pay more for things we buy – if we had to do so. The oil shocks of 1973 and 1979 illustrate this. Within weeks in both those years, gasoline prices at the pump doubled – but most of us still bought gasoline. Most customers get more worth from the products they purchase than they must pay, because most suppliers can deliver the products for a cost less than their worth to most customers. The first step to effective price forecasting is to examine the costs of the suppliers of the product.

LESSON TWO: The purpose of a price is to discourage production. The effect of price can be viewed as either a) covering the suppliers’ costs or b) discouraging some competitors from producing. In practical terms, the discouragement of production is the more powerful function of price. Pricing will often fail to cover some companies’ costs, but it never fails to discourage production. Companies decide against entering or expanding in markets where the price is unlikely to cover their costs. The demand for domestic onshore oil service equipment today is a small percentage of its level in the early 1980s, because many domestic oil and gas explorers cannot cover costs when oil sells for $20 a barrel. OPEC’s new, low price strategy has discouraged U.S. domestic oil production. The second step in price forecasting is to identify this “discouraged” production.

LESSON THREE: Prices are set by high cost producers. This observation seems to fly in the face of experience. After all, low-cost competition offers lower prices and establishes a new level of pricing. To explain this seeming contradiction, we need to distinguish price “leadership” from price “setting.”

Low-cost companies often lead pricing down. The resulting lower price must still be high enough to keep the high-cost companies in the market, though not so high as to attract the currently “discouraged” producers into production. If prices fall below the costs of the high-cost producers, these producers will withdraw from the market. The fact that some high-cost producers, in addition to low-cost producers, remain in the market is evidence that their costs are covered by the price. That is, the costs of the high-cost producers keep current prices from falling further because their production is demanded by customers. Prices, then, get “set” by the costs of high-cost producers. This leads us to the question of which costs set prices.

LESSON FOUR: The marginal cost of the “discouraged” marginal producer is the price. To see this principle in action, observe what happens in industries where there is substantial overcapacity, like the copper industry. Between 1980 and 1985 nearly one-third of U.S. domestic copper production capacity withdrew from the market as the price for a pound of copper fell from $1.34 to 67 cents. During this period, low cost producers from Chile, Zambia, Zaire, and Iran expanded aggressively, more than absorbing all the growth in market demand. These low-cost producers gained share by cutting price.

The high-cost producers, U.S. domestic companies, drastically cut their production costs by investing in efficient leech mining and electrowinning processes, but this was of little help. High-cost domestic producers reduced their marginal production costs to as low as 60 cents per pound. Prices fell along with the reduction of domestic producers’ costs. Several U.S. mines closed. The cost reduction investments had indeed reduced costs – but did little for profits. U.S. copper industry returns remained low because marginal costs of the “discouraged” marginal domestic producers constrained the price.

The banking industry illustrates how marginal costs of marginal producers can rise because costs of the current marginal producers increase. When interest rate limits were removed in the early ’80’s, banking costs and prices rose. Within a few years following this rate deregulation, average bank prices for retail services doubled to cover the rising cost of funds.

Alternatively, the marginal producer may change. Market growth may require a new higher-cost marginal producer to bring additional supply into the market. Sometimes this happens through “capacity creep.” Small increments of marginal production are introduced into the market through a streamlining or “debottlenecking” of current production. “Capacity creep” is the way the polyvinyl chloride (PVC) industry is adding capacity today. In this situation, prices normally will not rise high enough to bring an attractive return to brand new capacity. Many competitors in the industry will not earn an attractive return on the replacement cost of their investments, though their returns on the book value of their investments may be very attractive. Despite the recent turnaround in the lumber industry, few companies could justify the investment in their sawmills on replacement value accounting.

On the other hand, market growth often requires additional facilities, or even new companies. When a market grows this fast, prices will rise high enough to attract entirely new capacity and existing suppliers will make very high returns. These conditions characterized the personal computer market in its early history and shape the bottled water market today. In those markets, marginal costs are the full cost of new production capacity, including an attractive return on invested capital.

A management team forecasting a price increase should evaluate its forecast against the industry’s marginal costs. Profits do not govern here – only cash does. The price must cover all producers’ marginal costs, not full costs. As a result, a large number of companies can be losing money and yet continue to price low. Witness the domestic auto suppliers in the early ’80’s, and oil field service suppliers in 1986. These companies were covering their marginal costs and making some contribution to fixed costs. But all of them were reporting losses.

At the other end of the spectrum, high prices produce high returns, which attract new capacity. When silver prices boomed a few years ago, people melted down jewelry and family heirlooms, effectively adding capacity. Many generic drug manufacturers are expanding today because they have figured out how to gain FDA approval for high-priced drugs coming off patent protection. And, despite the doldrums in the domestic steel industry, specialty steel makers, like Nucor and Worthington Industries, continue expanding under the price umbrella of the large, integrated steelmakers.

Higher price forecasts often imply some kind of industry capacity expansion. That leads to the second question to answer, before betting the forecast on a price increase: why can’t low-cost suppliers expand at the current price? If low-cost suppliers can expand, the price is unlikely to rise far or for very long. This explains why prices often do not rise much, or at all, after a shake-out. Many competitors have been shaken out of the personal computer industry, yet prices continue to fall. The same holds true in the commodity semiconductor market, adding some irony to U.S. accusations that Japan is “dumping” commodity DRAM chips in this country by selling them below cost. Japanese producers who bet on the shakeout of domestic U.S. semiconductor producers in order to raise prices and reward their staying power have been sadly disappointed at their anemic profits due to low prices. As long as the potential for additional low-cost supply exists, prices will not rise much – even after a shake-out.

Even when current pricing is used to justify large investments in cost reduction, which might be needed to fend off expanding low-cost suppliers, planners must be wary. Cost reduction investments may reduce costs. But if these investments reduce the marginal costs of marginal suppliers, prices will tend to fall and wipe out the returns planned on the investment. Pan Am has been reducing its costs for years. It has trouble turning a profit, though, since lower cost competitors, such as Texas Air, continue expanding.

We do have inflation in this country. More prices are going up than are coming down. But forecasting a price increase should become more than an annual ritual performed religiously during the fall.

(Note: This Perspective was written in the context of the economy in 1987. While some of the companies may have changed their policies or indeed no longer exist, the patterns they exhibit still hold today.)

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