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Why companies raise their prices: Because they can

Markups on household items started climbing years before the COVID-19 pandemic. Companies have realized just how much consumers will pay for the brands they love, says research by Alexander MacKay

Published: Jun 7, 2022 11:38:05 AM IST

Why companies raise their prices: Because they canDespite the steady increase, shoppers still bought their favorite breakfast cereals, paper towels, and other consumer goods during the decade and a half before the pandemic began Image: Shutterstock

Grocery bills may be ridiculously high these days, but supply chain problems, energy costs, and inflation aren’t the only factors to blame. New research suggests that companies are raising prices simply because they can.

In 2021, US companies logged their most profitable year since the 1950s, as many took advantage of economies of scale and other more efficient production processes. Yet, firms increasingly held on to the savings they gained from these reduced costs, rather than passing them on to customers in the form of lower prices.

Instead, markups—the difference between prices charged at checkout and the marginal costs incurred by a company in order to make a product—climbed about 25 percent between 2006 and 2019, according to research by Alexander J. MacKay, an assistant professor at Harvard Business School.

Despite the steady increase, shoppers still bought their favorite breakfast cereals, paper towels, and other consumer goods during the decade and a half before the pandemic began, write MacKay, Georgetown University’s Nathan Miller, and the Düsseldorf Institute for Competition Economics’ Hendrik Döpper and Joel Stiebale in Rising Markups and the Role of Consumer Preferences (pdf). The research sheds light on how markups on key household items had already taken off in the years leading up to the Covid-19 pandemic.

“I was surprised to find that product markups went up as much as they did,” MacKay says.

Rising prices don’t stop consumers

To test consumers’ willingness to keep buying higher-priced everyday goods, the researchers examined Kilts Nielsen scanner and consumer panel data for about 14.4 million retail products in 133 categories. The researchers focused on the top 20 brands within each category, including private-label products.

The data included unit sales and revenue by universal product code, or UPC, for each week and physical store. Products included everything from cereal, bottled water, paper towels, and over-the-counter cold medications to specialty soaps, coffee, and frozen pizza.

 The researchers came to a startling conclusion: Consumers were 30 percent less price sensitive—meaning less likely to abandon favorite brands and seek cheaper equivalent products—in 2019 than they were in 2006.

“Here’s one way to think about it: How much would you need to be paid to move from your most preferred brand to your second-most preferred brand?” MacKay says. “Maybe you value a few dollars here and there a little less than you used to. Maybe your preference for your top brand is even stronger than it was 15 years ago. Both of those things play into that price sensitivity component. Either way, our findings indicate that consumers would need to be paid more.”

Consumers are clipping fewer coupons

The authors looked at several possible reasons for the shift, including whether the move to online sales during this time period spurred consumers to pay more for products. While they saw some categories were more affected by online shopping than others, web shopping “really doesn't seem to explain the trend in price sensitivity,” MacKay says.

To study whether the drop in consumer sensitivity was part of a longer-term trend, the researchers turned to coupons, since using them takes effort on the part of the consumer and shows a willingness to hunt for lower prices for similar products.

They found that coupon use plummeted starting in the early 1990s after decades of rapid growth. Consumers redeemed about 7.7 billion coupons in 1992, roughly double the amount in the previous decade. By 2006, the number fell to 2.6 billion, the authors found using data from NCH Marketing and Inmar Intelligence.

In 2019, the last year included in the research, consumers redeemed 1.3 billion coupons, half as many as 2006, despite the abundance of coupons that were available to clip, MacKay notes.

“The number of coupons redeemed has been falling faster than the number of coupons that companies have been issuing,” MacKay notes. “It's not 100 percent conclusive, but it is consistent with consumers becoming less price sensitive.”

Will prices rise even faster?

Meanwhile, company costs have declined over time as firms have squeezed more productivity out of increasingly efficient operations. Since 2006, marginal costs have dropped by 2.1 percent annually on average, the authors estimate. In the latter part of the study period, from 2017 to 2019, firm costs were about 25 percentage points lower versus 2006.

Rising markups come from either price increases or marginal cost reductions. These reductions can come from investments and economies of scale that make larger quantities less costly to produce. The authors find that falling marginal costs are the primary driver of increased markups, in part because the cost reductions are not passed on to consumers.

“What we're seeing, at least in the lens of our paper, is that companies are already realizing this to the extent that they can figure out what price they can charge for their products,” MacKay says. “If you knew your costs were falling, but you didn't have to lower your price, they're already internalizing the fact that consumers are a little less price sensitive.”

That may ultimately mean that companies can reduce costs and keep raising prices without losing many customers, MacKay says. Take consumer product giant Procter & Gamble, one of the biggest companies in the study. In 2012, P&G announced a “productivity and cost-cutting plan” to slash $3.6 billion in expenses by 2019.

In 2021, well into the economic disruption caused by the pandemic, P&G management announced price increases for a range of products, from adult diapers and baby care products to laundry detergent and home cleansers.

“Despite the rapid inflation in prices since the onset of the pandemic, consumers are still buying, likely reflecting a lower price sensitivity. This could continue to allow companies to raise prices faster,” MacKay says.

[This article was published with permission from Harvard Business School Working Knowledge<a target="_blank" href="></a>]