Sunday, April 19, 2009

In the Long Run, Prices will Fall

In the Long Run, Prices will Fall.

Prices, of good and services, is made up of:

Raw Material + Capital Cost + Labour + Profit = Price of Goods or Services

This simple rule apply to almost all known new goods and services. Of course creative marketing would tweak on the final price. We are not going to dwell on microeconomics of good and services, but examine the impact of current economic turmoil on future prices of good, services, capital, commodity and labour.

Raw material
The most watched price of commodity, oil has had a rough ride for the past year. At its peak, it reached $147 per barrel, and then as the news of falling demand due to recession sink in, it has fallen to current level of $40-50 per barrel. At its peak, expensive oil has spurred new initiative to energy saving and research into alternative energy sources. As the new habit of saving energy and exploiting alternative energy come in stream, demand for oil will be lower. Other commodities like metals and food have also reached its peak in the past year or two. This has also spurred efforts in recycling and savings. True that demand from India and China were behind the bull market in commodities for the past 3 years, but new supply sources have come in stream and industrialized economies has also making significant savings and recycling.
I don’t expect raw material prices to increase significantly in the near future.

Capital Cost
The current economic turmoil brings in new opportunities; lower interest rates, hence lower capital cost. Most major economies, USA, Britain, Europe, Japan and Australia have reduced their headline interest rate to near zero.
The rout in the stockmarket, whereby major indexes has fallen up to 40% in the past 6 month also contributes to the lower cost of capital. Shares/stocks are usually the most expensive form of financing, but with the share prices have fallen so much, the expected dividend is also lower. Take example of Citigroup, at its high of $27.35, stock holders expecting 5% return would expect at least $1.35 dividend, but at today’s price of around $3.60, a $0.18 dividend would be adequate.
As we know major economies are flooding the market with cheap money, so we can expect that cost of capital will continue to be low in the near future.

Normally labour cost doesn’t change much, workers would not be willingly take pay cut, but significant savings could be made in perks and bonuses. Firms normally fire their surplus workers as demand falls, because they cannot reduce wages.

In recession, profit expectation is lower. It’s simply obscene to make huge profit when everyone else is losing money. So firms tend to pass on the savings and offering deep discounts and gain market share during recession rather than reporting big profit.

All those components of price indicate lower price.

Some people have estimated that up to $3 trillion dollars of wealth has been destroyed in this economic turmoil. Housing assets values have plummeted across the world. A house that was valued and bought for $700K now only worth less than half of its purchase price in some counties in California. The same story in Dubai, UAE. Individual wealth has taken a hit. Here in New Zealand average price for houses has fall by 9% for the past year, and some people owe more than their house is worth, ie negative equity.

What do you think average person would do in this situation? Most people, knowing that their wealth has taken a hit, feeling poorer, would work longer to build up their wealth again. They would save more, and put that idea of early retirement on shelf. We would see higher productivity; hence more goods and services become available at lower prices.

1 comment:

Hamba said...

Not true...If the corruption index rises exponentially which it will under najib's admin...Prices will go up still..Just look at the toll rate, it should have gone down but no, it went through the roof just over a couple of years....Toll company are making profit of billions and still receiving compensation??? That the corruption index going up!