Prices go up. Why? Do prices come back down?

In my last post, I talked about the cost of real estate. In this issue, I want to talk more in depth about the Cost of Goods.

Why do they go up?

I don’t really think I have a good, solid definitive answer on this. Instead, I’m going to try sketching out on version of what might happen.

An easy thing to dissect might be the cost of lumber. 2x4’s have been making waves on the world wide web for having their price jump from $2.50 a piece to a whopping $7.50 over the last year.

Steel’s been doing a similar thing. A friend of mine runs a metal laser cutting business; he says carbon steel prices have gone from about 43c a pound to 70c or so cents a pound.

Normally, he tells me, lumber and steel prices keep each other in check. If the price of steel goes up, then demand just shifts to lumber. If the price of lumber goes up, then demand shifts to steel.

The cost of lumber (and steel) climbing means that anything that needs wood or steel to be built will also experience similar cost increases. For most produced goods, the final price is usually twice as much as the raw cost of the things it took to make them. An increase in the price of some raw components would mean that the price of the final, finished product would cost even more.

Let’s say there’s an widget that retails for $100. The ‘at cost’ price is $50, with $10 of 2x4s in it (at the $2.50 price). If the price of wood triples to $30, the total ‘at cost’ price would climb to $70. If we use the typical “double cost is retail” heuristic, we’ll end up with a new retail price of $140.

A forty percent increase in the raw inputs leads to a 40% increase in the final cost.

Sure, the manufacturer might not double the ‘at cost’ price at least not right away, but over time it’ll move back up to that.

Housing requires steel and wood. When the cost of building a new house goes up, you’d better believe that the cost of existing houses also goes up, commensurately.

They say that the current lumber and steel price hikes are coming from a shortage. I’d like to know who decides to raise prices when a shortage crops up. In theory, they could just keep selling the existing stock at the previous price, right? They’d just run out of it a lot faster. Then there wouldn’t be any lumber or steel left to acquire.

They don’t do this, this isn’t what happened. In fact, I haven’t seen anyone say that they haven’t been able to procure steel or lumber. Just that it’s expensive.

I suspect that what actually happens is that the cost of producing the good goes up. It went up because the factory is still paying people their wages but it had to do a lot of work to shut the factory down while COVID ravaged its workforce or disrupted the supply chain. That means that there were more days with less work for everyone to do, so the product that did get produced actually, physically, cost more money to make. The factory cost the same amount to run, but there was less product coming out of it.

Here’s a quick illustration of how I’d imagine that this works.

Let’s say on a normal non-delay day, a factory can produce 1,000 2x4s. It costs them $100 to acquire the underlying wood, pay their workers, and run the machines. Their costs per piece are $100/1,000 or 10c per 2x4. They add some markup and transportation costs to that and arrive at the $2.50 retail price.

Then COVID hits. A factory that was producing 1,000 2x4s a day is now producing 100. It still costs them $100 a day to run the factory. Their actual cost for that 2x4 is $1 a piece now. If they used their ‘normal’ markup of 25x to arrive at the price, it’d cost $25 a piece. Instead, they use a reduced markup and end up at $7.50.

Demand probably went down too, which meant that they’d need to charge more per piece to cover their costs.

So somewhere between their fixed base costs and the decline in revenue due to less stuff happening because of COVID, the price went up.

Once a lumber manufacturer successfully sells their goods for $7.50 a piece, why would they reduce their costs?

If demand comes back, even at the $7.50 price, would you lower your prices? I wouldn’t, unless demand dropped off enough to impact my bottom line.

The problem with demand, however, is that demand did drop far enough off that you raised your prices. There’s a lot of wiggle room here for demand to skirt up and down before the lumber producing companies start to lose out on business that’s actually just going elsewhere.

The problem is, the same process that impacted lumber also impacted steel. Normally competitive pressure between the two would result in the prices coming back down, as they played off against each other, until they got down to the point where they were back at 1,000 pieces a day cost plus some built in profit percentage.

There’s no roadmap for how that’s going to happen however. They might come down a bit, but short of a new competitor hopping into the market and undercutting the new normal price level, I’d bet that prices stay high for the foreseeable future.

When the base costs of goods goes up, the end user costs also go up, often at the same or a faster rate. Since wood and steel are in so many things, this is going to push up the prices of a lot of things.

Thank goodness plastics (and the price of oil) are still cheap. Right?

/me glances nervously at the Suez Canal blockade