With the latest data coming out today from the Bureau of Labor Statistics on inflation, there is likely to be continued discussion about rising cost of food. The latest data show a 2.6% year-over-year (i.e., July 2020 to July 2021) increase in the price of food at home and a 4.6% year-over-year increase in the price of food away from home. These figures aren’t crazy high but they are higher than what we have come to expect in the past decade. For example, average year-over-year increase each July from 2009 to 2019 (i.e., the decade preceding the pandemic) for food at home was 1.04% and for food away from home was 2.54%.
In engagements in recent months with some food brands and agri-food investment groups, I’ve been asked my thoughts about whether demand for “premium” or “niche” products might be more or less affected by inflationary factors.
One way to think about this is the elasticity of demand, which tell us how the quantity (Q) that consumers want to buy varies with a change in the product’s price (P). The basic formula for a product’s demand elasticity is given below:
This formula tells us how much the quantity demanded will change (in percentage terms) with a 1% change in the product price. The term, ΔQ/ΔP, is the slope of the demand curve. It’s hard to outline any general rule for how this slope varies for conventional vs. “premium” products. However, the later term, price divided by quantity (P/Q), is almost certainly higher for premium than conventional products. By definition, premium products have a higher price and it is typically case that premium products have smaller sales (a smaller Q) than conventional products. Thus, there is reason to believe, based on the formula above, that “premium” products and brands will have larger demand elasticities - i.e., they will be more price elastic than conventional non-premium products. This would mean that a 1% change in a “premium” product’s price will cause a greater percentage change in the quantity of the “premium” product demanded than would be the case for conventional products.
So, what does the data say? There are a million “premium” products, but let’s look at a few examples. A study I conducted a few years ago estimated demand elasticities for organic and cage free eggs vs. conventional eggs using grocery store scanner data. The demand elasticities for cage free, organic, and conventional (in Dallas) were -2.99, -1.52, and -1. Thus, as suggested above, the premium egg products are more price sensitive (at least in percentage terms) than the conventional. As another example, consider this study by Dhar and Foltz on milk demand, which also used grocery scanner data. They found own-price demand elasticities of -4.4, -1.4, and -1 for non-rBST, organic, and conventional milk. Again, the premium milk products are more price sensitive (in percentage terms) than the conventional. Another example is this paper by Lin et al., which shows demand elasticities for organic apples, bananas, and grapes are -1.1, -3.2, and -3.5 whereas for elasticities for conventional apples, bananas, and grapes are -0.83, -0.7, and -0.49, respectively. In all these examples, the “premium” products are more price sensitive than the conventional products.
The above discussion would suggest that inflationary factors related to increased costs of labor, energy, or packaging, that push up retail prices will have a bigger impact on sales of premium products. That being said, keep in mind that a 1% change in the price of a premium product is a much larger absolute price change than a 1% change in the price of conventional product.
For example, suppose organic eggs sell for $3/dozen whereas conventional eggs sell for $1.5/dozen. Suppose higher costs of packaging mean each carton is now $0.25 more expensive. If this cost is fully passed on to the retail price, this would imply a (0.25/3)*100 = 8.3% increase in the price of organic but a (0.25/1.5)*100 = 16.7% increase in price of conventional. So, a fixed per-unit increase in cost will have a bigger percentage impact on conventional products than premium ones.
Even if own-price elasticities of demand are larger in absolute value for premium products, increased production, processing, and transportation costs are likely to represent a smaller percent of the retail price for premium than conventional products. In this context, it is important to keep in mind that conventional and premium products are demand substitutes. A phenomenon dubbed the Alchain-Allen or “ship out the good apples” effect comes into play. Wikipedia explains it as follows:
“when the prices of two substitute goods, such as high and low grades of the same product, are both increased by a fixed per-unit amount such as a transportation cost or a lump-sum tax, consumption will shift toward the higher-grade product. This is because the added per-unit amount decreases the relative price of the higher-grade product.”
In sum, it’s hard to know whether premium products are more or less affected by inflationary factors than conventional products. Premium products might be expected to be more demand elastic; however, if costs are increasing in a way that increases per-unit costs by a fixed amount, this will have a higher relative impact on conventional products. How’s that for economic “on the one hand … on the other hand” answer?