Price elastic ain’t fantastic

If you studied economics at university, you may remember a section called “elasticity of demand ”— a concept that’s far more important to businesses than most people realise. If you didn’t have any economics subjects at university, now is your chance to catch up.

Price elasticity of demand is calculated as the percentage change in quantity of items sold divided by the percentage change in price. That sounds complicated, but you already know the basic principle here: as the price goes up, volume usually drops. This is because supply and demand are linked, a fundamental law of microeconomics. Of course, every law has examples of products that break it.

For the vast majority of goods and services, demand drops as the price increases. An important exception is Veblen goods, named after US economist Thorstein Veblen, who wrote about them in the late 19th century. These are luxury goods where demand rises as the price rises, because exclusivity and perceived value are core to the purchasing decision. A perfect example is Ferrari, a company that literally chooses how many units it wants to sell in a year and then prices them accordingly.

The argument of “why don’t they sell as many units as the market demands?” falls flat, as demand would diminish if the prices were lowered and supply increased. Ferrari would be worse off as a business if the products were more competitively priced. This is why luxury goods manufacturers command valuation multiples that are richer than the clientele.

There are only a few companies in the world that produce true Veblen goods. They range from cars through to handbags and timepieces. It just feels wrong to call them “watches” when they can cost more than a family home. Names such as Richemont, Hermès, LVMH and indeed Ferrari should spring to mind here.

Horror show

Moving on from Veblen goods, most companies experience a drop in volume if the price increases, which is why this inflationary environment is causing serious headaches for so many large businesses. Many are just passengers on this journey, either benefiting from the right inflationary mix or getting crushed by it because of factors beyond the control of the management team.

A company with rapidly rising input costs and little ability to pass through price increases to consumers is a sitting duck in this environment. A good example would be the local fishing businesses, which have had to contend with rising fuel costs that cannot be recovered through price increases. Like a scene from the worst of Hollywood, a giant squid emerges from the depths and devours the profits, leaving shareholders with only the rotten heads to enjoy.

Yet the fishing groups look like the agricultural equivalent of Apple or Microsoft

in this environment compared with the poultry groups. Even in decent operating conditions, the margins in chicken farming are skinnier than a 1990s supermodel. When the price of maize goes up and load-shedding costs kick in, pricing needs to increase significantly for there to be any profit at all. As a staple protein for so many people and with the ever-present threat of cheaper imports, the poultry industry finds it difficult to increase pricing. The enormous sensitivity to input costs in these businesses is why traders use poultry stocks to take a leveraged view on factors such as maize prices.

Conversely, a group such as Mpact released excellent results in this environment because volumes in the paper business increased significantly, despite pricing increases to protect margins. In any kind of industrial business, this is the holy grail for profitability thanks to operating leverage and economies of scale. There are simply numerous fixed costs in these businesses that don’t increase as volumes rise. If you combine growth in both volume and price, the net impact is higher capacity utilisation in the facilities, and thus expanded margins and exceptional profits.

As is usually the case in life, reading gets you far. Management commentary is packed with information on key input costs and how a company can (or can’t) control them, along with notes on the level of pricing power enjoyed in the market.

Common sense also gets you far. Sometimes, you just need to ask yourself if a substitute product is available. When one type of protein becomes expensive, you can pick another one. If your Microsoft Office 365 subscription becomes more expensive, you’re stuck. Price elasticity is something you experience every day without realising it.