Real Estate Info: Do Firms Have Pricing Power?

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August 23, 2012

Do Firms Have Pricing Power?

Here's a question every policymaker would like to know the answer to: How much slack is there in the economy? You know the drill: If there's lots of slack, firms have little power to pass cost increases on to customers. But as the economy approaches full employment, the pricing power of firms strengthens, and cost pressures get more readily passed along. The problem is, there doesn't seem to be any practical consensus about the amount of slack in our economy. To paraphrase a well-known adage widely attributed to Nobel Laureate Ronald Coase, we've been torturing the Phillips Curve, but it isn't talking.

We wondered if businesses might be in a better position to say what kind of pricing power they have. So this month we asked our Business Inflation Panel to weigh in on how they might adjust their prices in the face of a hypothetical, unanticipated increase in costs. Not knowing what kind of cost pressure a firm might respond to, we randomly sorted our panel into two groups'one given a 2 percent cost-increase scenario, and one given a 6 percent cost-increase scenario. Here's what we learned:

On average, firms faced with the 2 percent cost increase were likely to pass about 1.3 percentage points (or 66 percent) to their customers. In the portion of our panel considering the 6 percent cost increase, the average impact on customer prices was 3.8 percentage points (or about 63 percent of the cost increase). So in the aggregate, firms think they can pass about two-thirds of any cost increase through to prices, and that belief holds roughly true whether the cost increase is relatively modest or somewhat large.

We asked a similar question of our panel last October, but the responses we got then indicated that firms held a more conservative view of their pricing power.

What effect would an unticipated, 2 percent rise in unit costs have on your prices

Of the firms facing the 2 percent cost-hike scenario last October, only 31 percent said they would pass along most of the cost on to their customers, compared with the 53 percent that said they would do so today (see the chart above).

What effect would an unticipated, 6 percent rise in unit costs have on your prices

Likewise, of the panelists asked to consider a 6 percent cost increase, only 37 percent said they would pass most of the increase on to customers last October, compared with 60 percent who said they would do so today (see chart above).

What's behind the reported increase in firms' pricing power since October? Well, we'd be speculating on that point, but one thing that's changed since October is that a smaller proportion of firms are reporting sales levels 'less than normal' (54 percent compared with 64 percent in October). Said another way, firms, in the aggregate are reporting less slack today than they were ten months ago'a finding that aligns with recent results from the NFIB small business survey showing a decrease in the percentage of firms that consider poor sales to be the primary issue they face.

Percentage of firms reporting sales less than normal

Comparisons across industry groups also suggest that slack may be influencing firms' reported pricing power. Retailers, for example, say they would pass through about 75 percent of a cost increase to their customers, compared with only 64 percent for manufacturers and 60 percent for other firms. At the same time, retailers are reporting that sales and price margins are closer to normal'a sign that their perception of 'slack' is not as great as other firms.

Industry breakdown of the pass-through from the hypothetical...

Does the analysis above indicate that firms are running out of slack? Sorry, but we can't quite go that far on the basis of these two surveys. But one thing seems clear'while our panel of businesses says sales levels are still below normal, sales and pricing power are better today than they were last October.

By Mike Bryan, vice president and senior economist;