The Cost Disease

In today’s post, we talk about an idea in economics called the Cost Disease and how it affects the prices of the things we buy. It’s an interesting idea which allows us to pick apart the FP industry and think about how it might change the industry in the future. 

Before we start, I want to say that the analysis in this post is based around a core principle in economics called ceteris paribus (‘all else being equal’). It means that we’re assuming nothing is changing except for the one variable – which is unrealistic, but it’s a useful way to explore and tease out the effects of one particular change. 

To begin, we let’s discuss a common misconception about product prices. For most physical products – cars, kitchen appliances, clothing, IT, etc. – the quality-adjusted price will decline over time. Either the products get cheaper, the quality improves (in terms of reliability, features, design, and the like) or both. That might strike some of you as quite wrong but there’s decades of data which bears this out. 

Televisions are a great example: in the mid-1950s, a decent television would have cost around $500 and a typical schoolteacher’s salary would have been around $3000: roughly two month’s wages. Today, the average wage for teachers is around $60,000 while you can still pick up a decent television for roughly $500. While it’s the same price as 60 years ago, it now costs less than half of a week’s wage so televisions are now just one-eighth the price. It’s probably fair to say that the quality is a bit better today than in 1953.

That’s a result of competition. Brands compete by continually improving their value proposition to buyers: to try and sell more product, they offer a better price or a better product. Other firms respond by also improving their own proposition, and consumers benefit from that competition. Typically, firms making the cheaper products in any particular market will focus on reducing costs while firms at the more expensive end will focus on improving quality. Releasing the Twsbi Eco in a new colour probably isn’t going to blow anyone away, but slicing another $5-10 off the price could catapult sales. At the other end, cutting $25 off the price of a Pelikan M800 probably isn’t going to sell all that many more units but introducing a new colour variation (like the Stresemann) might lead to thousands of extra sales. 

Unfortunately, this tendency of falling prices isn’t true of everything we buy. Food and energy costs tend to be more cyclical – they go up and down in a fairly random way – while land and property prices tend to increase (most at the time, anyway). But the service sector is the part of the economy where this rule doesn’t seem to apply at all.

At first glance, this might not make sense. Services principally comprise education and healthcare but also include communications, construction, finance, culture, retail and wholesale, and legal work. Most of these sectors are fairly competitive, so you would expect the same forces to apply to them as apply to physical products. And research does seem to bear this out: competition forces down costs (although not prices) and improvements in quality, at least in the more competitive industries. But there’s something else going on, something which cancels out all of that. 

Back in the 1960s, a couple of economists twigged to the fact that one type of cost was rising in the service sector, well beyond what you’d normally expect: wages. It’s a bit of an oversimplification but increases in wages are generally tied to improved productivity (performance). If you think of a factory, employees making more product means the business can sell more, which means there are funds available for higher salaries. But Baumol and Bowen identified that service sector wages seemed to be rising without productivity growth, and rising quickly enough to offset the gains from competition. 

Rising wages are a good deal for workers but it’s not such a good deal for consumers. Even as the prices of most products consistently fall, the price of services ends up rising – even if the product isn’t improving in quality. There was a semi-recent report from the Cato Institute which put this into sharp perspective: the total, per-student cost of K-12 education in the US increased threefold between 1970-2012 while math, science, and reading scores were essentially flat. Taxpayers were forking out a whole lot more money, and teachers were earning more, but there wasn’t any actual benefit for students or for society as a whole. This shows the problem of the cost disease pretty dramatically. (And, if you’re wondering, the problem is actually far worse in tertiary education. The cost of college has increased even more while academic outcomes have actually fallen.)

Baumol and Bowen’s explanation for this is that workers in many sectors of the economy are getting more productive, and this forces wages up for everyone else. My own region is a good example of this: there was a major mining boom north of here around 2005-10, which led to an explosion of high-paying jobs which required no special skills. You could graduate high school one day and start work the next, driving a truck on a minesite and earning US$120k. For local businesses like retailers and restaurants, this made it very difficult to hold onto employees and so they were forced to raise wages. It also distorted the quality of their employees, which meant the workers were performing less and less well but getting paid more and more. And for small businesses forced to double wages, the only way to survive was to increase the price of their products. Clearly, the consumer is getting screwed in this situation as they’re left paying exorbitant prices and receiving slow, terrible service. 

