If microeconomics teaches us anything, it's that rising prices are associated with lower levels of demand. With inflation at 9 per cent, soaring prices are pushing up costs. Companies, in turn, are under pressure to pass these on to consumers through higher prices. Yet there is increasing evidence that prices can get stuck.
For companies selling non-essential products, inflation poses a significant threat. For these ‘elastic’ goods, quantity demanded is prone to snapping back with a painful twang as prices start to rise. Companies selling ‘inelastic’ essentials typically fare better: levels of demand remain relatively constant as prices increase. Items such as food, shelter and healthcare tend to have steady demand, with people buying constant quantities regardless of price changes. In theory, this gives companies the power to raise prices in line with inflation, leading to resilient earnings. This should spell positive quarterly results, happy investors and inflation-busting share price growth for consumer essential stalwarts.
Historically, this has been the case. Sean Markowicz, multi-asset strategist at Schroders, found that from 1973 to 2020, US consumer essentials stocks had a high probability of outperforming inflation over the period. Consumer discretionary stocks fared significantly worse, generating an average inflation-adjusted return of -7 per cent, and beating inflation less than 30 per cent of the time. This makes sense. Discretionary (non-essential) purchases such as takeaways, alcohol and holidays all tend to exhibit ‘elastic’ demand, and prove much easier to cut back on as prices rise.
But if it looks as though the secret to investing in times of inflation is as simple as exposure to companies dealing in inelastic consumer essentials (think Unilever (ULVR) and B&M European Value Retail (BME)), the reality is more complicated. Defining discretionary and essential products has always been an abstract art, and two years of pandemic restrictions have had a huge impact on consumption patterns. Business closures and social distancing regulations rendered over 20 per cent of regular consumer spending impossible during the first lockdown, encouraging consumers to re-evaluate what they consider a ‘staple’ purchase.
Nor is it easy for companies to gauge price elasticity of demand in practice. Netflix (US:NFLX) had boasted 10 years of constant customer growth, and picked up almost 55mn new subscribers over the pandemic. For a time, demand for streaming services seemed insatiable. But we know what happened next: April’s first-quarter (Q1) results saw Netflix report a loss of 600,000 North American subscribers and 400,000 more in Latin America as consumers baulked at price increases. And as inflation bubbles on, more companies will be forced to test whether their demand is really as resilient as they hope.
The growth of shrinkflation
Yet companies with lower pricing power have another means of protecting their bottom lines: ‘shrinkflation’. Shrinkflation describes products becoming smaller while the price stays the same. Consumers therefore pay the same amount of money for less: we see inflation in another guise. And the idea strikes terror into the hearts of consumers: note the howls of outrage when the gaps between the triangles in a Toblerone expanded and the corners of a Dairy Milk bar were rounded off.
But a recent report from Jun Yao, Di Wang and Gary Mortimer at Macquarie University suggests that consumers doth protest too much. Their research mocked up different price and size combinations in a Brisbane supermarket. Consumers were presented with a choice between offers implying a price increase, a static price and a smaller size (shrinkflation), a size increase and a greater price increase, and a shrinkflation variant that saw the product’s price fall but its size reduced even more. Crucially, all four options represented an identical increase in per-unit price.
Shoppers overwhelmingly preferred the final shrinkflation option, with the old-fashioned increase in price proving the least popular. This was attributed to the idea of ‘loss aversion’ developed by Kahneman and Tversky in their work on Prospect Theory. Loss aversion reflects people’s preferences for avoiding a loss over acquiring a gain. In this case, it means consumers prefer the mixed bag of lower prices and smaller products to the purely negative outcome of higher prices – even though the per-unit cost is the same for both. Yao, Wang and Mortimer note that an automatic cognitive response seems to have kicked in here too, with shoppers in a supermarket more attuned to looking at prices than weights.
Prices make a quantum leap
This is unexpected. According to the smooth curves of a supply and demand diagram, higher costs of production lead to higher prices and reduced levels of consumer demand. This reduction is expected to be more significant for non-essential products with elastic demand, and less severe for consumer essentials with an inelastic demand curve. But shrinkflation means that headline prices are staying rigid when we expect them to move towards a new equilibrium. And this is making the impact of rising prices on consumer demand more difficult to predict.
‘Quantum pricing’ at retailers such as Apple (US:AAPL) and Zara complicates matters even further. Quantum pricing sees retailers cluster prices around a few key values – think £4.99 and £9.99, rather than £3.64 and £5.43. Under quantum pricing, prices change rarely, but when they do, they leap – often jumping from one key price point to the next. A 2021 working paper by Diego Aparicio and Roberto Rigobon suggested that this was down in part to the ‘menu costs’ faced by a business – so-named to reflect the cost of reprinting menus when a restaurant changes the price of a dish. Menu costs can leave companies reluctant to change prices until there is a significant disparity between the current price and the equilibrium market price, meaning sudden and significant price changes.
Economists have always known that smooth supply and demand curves are a simplified model of a complex world. Yet empirical evidence on shrinkflation and quantum pricing suggests that the real world’s lumpy curves have been airbrushed beyond all recognition. And this has the potential to make the job of calculating inflation increasingly difficult.
Sticky prices make for noisy data
Quantum pricing means that when prices eventually change, they do so erratically. Research suggests that this may require the Office for National Statistics (ONS) to consider a larger basket of goods to accurately capture general price movements. Quantum pricing can also make inflation data noisier: it can be hard to differentiate between ‘historical’ price increases delayed by menu costs and sudden sharp inflationary shocks.
Keeping track of shrinkflation also causes statistical headaches. The ONS has reported on the phenomenon since 2012, and found 2,529 cases between 2012 and 2017. But calculating shrinkflation is no mean feat. Data collection on product sizes is typically poor, and the ONS is forced to manually compare the previous product descriptions recorded by price collectors with current sizes. This is complicated by the fact that many products are sold per unit (eg ‘bacon per kg’) or have no recorded size (eg ‘one donut’). This labour-intensive collection process means that, unsurprisingly, shrinkflation data is not regularly updated.
The ONS’s most recent release covers September 2015 to June 2017, a time of low inflation (CPIH ranged from 0.2 per cent to 2.6 per cent). Shrinkflation over the period was noteworthy but not widespread: 1-2.1 per cent of food products in the sample got smaller. But as my chart shows, prices tended to stay static as these size changes occurred – meaning that consumers got less value for their money as products shrank. With consumer price index inflation at 9 per cent in April and food prices up 6.7 per cent year on year, we could find that the idea of protecting margins by shrinking products becomes increasingly attractive to companies.
And although it is easy to spot changes in our favourite food products, there is scope for sneaky shrinkflation in other industries, too. Hotels hit by soaring food prices and staff shortages could ‘shrink’ their product by reducing the frills offered with a room. Clothing manufacturers facing rising freight, labour and materials costs can also change the cuts of their products to appease cost-conscious consumers. If shrinkflation provides a buffer for companies at risk of customer cutbacks, it could leave consumer discretionary stocks more resilient than anticipated.
Consumers might initially find little to celebrate in paying the same amount for less. However, Prospect Theory suggests that they will find this situation preferable to a straightforward price hike. As for producers, shrinkflation can allow companies dealing in non-essential products to protect their bottom lines, while avoiding unpopular price rises. Although sticky prices can render markets less predictable, they may well help a few companies out of a sticky situation.
