We have spoken a lot about price inflation; how increased costs, whether through imposed fees like tariffs, or by increased costs for foreign producers, lead to increased costs of production, and downstream increased costs to the consumer.
We have also spoken about how “goods” only account for 30-40% of the GDP, the balance coming from services.
So, what happens when tariffs cause import costs to go up? There is pressure to increase pricing to offset those costs and maintain the profit margins. But counterpressure can be exerted by consumers by reducing sales. This is the traditional, textbook dynamic based on demand. It assumes that buyers act on individual products based on their assessment of the market.
What about companies that do not purchase parts and materials from offshore suppliers? They are not as affected as the other companies. And what about service companies who are not subject to the pricing pressures due to costs?
Sometimes the “natural” market is changed because the public BELIEVES that inflation is inevitable.
Consider 2020 and the COVID19 pandemic. Lockdowns spread worldwide. There was a spike in the demand for online shopping. International shipping was disrupted as containers piled up in markets and dried up in offshore shipping ports. The costs of shipping containers skyrocketed. Containers that used to cost $3,000 from Asia to NY, now were costing $25,000, if the manufacturer could even find space on an outgoing container ship.
Without imported parts, manufacturers in this country saw their output drop. This resulted in great pressure to increase prices, and we saw inflation spike to over 7% worldwide.
But those pressures did not apply to restaurants who were using local suppliers for their meals. They did not affect the costs of providing accounting or legal services. They did not increase the costs of manicures, haircuts, spa treatments, or rental apartments. And yet, those prices rose also.
Everyone raised their prices.
Grocery Retailers raised prices, even for items that were sourced domestically. Lowes, Target and TJX (the parent company of Marshalls, TJMaxx and HomeGoods) saw profits soar over and above any product price increases. Same thing with Keurig Dr. Pepper, Lennar and the PulteGroup (home construction).
The public believed that price increases were inescapable due to all of the media stories about supply line shortages and shipping problems. The general public was primed to anticipate increased prices, so when those prices increased, they were usually accepted with minimal resistance.
Service companies raised their prices, not due to increased costs, but because they could.
I choose to refer to this dynamic as “Opportunistic Inflation”. There is probably a real term that economists use, but for this discussion, Opportunistic Inflation will suffice.
I refer to the increased prices that CAN be passed on to the market, because the public is prepared to expect them even though those increases are not due to escalation of product or service costs, but due to the fact that there is no market resistance to them.
THE OPPORTUNISITIC INFLATION MATH
Let’s look at the math using the same model as my previous note. (In this analysis I have used the example of a product manufacturer in this country, but you can see that it applies equally to service companies like barbers, accountants, pool cleaners, etc.)
A company in this country makes a product for $64 and sells it to the public for $80, a profit of $16, or 25%. None of the resources for this product are sourced from outside the US. All labor and production costs are not subject to tariffs.
Now, consider that the public is seeing price increases of 5%. They read articles, hear commentators, and receive posts on social media, all telling them that prices are increasing and we will be seeing inflation in the near future.
What do you, as the company owner, do?
Do you consider raising your price by 5%, making the selling price $84, even though you have no inflationary pressures which have increased your costs, but solely because the public is expecting your product to go up in price?
Raising the price to $84 (an increase of 5%), with a continued production cost of $64, means your profit grows from $16 to $20. Your profit margin increases from 25% to 31%.
Considering your sales, 1,000 units sold at $80 yield a profit of $16,000, but at $84 it yields a profit of $20,000, an increase of 25% in profits.
And now consider what would happen if that price increase resulted in fewer sales. How many units would you need to sell now at $84, to make the same gross profit of $16,000 that you made when you sold the product for $80?
The answer is you only need to sell 800 units at the higher price to make the same profit you would have made at the old price with 1,000 units sold.
What would you do?
Opportunistic Inflation