As inflation finally shows signs of retreat, consumers are left scratching their heads. The news headlines talk about falling inflation, yet their grocery bills remain stubbornly high. The culprit? Elasticities are the hidden force shaping the price tags on our everyday goods.
Price elasticity is a term economists use to measure how sensitive demand is to changes in price. Think of it like a seesaw. When prices go up, demand goes down (the seesaw dips). Conversely, a price drop sends demand soaring (the seesaw rises). But the seesaw’s balance isn’t always equal.
For some products, like generic peanut butter, demand barely flinches when the price fluctuates. These are inelastic goods, and their price changes have little impact on sales. Think of insulin or life-saving drugs – even a small price hike might not deter desperate buyers.
But for others, like trendy sneakers or fancy coffee, a price bump can send customers scrambling for alternatives. These are elastic goods, where demand plummets with even a slight price increase.
So, what does this have to do with stagnant prices? Even with inflation falling, companies are wary of lowering prices for inelastic goods. They know demand won’t budge much, so why sacrifice profit? Instead, they pocket the savings from lower production costs, quietly boosting their bottom line.
For elastic goods, the story is different. Companies face the seesaw’s other end – a price drop can trigger a surge in demand. This can be a double-edged sword. While sales might increase, the profit margin on each item shrinks.
The result? A complex dance between falling inflation and sticky prices. Companies are carefully assessing their products’ elasticities, playing a game of price optimization where every penny counts.
Three things determine the cost of a product: raw materials, production (including facilities, machinery, and labor), and shipping. Based on those costs and the quality of the product, when compared to the quality of a competitor’s product, a price is established that represents what the consumer will pay to give the company a reasonable profit.
As a rule of thumb, 5% is a low profit margin, 10% is a healthy margin, and 20% is a high margin.
Mondelez, the giant food corporation, spun off from Kraft Foods in 2012, has more than 53 brands of foods, snacks, and refreshments. In the 2021 third-quarter earnings report, they announced plans to raise prices by 7% in 2022. For the consumers who buy Chips Ahoy!, Oreo, Ritz, Triscuit, Cadbury, Toblerone, Trident, Dentyne, and many more popular products, that is a hefty price increase, and they did it because the elasticities factor proves that they can. Mondelez’s gross profit for the twelve months ending September 30, 2023, was $13.369B, a 20.77% increase year-over-year.
The latest numbers from the U.S. Bureau of Economic Analysis, out November 30, 2023, showed that total corporate profits in the third quarter grew 3.3% to an annualized rate of $3.28 trillion. That’s just shy of the all-time peak of $3.3 trillion in Q3 2022.
Why it matters: The rise in profits shows that U.S. companies have adjusted to the post-COVID operating environment, which includes higher wages and borrowing costs.
What is the Federal Reserve doing?
Contrary to what people believe, the Federal Reserve is not trying to make prices fall. The goal of the Fed is to have prices grow a little less quickly than has been the case in recent years but grow, nonetheless.
Economists generally consider an upward trend in prices a good thing as long as it’s happening at a modest, steady, and predictable pace. Some limited level of price growth is believed to help facilitate economic expansion, reduce the risk of recession, and help businesses and consumers plan. For these reasons, the Fed has targeted annual price growth of 2 percent.
In the modern era, we’ve rarely seen price growth turn negative in the United States. Yes, we’ve all seen prices for many individual products swing up and down. Still, year over year, the price of goods continues to climb. The cost of raw goods and labor significantly influence the price of the final product. But another dominant factor desire for increased corporate profits and elasticity—how much the consumer is willing to pay.
However, increasing corporate profits does not always mean raising sticker prices. Many companies camouflage what is essentially a price increase by shrinking the product size, weight, or quantity—a practice called shrinkflation. By shrinking the products, they reduce the cost of raw materials and production costs and, therefore, increase profits. And, even though the quantity of product is clearly printed on the label, as required by law, consumers don’t always remember how much used to be in the container and don’t realize they are paying the same price for less product.
So, what does this mean for consumers? The good news is that while prices might not drop dramatically, inflation’s grip is loosening. The bad news is that the days of instant price relief with falling inflation might be a thing of the past.
Regardless of the inflation rate, spending your dollar wisely is the key—understanding elasticities and shrinkflation empowers us to navigate this price puzzle. Knowing which goods are more elastic and which are shrinking allows you to hunt for deals and switch brands when prices soar.
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