MARKET COMMENT
Beware of Unexpected Price Increases

By David Kuo (TMFDragon)
November 9, 2001

Carburton Street, London -- A recession or even the spectre of a downturn in economic activity can invoke some unexpected responses from companies. Simple economics, and even intuition, would suggest that if a company anticipates a drop off in demand for its product or service, it should immediately trim prices to boost demand. However this relies on the premise that the product or service will respond positively to a cut in price. But life isn't always that simple.

Airline operators, like British Airways (LSE: BAY), will find that demand for first and club class air travel is largely inelastic. This means that shifting prices either upward or downwards will have minimal effect on the number of passengers that will use this type of premium service. This is in contrast to demand for budget air travel that can be highly elastic. Ryanair Holdings (LSE: RYA) and easyJet (LSE: EZJ) in response to a reduction in demand for air travel immediately slashed prices. This is known as survival pricing and is used when a company is faced with over capacity. This is a short-term strategy and is highly effective as long as prices cover short run costs and some of the fixed costs.

Telecom companies have shifted their focus away from customer acquisition and moved in favour of increasing the revenue that it generates from each customer. This strategy towards improving ARPU or the average revenue per user has resulted in the reduction of subsidies for mobile handsets. In the early stages of market development, the wireless telecom operators were more interested in maximising sales growth. This resulted in market penetration pricing prompted by the belief that higher sales volume would lead ultimately to lower unit costs. There is now a concerted and conscious shift towards perceived-value pricing with the more mature user now prepared to pay a little bit more.

Some debt-laden cable operators have also embraced the ARPU concept and used price increases to boost revenues. NTL (Nasdaq: NLI), the Nasdaq-listed company that operates predominantly in the UK, plans further price increases following news that BSkyB (LSE: BSY) intends to hike prices early next year.

It is a popular misconception that recession is accompanied by price reductions that will benefit consumers. In fact quite the exact opposite can happen as companies compensate for falling demand with increased prices. The really scary bit is that businesses are then reluctant to reduce prices once those prices have settled at a higher level. And is that going to cause inflation? You betcha.

The author owns shares in British Airways.