"Prices rocket up and feather down" is an economic truism. It is annoying when those higher prices impact your cost of living. Do you ever feel like companies are unnecessarily tight-fisted after raising their prices? In this article, we show how a hidden impact from us consumers pushes those prices up. Following a price rocket, we show how the feathering process is part of the broader creative destruction transformation. The creative destruction end game provides new and improved products and services.
About the Author: Jeff Hulett is a career banker, data scientist, economist, and choice architect. He teaches personal finance at James Madison University and provides personal finance seminars. His new book -- Making Choice, Making Money: Your Guide to Making Confident Financial Decisions --will be published in Summer 2023. You may register for pre-order information at jeffhulett.com.
The rocket has launched - Economics has a way of impacting our day-to-day life. One of those time-tested life truisms is –
“Prices rocket up and feather down.”
We tend to see this truism play out in gas prices or mortgage rates. But it applies to many consumer products and services. During the “great inflation” in the post-pandemic 2020s, the “rocket up” side of this truism was on grand display. For more than 2 years, via monetary and fiscal policy, the U.S. government pumped money into our economy. The purpose was to protect us from dangerous deflationary risks caused by the pandemic shutdowns. Not surprisingly in a big, complex, and incentives-ladened macro policy environment, policymakers oversteered.
An inflation analogy - policy oversteering causes overfilling the water bucket:
Think of economic policy oversteering and the resulting inflation as overfilling a water bucket. In more calm, normal economic times [1], monetary macroeconomic policy is able to maintain optimal levels of inflation and economic activity. Metaphorically, standard macro policy appropriately maintains the bucket's optimal water level. In 2020, the pandemic caused a large, water-gushing hole [2] in our economic bucket. As a result, both monetary and fiscal policymakers blasted water -- actually money -- into this bucket while the hole was being fixed. They did this with the well-intended desire to maintain the correct water level and reduce the emergency water flow [3] once the hole is patched up. Unfortunately, the big fiscal and monetary policy spigots kept flowing even after the hole was fixed. Macroeconomic policy is subject to difficult-to-control inertia. The water overrunning the optimal level [4] is inflation faced in the post-pandemic world.
The policy oversteering ignited the inflation rocket! As a result, prices rocketed upward. Part of that oversteering resulted from unforeseeable events outside policymakers’ control, such as Russia’s attack on Ukraine. While gas stations, mortgage companies, and many other suppliers were quick to increase prices, those prices persisted and stayed stubbornly high.
The big annoyance - Most people experience the Rockets and Feathers truism through their emotions. They experience gas stations, mortgage companies, or others behaving selfishly. If emotions could speak, they may say: “Hey supplier dude, you were quick to raise your prices to protect your profitability, but now when your prices come down, you are slow to bring down my prices. You are printing money at my expense... this feels cruddy!”
The P and Q dilemma - This article seeks to set the record straight. In a competitive market economy, deep with both competing suppliers and many, reasonably homogenous consumers, the Rockets and Feathers truism makes perfect sense… for both suppliers and consumers.
To start the explanation, a core idea of economics is that supplier profitability is a function of Price x Quantity or P x Q. At the end of the day, the average PRICE of something sold, like the price of a gallon of gas TIMES the QUANTITY sold, like the number of gallons sold, is the TOTAL REVENUE for the supplier. From there, they subtract costs (variable and fixed) to reveal the owner’s profit. The owner’s profit is like their salary after all other ‘mouths have been fed’ in their supply chain.
The challenge for us consumers is that we only see the latest price as a poignant reminder that our cost of living recently increased. For example, we only see the higher price of gas as we drive by a gas station. Media may also report that “the price of crude oil has dropped, and gas prices remain stubbornly high.” Often hidden from our view is the other side of the P and Q story. We cannot see the quantity being sold by the companies serving our purchase needs.
The cause of annoyance - As commonly understood via behavioral economics, all people are subject to Availability Bias. That is, our attitudes are impacted by overweighting that which is salient (Prices) and underweighting that which is not salient (Quantity sold). Our naturally occurring Availability Bias underlies and greatly impacts our perceptions of the P and Q story. We are likely annoyed by very salient higher prices. We place blame on the most available culprit and underweight less salient reasons contrary to our beliefs. Next, contrary to our brain's natural instinct to denounce the more salient P, the less salient Q is explained as the reason for stubbornly high prices.
Thus, in a rising price environment, Q goes down and tends to be sticky. Lower Q has inertia. People tend to create substitution habits that take time to change. In the case of work-from-home, for some, these habits will never change. Eventually, pricing for the factors of production will come back down. (e.g., crude oil is a factor of production for gas) However, if Q stays low, the supplier will have no choice but to maintain higher prices to offset less quantity demanded. The supplier needs to cover their costs, which are effectively fixed over a short time horizon. So if Q goes down, P must be maintained at higher levels to maintain cost-covering total revenue.
The laws of economics suggest that higher prices drive lower demand. But in the short term, companies will be slow to reduce prices as a means to encourage demand because they still need to cover their costs to survive. It is quite a conundrum!
For this reason, the short-term environment after a fast price increase is also called the "shake out phase." This is the time when less resilient companies "shake out" and fail. In the timeless words of legendary investor Warren Buffett:
"Only when the tide goes out can we see who has been swimming naked.”
...and the post-pandemic fast-increasing prices are the mother of all low tides!