Recently, a hypothesis has popped up in the econ-blogosphere that suggests the cost disease is largely concentrated around work which requires an individual’s undivided attention. (It’s a bit more complicated than this, but this definition works for our purposes.) While the hypothesis hasn’t been tested, it’s an interesting idea to think through. There are lots and lots of things which we could do with our time, and now we have more opportunities than in the past, as well as an improved ability to multi-task. Given we can do more with our time, and we have more alternatives, it means that getting out undivided attention is more expensive than it used to be – so we demand to be paid more for that. This fits with healthcare and education, both areas which involve a lot of undivided attention and one-on-one interaction, but it also works for a lot of other services – including some of the services we enjoy in the pen community. 

Organisation of the FP Industry

Before we can apply the hypothesis, it is useful to unpack the organisation of the FP industry. As a simplified model of the supply chain, there are four stages: design (which sometimes incorporates marketing insights about consumer segments and their tastes), production, distribution, and retail. These are just the activities which need to occur; while the activities are separate, there’s no reason why one business can’t operate at multiple segments. A brand like Montblanc sits across all four stages, Pilot sits across the first three, while a business like Couronne du Comte is only active in one (retail). Firms can also change what they do: Nock Co have effectively moved from the first two stages to just the first one. 

If we assume that every stage of the supply chain was equally competitive, and the firms in each stage were equal in all respects, everyone would make the same return on investment (basically, their profit margin). In reality, neither of these assumptions are true, but by relaxing those assumptions we can start to figure out how the industry works. 

FP retail is a fairly competitive business overall and this would suggest that the average retailer only earns a normal return (basically, a break-even profit – say 5%). But not every retailer is average, and I suspect that there are a select few who earn an excess return, a profit well beyond that earned by their competitors. I very much doubt that group includes any retailers who predominately or exclusively sell product through a physical store: their markets are too small to get the volume and economies of scale necessary to punch through. 

Distribution strikes me as a business which is even more competitive. Although they are under-appreciated by the community at large, they perform an important role by taking on a lot of the heavy lifting which would otherwise fall on brands. They manage relationships with retailers, carry valuable information, handle bulk-breaking, logistics, and product returns/servicing. I suspect that the business has become more competitive over the last decade, with returns falling and some will be under extreme pressure just to break even. 

(Were I involved with distribution, I’d be trying my hardest to bring together more brands and to achieve economies of scale. Since it’s fairly unusual to hear of a brand switching distributors, it’s possible that loyalty and relationships are a powerful factor – and so distributors may need to merge or acquire competitors, to give themselves the best chance of survival.)

Production is the stage with the least competition and the biggest returns, which are probably concentrated amongst the brands with the largest economies of scale – I’m thinking of the Japanese Big Three, Montblanc, Pelikan, and Lamy. While pretty much anyone could hang out a shingle and call themselves a retailer, distributor, or designer, becoming a big manufacturer requires substantial capital investment to make lots of product and a product that is popular enough to sell in large quantities at an agreeable price. I suspect that other producers – the Italians, the smaller Germans, the boutiques, the custom-makers, etc – all make a normal or above-normal return, but nothing like that enjoyed by the bigger brands. 

Finally, the design and marketing stage is basically a hostage of production. As long as you’re tied to a big producer, you can make a normal return, but if they decide to go with a different designer, those skills and talents might be worthless. To make them valuable, they would have to start up their own production operation – which requires capital and expertise, and carries substantial risk – and it’s not obvious they would even make a return that justifies the investment. 

Effects of the Cost Disease

So now we have the lie of the land, we can start to think about how this would change if the cost disease hypothesis were true. We’ll go through each of the stages again in the same order. 

The cost disease has a direct effect on physical retailers: shop assistants might not become any better at their jobs but the cost will rise. Giving 30 or 60 minutes of their undivided attention to a customer is already expensive, and will become more expensive as the disease drives wages up. And if they’re not becoming more productive, there’s nothing to suggest customers will be buying any more products than they currently do. 

