Sunday, January 30, 2011

Volume 3 Issue 5: Two-Cent Economics

Finding Inelastic Demand to Fight Inflation

In the previous issue of the Mainstreeter, we brought up how companies that produce goods with price inelastic demand could raise prices to pass on the effect of higher costs to its customers. This would in effect, pass on inflation to their customers, and thus buffering their profits.

While we can go into great detail about what price elasticity means and talk about its mathematical derivation for the sake of precision, we should keep in mind the goal of using this concept as a tool to help us look for good companies to invest in.

Because of that, we would only venture as far as the intuitive definition of price elasticity. In the broad sense, as the term elasticity suggests, price elasticity of a good measures the sensitivity of its quantity demanded to a change in price.

In all our explanation, we shall assume that the goods we are discussing face normal demand curves, in that when the price of that good increases, the quantity demanded will fall. Now for the formal definitions.

A good that is price elastic is one which would have a more than proportionate decrease in quantity demanded for an increase in price. Conversely, the quantity demanded for a price inelastic good would decrease by less than the proportionate price increase. 

Here is a better illustration. For example, if the quantity demanded for cheesecakes fell by 15% (more than 10%) when the price of cheesecakes increased by 10% during the Chinese New Year, then the demand for cheesecakes would be classified as price elastic.

In the case of vegetables, the 10% increase in price during the same season caused the quantity demanded for  vegetables to drop by 5% (less than 10%). This means that the demand for vegetables are price inelastic.

While it may need a bit more justification, I would just like to point out that when the demand for a particular good is price inelastic, an increase in price would raise the total revenue received for selling the good. This is because the rise in prices more than offset the decrease in quantity demanded. Also, a relatively price inelastic demand curve would allow the producer to pass on rising costs to consumers by raising prices. Bear in mind that it is in this context that we are looking at price elasticity.

Now that we have the definitions out of the way, what causes the demand for goods to be price inelastic? That is what we want to look for when we are analyzing the products of the companies that we are researching.

1. Availability of substitutes

This is intuitive. If the good that the company we are looking at produces has many substitutes, it would be less able to raise prices because its customers could easily switch to buying from the company's competitors. Hence, we want to invest in companies that produce goods which not many other companies can produce. For example, aeroplane engines. Not many companies in the world can produce aeroplane engines apart from Rolls-Royce. In addition, the quality of the engines also play a huge role because of the safety requirements needed in the aeroplane industry and not many people can match that.

2. Price as percentage of income

When a good costs very little as a proportion of our income, we tend to pay less attention to its price increases. Hence, the good would be relatively price inelastic. If we are talking about say, a car, then any amount of price increase would create a bigger deterrence to purchase as the car comprises a large portion of  our income.

3. Degree of necessity

This ties in with the vegetable example. Goods that are perceived as necessities tend to be price inelastic. Another example would be banking services. Most of us need to use banks for savings, loans, credit card purposes.

4. Brand loyalty

Well, this is pretty self-explanatory. Some of the more famous brands I can think of are probably Coke, Apple, and Intel. Barring anything that would give these names bad reputation like what Toyota is facing, it would be difficult to disrupt the brand loyalties that these companies have. Hence, an increase in prices would unlikely change the preferences of their customers.

That said, it would be rather difficult to find companies that produce goods that have all of the above factors. Nonetheless, we can look for goods that have as many of the above-mentioned qualities as possible. Bear in mind that there are a few other minor factors that I left out, but these should be a good enough guideline to get you started.

Of course, price elasticity may not have to be applied to only consumer goods. It can be applied to intermediate goods as well. So, when you try to think of goods that are price inelastic, do not limit yourself to end-products. Think of the ingredients and parts as well. These will help you find companies that can maintain robust earnings through inflationary periods. This is particularly important as we are possibly experiencing a period of high inflation right now. Firms that are not flexible enough to pass on the rise in raw material costs will take a hit in their profit margins and could even suffer losses in the coming quarters.

That could be a good excuse for the stock market to cool off even more and provide some buying opportunities.