Mortgage companies are especially sensitive to the P and Q dilemma. The mortgage origination industry has massive price swings (rates) and refinance demand. A smart mortgage executive is one that builds business resilience in the higher demand good times in anticipation of the inevitable lower demand bad times. Many less resilient mortgage companies shake out in the lower loan demand bad times caused by high-interest rates.
This is why prices tend to feather down. Lower Q caused by demand substitution is a moderating factor delaying the speed at which the supplier may reduce P. Also, companies tend to have short-term "all else equal" fixed costs, such as rent. Most companies have little short-term flexibility to accommodate less Q by lowering their cost structure. This just adds to the slow nature of P feathering down.
So, keep this in mind the next time you feel that urge to channel your higher-price-annoyance as blaming the suppliers. At least you have substitution choices and are not facing business failure! Trust me, the suppliers would love to reduce prices to attract more demand more quickly. The problem is that we consumers are just not showing up!
Another way of approaching higher prices is by using John F. Kennedy's advice: "Don't get mad, get even." Higher prices provide a great reason to try something new. Perhaps online shopping or remodeling your home is a great way to adapt to higher prices. Finding new and effective solutions often provide value to your life.
So far, the P and Q dilemma focus has been on short-term economic dynamics. Next, we take a step into the more distant future. As the P and Q dilemma persisted into the longer term, it naturally leads to creative destruction.
Creative destruction and the longer-term P and Q story - as mentioned in our rockets and feathers story, costs are mainly fixed in the short term. Rent is a big fixed cost. In the post-pandemic world, it became clear that U.S. retail consumer habits changed. The transition to online shopping was accelerated during the pandemic. Many people reduced their desire to shop in retail stores. The Commercial Real Estate market is coming to grips with the fact that there is too much retail commercial property supply. Retail commercial property is like the gas station building and land typically leased to the gas station owner.
Similarly, with the increased acceptance of mobile workers, there is now a secular decline in office commercial property demand. As office leases come up for renewal, many companies are either ending the lease or reducing their office footprint. Reducing fixed costs like commercial real estate, means companies may balance the P x Q equation by reducing both P AND Q. This is a long-term change because many commercial leases are 5 or more years long. Following the shake out phase, recasting longer-term costs like leases is the final step to equalizing the market. This equalization establishes a "new normal" and provides a resolution to the P and Q dilemma. In effect, the feather has come to rest... at least until the next rocket launches!
This permanently reduced Q is the final step in the evolutionary economic process known as "creative destruction." "Creative" because there is a new solution more to people's (demand's) liking. "Destruction" because this comes at the expense of the previous solution. Creative Destruction is the magic of the market economy!
We discuss the commercial property challenges in the article:
The creative destruction framework - an economic narrative:
Economist Joseph Schumpeter developed the "creative destruction" thesis in the 1950s. This is the economic theory telling the "out with the old and in with the new" story. Creative destruction is necessary as society adapts to cultural or other changes.
In the short term, higher prices [P] cause people (demand) to vote with their feet. They flock to substitutes and the quantity demanded drops. [Q] The question for people (demand) is: "Is this the new normal, do I like the new more than the old?" This is the magic of market economics, new companies provide new solutions to test whether people like them better. Please notice the supply curves are almost vertical in the two short-term scenarios. This is because, owing to fixed cost structures, the supply of many products is effectively fixed in the short term.
In the long-term scenario furthest to the right, the "new normal" is permanently reduced Q to make room for the new solution. Fast-moving prices experienced following the pandemic fuel the creative destruction evolution. These fast-moving prices give consumers a good reason to consider new products or services solutions. Fast-moving prices help break the inertia associated with our natural 'because we have always done it this way'-based habits.
In the long run, the demand "votes" are tallied and supply shifts to accommodate. It starts with the shake out phase, but may end with a reduced supply of the "old normal" to accommodate the “new normal.”
Notes
[i] During the pandemic, fiscal and monetary policy stimulation caused total savings to increase. In the U.S., according to the Federal Reserve, savings increased by almost $5 Trillion from 2020 to 2022. This excess capacity may delay the substitution effect. In other words, a consumer may be willing to spend more because they have savings capacity in excess of previous savings levels. The delay in substitution should be resolved as savings return to previous levels. Also, other forms of liquidity may delay the substitution effect, those include unused credit card capacity and unused Home Equity Line of Credit capacity. As it stands in May 2023, home equity and card capacity are close to pre-pandemic levels and/or rates of change.
Editors, Deposits, All Commercial Banks (DPSACBW027SBOG), FRED Economic Data, The St. Louis FED, report accessed 5/30/23
Editors, Balance Sheet: Unused Loan Commitments - Total: Unused Home Equity Lines (QBPBSNLNNHOMEEQ), FRED Economic Data, The St. Louis FED, report accessed 5/30/23
Editors, Balance Sheet: Balance Sheet: Unused Loan Commitments - Total: Unused Credit Card Lines (QBPBSNLNNCRD), FRED Economic Data, The St. Louis FED, report accessed
In the U.S., there have been six episodes of significant inflation since World War 2. Each of those was preceded by inflationary fiscal spending or externalities like gas and oil prices. The monetary policy quickly reined in inflation. It remains to be seen how much the magnitude of the pandemic fiscal policy and excess consumer capacity will impact the transition timing to the substitution phase.
Editors, Historical Parallels to Today’s Inflationary Episode, The White House, 2021
Comentarios