Most challenging for physical retailers is that their efficiency (and therefore their returns) will decline while the efficiency of digital retailers will continue to increase. The digital equivalent of a shop assistant isn’t devoting an hour to a single possible buyer; in that same time, they could answer 10 or 15 emails from interested customers. And committed customers might not require any time at all, given that transactions are entirely automated. Digital retailers will continue to find ways to become more efficient and productive while their physical counterparts are essentially stuck with rising costs. Without some offsetting factor, the returns to physical retail will fall below the break-even level, and some (perhaps most) retailers will have to leave the market. 

The interesting question from this is what happens to the competitiveness of digital retail. Do we end up with just a few dominant retailers, each earning an above-normal profit, or do we see a lot more investment in digital retail and more competitors enter the space? Consumers are the big losers if it’s the first group, because some of those returns will come from higher prices. It’s not obvious to me which outcome is more likely – but it matters a whole lot for distributors.

If we end up with a few dominant retailers it may be easier for brands to deal directly with those eight, rather than run through middlemen. For example, Pelikan has Chartpak to manage their US operations, likely dealing with at least a couple dozen retailers of varying size. But if most retail sales are captured by a couple of firms – say, two retailers sharing 80% of the US market for Pelikan – I wouldn’t be surprised if Pelikan abandoned Chartpak and handled those relationships directly, even if that meant cutting off the other 20%. The loss of an anchor brand like Pelikan (or Visconti for Coles, or Aurora/Montegrappa for Kenro) might be enough to tip some distributors into unprofitability, and out of the industry. 

The future of distribution also depends on what happens to production. I’ve been thinking about the flip side of the cost disease – reducing costs and boosting quality – for a while, particularly as I hear more about innovation and the future of manufacturing. While I take it all with a hefty grain of salt, one common thread seems to be that the initial investment for setting up a manufacturing operation will fall and so the benefits of very large scale production will decline too. The most extreme vision of this is a 3D printer in every home, which can manufacture products on demand: that’s a world where the big production businesses of the past are rendered entirely irrelevant. (But who knows when or if that future will ever materialise.) Regardless of the extremes, it may be production becomes cheaper and easier to get into, which could lead to lots of new entrants and thereby eliminate the excess returns currently enjoyed by large manufacturers.

The most curious scenario (and not necessarily one I find likely) is that distributors could go from being a middleman between a few large manufacturers and many small retailers, to being a middleman between many small manufacturers and a few large retailers. In other words, they’d become an agent working on behalf of retailers. Their work would essentially be a mirror image of what they currently do, and life could well go on as before.

Most interesting, though, is what happens to design. Design is exactly the kind of task that is affected by the cost disease: it requires an individual’s undivided attention for long periods of time. And while creativity isn’t in short supply, the ability to design a product which is elegant and functional is far more scarce. Particularly if the designer can come up something which can be produced at low cost, as with a home 3D printer. This suggests that, in the midst of many large transformations throughout the industry, the returns to this stage should become much larger – even if practitioners don’t necessarily get any better at their craft.

In many industries, the last few decades has been a period of unbundling: firms who were once active at every stage of a supply chain (sometimes going right back to producing the raw materials) deciding to focus on the one thing where they can really excel. It’s not been possible for an unbundling of design and manufacturing in FPs, but it’s not impossible to envisage a future where this is the case. That’s a future where pen designers become names as familiar as the brands and nibmeisters of today (a fame they already deserve) and can make a return which reflects the significant contribution they make. 

Conclusion

The cost disease is an interesting phenomenon, and it’s interesting to think about how one particular phenomenon might affect the future of our industry. I’m not claiming that this is definitely how things will turn out – after all, we’re just looking at one particular variable when there are hundreds or even thousands of variables which could matter. It may be that the cost disease isn’t significant enough to drive much change in our industry or it may be that other things matter a whole lot more. So this isn’t a forecast or a prediction, it’s just an exploration of one changing phenomenon and some possible effects. But it’s nonetheless an intriguing set of possibilities for the future.