January 15, 2006
Volume II Issue 1
Economics 101: What drives prices?
Costs go up and producers try to raise prices. Buyers push back, claiming
market conditions don’t warrant a price increase.
Markets get tight, and producers try to raise prices. Buyers push back,
claiming costs don’t warrant a price increase.
Producers announce and implement four price increases in one year, never
rescind them, and yet at the end of the year, prices are right where they
were at the start of the year.
Markets are weak, demand is flat, and yet prices are rising.
Does any of this make sense?
I’m almost embarrassed to write this because it is so basic, and even
obvious. But these basics are often lost or forgotten in the realities of day to
day business, so a review of these economic basics is worthwhile.
Let’s start with costs. Many people are surprised to learn that in the short
term, in a free market, costs have little or no impact on prices. The long
term is another story, and we’ll get to that, but in the short term, supply and
demand drive prices. If supply exceeds demand, prices fall; if demand
exceeds supply, prices rise. In the paper industry, if the mills are sold out,
prices go up; if the mills are not sold out, prices go down. It’s that simple.
History suggests that for the paper industry, when mills are operating at
about 93%, they are sold out. Mills can exceed this for short periods by
reducing inventory, foregoing maintenance, and other short term tactics, but
at 93%, mills are at capacity and prices go up. At 92%, prices fall. The
difference is only 1%, and market changes can be swift and dramatic.
In 2005, mills attempted price increases and energy surcharges as costs
rose, but these attempts failed because supply exceeded demand.
So, what about costs?
This is an oversimplification, but in any business, costs can be classified at
three levels: Variable Cost, Fixed Cost, and Cost of Capital.
If you don’t cover variable cost, it is better to shut down than to run. If you’re
in retail, if you buy it for $100 you can’t sell it for $95.
If you cover variable cost but not fixed cost, you may be better off running
than shutting down, but you will lose money. Unfortunately, many paper
mills in North America are in this situation all too often. They’re trapped,
because if they run they lose money, and if they shut, they lose more
money. To use our analogy with retail, if you buy it for $100, you can sell it
for $105, but can you afford to pay the rent?
If you cover fixed cost and variable cost, you will break even, but will not
provide a return to your investors. Over the past ten years, this pretty well
describes the paper industry in North America.
So, if the industry is facing these cost pressures, why don’t prices go up?
We’ve already discussed that: supply and demand.
Watch for the next issue:
Economics 102: What Drives Supply and Demand?
Here’s a sneak preview: in the long term, the cost pressures mentioned
above will not directly push prices up, but they will result in high cost
producers shutting down, reducing supply, and balancing supply and
demand. This is exactly what is happening today.
For more information about paper industry supply, demand, and prices, call
Jack Miller at 203 925 0326, or email Jack Miller at
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