Photo by Adi Goldstein on Unsplash
 

Computer chip prices are plummeting. But wait—weren’t we in a chip shortage that should keep pushing prices upward? It turns out that chip prices illustrate an important economics lesson: Prices in capital-intensive industries are highly volatile. This has played out in oil prices, airfares, and a myriad of other industries.

It costs a lot to build a computer chip plant. Intel (INTC) just spent $3 billion on the expansion of an existing facility in Oregon. Any expenditure costing that much will take some time. This expansion began in 2019 and was finished in 2022—and it was just an addition.

Yet in the space of time required for an expansion, a lot can change. Pandemics bring death, wars are fought, and recessions can come and go. If demand rises quickly and unexpectedly, supply cannot keep up right away. Prices rise. More supply will bring the prices down, but the capacity to supply more products takes time to build.

The same slow supply adjustment is even greater in oil. New production begins with an evaluation of geology, then new seismic tests, exploratory wells, production wells, and infrastructure to get the oil to market. A decade can pass during the process. In the meantime, prices shoot up.

But what if demand falls unexpectedly? Most of the production cost is fixed by the high capital expenditures. Actually running a computer chip plant or an oilfield is relatively small once it is built. So falling prices don’t dissuade producers from cranking out products—at least until prices fall tremendously far.

The many airline industry bankruptcies illustrate the challenge of capital-intensive businesses. (Bankruptcies include Eastern in 1989 and 1991, Braniff 1982, Continental 1983, Frontier 1986 and 2008, Pan Am 1991, National 2000, TWA 2001, US Airways 2002 and 2004, United 2002, Air Canada 2003, Northwest 2005, Delta 2005 and others.) When demand softens, companies cut prices to keep sales up. At some point, they have cut prices so much that revenue drops below their total costs.

They don’t stop operations when price fails to cover total costs, because, for capital-intensive businesses, most of their costs are fixed costs, such as debt service. They have to pay that cost whether they operate or not. Their decision to keep running the business depends on whether the price covers their variable cost. For an airline, that’s airplane fuel and labor. For an oil producer, it’s the cost of running pumps and getting the oil to a refinery. For a computer chip company, it’s a little labor and silicon. Thus, the volume of products supplied hardly falls at all when demand is down, so the price has to plunge really far to bring supply into equilibrium with demand.

Compare capital-intensive businesses to less capital-intensive businesses. Many neighborhoods have tutoring companies for students. The capital expenditure is low: the upfront cost to rent an office and some advertising. Tutors are hired as customers are signed up. Most of the cost is labor that can be cut back if demand weakens. The businesses can scale up quickly when demand surges. And none of these companies operates at a loss for very long. Pricing is fairly stable.

Even businesses that are not capital-intensive must understand this concept. A company’s customers may be capital-intensive businesses, or its suppliers might be capital-intensive. Providers of ongoing services to capital-intensive companies will enjoy fairly steady sales. But providers of capital equipment to the same companies must be ready for boom-bust cycles of expansions. Companies that buy products from capital-intensive companies should prepare for extreme price volatility.

This simple generalization is usually understood by veterans of the industry, at least at the gut level, New management may have to figure it out for themselves, and their customers and suppliers need to learn this generalization and apply it to their own situation.

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