Tuesday, July 23, 2013

Why prices of consumer goods rise (or could rise) when a disaster or other "extraneous" event occurs.

Most producers of a good do not maintain excess capacity to produce and supply a particular good.  It would be costly to maintain facilities and to stock extra inputs/materials over what is necessary to make the good on a daily basis.

If I produce bottled water I maintain just enough machinery, inputs and transportation capacity to make my current production goals. I can make small adjustments here and there, but I try to have my costs as fixed and predictable as possible.

If there is a major, unexpected disruption in the supply chain my cost structure can be altered.

Example.  A looming (or just occurred) natural disaster increases the quantity demanded for bottled water. Stores are screaming at me to get them more water!!

The only way for me to produce what I already produce PLUS additional bottles AND deliver it in the short term is to add a production shift (overtime costs!), order more inputs (plastic bottles,etc) which I likely will have to pay a premium to get quicker, and get additional contract trucks to deliver the water (I likely don't have trucks sitting idle). Or I can have my drivers make additional runs in my trucks but that will incur more transportation costs as well.

All these things increase my costs of producing those additional bottles of water that I NORMALLY don't produce on a daily basis.  The Marginal Cost of those bottles is going to be higher than the ones I usually produce. Hence, I should receive a higher price for those bottles.

But will I?  I may not pass on the cost to the retailer for a variety of reasons.  I may require the retailer to pay me more for the bottles but they may or may not charge their customers more for them. It gets complicated.

But what does not get complicated is the increase in cost associated with producing additional units of a good, assuming no/little excess production capacity.

This posting was inspired by this article.  While it is not about the event of a disaster, the principle still holds.
View My Stats