A few months ago, I mentioned in my marketing strategy course at Columbia Business School that in most industries, real costs and prices decline over time. Without getting too technical, the reason is either that manufacturing costs generally decline over time with accumulated production (the “experience effect”), global sourcing optimization reduces factor costs over time, technology disruption introduces inherently lower cost solutions, or some combination of all of the above.
The consumer doesn’t always see these effects at the checkout counter because the quality of goods and services continues to increase to meet rising consumer expectations. For example, the base price of a Honda Accord in 1993 started at $13,800, equivalent to $22,207 in current dollars. Fast forward twenty years and the base 2013 Accord starts at $21,680. So prices haven’t declined very much, but, over twenty years, for essentially the same price, consumers are getting a vehicle that is bigger, better handling, faster, quieter, more fully equipped, more fuel efficient and safer. If consumers were willing to live today with the quality of vehicle offered twenty years ago, prices would indeed be considerably cheaper.
Of course in the high tech sector, consumers have benefited from both dramatic increases in product quality (speed, capacity, etc.) and dramatically lower costs. Moore’s law has been good to consumers.
So are there cases where prices have gone up rather persistently, without commensurate improvements in quality? The answer is yes and it’s worth exploring these exceptions, because such situations generally portend an ominous outlook for the companies involved. If you’re in such and industry, enjoy it while you can.
As a general rule, when real industry prices are increasing, adjusted for quality effects, it indicates that the industry is undergoing a structural change in competitive dynamics. Specifically, it either suggests:
- Industry structure has at least temporarily conveyed pricing power to current players, either because of high degrees of concentration, high customer captivity or both
- Industry disruption is eroding incumbents’ core business, inducing them to raise prices on remaining loyal customers to shore up revenues
Neither of these cases is sustainable long term, and you should expect inexorable pressure for quality-adjusted real cost and price reduction to reassert itself over time. In the first case, increasing prices will attract more competition, undermining the pricing power incumbents temporarily enjoy. And in the second case, low end disruption will inevitably overwhelm incumbents’ remaining business.
Let’s look at examples of both situations.
Industry Structure Effects
In the airline industry, it is well known that legacy carriers were unable to earn their cost of capital for the first three decades following industry deregulation in 1978. Bruising competition driving chronic over-capacity, exacerbated by disruptive low-cost carrier entrants resulted in massive shareholder value loss, liquidations, bankruptcies and industry consolidation.
But as consolidation reshaped the industry — the top four US airlines now account for over 80% of passengers flown — surviving players have finally been able to exercise discipline in capacity planning and pricing. As shown in the exhibit below, airline fares have reversed their long term decline, as overall industry capacity has been scaled back.
Moreover, it should be noted that airline prices have been rising despite a decrease in product quality. In particular, not only have airlines been raising prices for lower flight frequency, but they have simultaneously been significantly cutting service features that used to be gratis. Not counted in the fare increases noted above are the fees now collected for checking baggage, onboard meals and reservation changes. For some airlines, fees account for over a third of fare revenue.
These actions have had a salutary effect on industry profitability and stock price performance. Over the past five years, airline stocks have increased in value by more than 3X. But if airline fortunes continue to improve, expect new entrants to be attracted by favorable economics, which should moderate continued price increases and service cuts.
Raising Prices in Good Times…. And in Bad
The newspaper industry is interesting, because it demonstrates a case where the same company raises prices in good times and bad, for both of the reasons noted above. In the first five years of the new millennium, the New York Times was enjoying an admirably strong competitive position. Sure, print circulation had been essentially flat since 2000, but other newspapers were faring far worse. Internet news was still in its infancy, (Google didn’t IPO until August of 2004), and the Times’ customer base of over 1 million subscribers were generally loyal and price insensitive. For most Times readers, competitive news sources were considered unthinkably inadequate — an ideal case of strong customer captivity.
Not surprisingly, the Times exploited its strong position by raising prices. Between 2001 and 2006, the Times raised print subscription rates by 24% nominally and by 9% in real terms, while revenues from news operations grew consistently through a 2006 peak of $3.2 billion. These were good times at the Gray Lady!
But alas, as we now know, in the years that followed, the Times, as well as the newspaper industry as a whole, suffered severely in a perfect storm of:
- Severe declines in general advertising revenue from a deep recession
- Internet-driven industry disruption, characterized by:
> Loss of highly profitable classified ads to Craigslist et al
> Loss of employment ads to monster.com et al
> Accelerating declines in readership, as internet news sources proliferated
> Accelerating declines in advertising revenues as ads followed readers to the internet.
To put a punctuation point on the severity of newspaper industry disruption, between 2005 and 2013, daily newspapers in the US lost 42% of its daily subscribers and advertising revenues declined by over 60%.
So what’s a disrupted company to do to respond to competition offering comparable products at lower prices or, most often, for free? As is often the case, disrupted companies raise prices despite (and in fact because) of sagging demand. And that’s exactly what the New York Times did. Between 2006 and 2013, for example, the Times raised home delivery subscription prices by 28% nominal and 11% real — a faster rate of price hikes than in better times.
Now of course, implementing price hikes alone is a bit like trying to hold back a disruptive flood by sticking a finger in a crack in the dam. Ever-escalating subscription price hikes will only accelerate the migration to lower cost (and less profitable) online news formats. And to their credit, the Times is working valiantly to find a post-digital business model to support its expensive news gathering operations.
But the fact remains, that if you observe a company persistently increasing real prices in quality-adjusted terms , it usually means that the company is already in the midst of, or about to become disrupted.
Other Price Hikers Facing Disruption
What are some other industries to watch out for that fall in this category?
Book publishers have been surprisingly reluctant to date to increase the price of hardcover best sellers. But as ebooks continue to gain share, readers who continue to prefer the heft and feel of a paper book should expect to pay considerably higher prices, as digital disruption continues to take its toll on printing economies of scale. On the brighter side, enlightened publishers may create digitally enhanced ebooks that create a higher consumer willingness to pay.
Health care costs have escalated far faster than the general CPI, and of course this sector has attracted considerable political attention in calls for industry restructuring. As a nation, everyone agrees with the need to “bend the cost curve”, but agreeing on how has proven elusive.
But perhaps the most egregious case of price escalation portending industry disruption is in higher education. As shown in the figure below, over the past three decades, tuition rate increases have outpaced the CPI by 4X, despite considerable evidence that the quality of education delivered has not improved. There is both an economic and moral imperative for higher education disruption, which warrants further discussion unto itself. Stay tuned.