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1 November 1977 Financial Analysts Journal Volume 33, Issue 6

Product Pricing in the Chemical Industry

  1. Paul C. Christopherson

In the chemical industry, pricing has a dominant effect on profits. To date, most industry analysts have relied on the competitive model, according to which capacity and demand determine price. In fact, a noncompetitive model, in which supply (not capacity) and demand determine price, may fit the industry better. The difference is that, whereas capacity represents physical ability to produce, supply represents willingness to produce.

The behavior of the chemical industry during two critical periods has encouraged use of the competitive model. In the late 1960’s, it was widely believed that prices declined because an imbalance between capacity and demand triggered a struggle for market share. In 1973 and 1974, an alleged shortage invoked the converse argument—namely, that sharply increased product pricing was the result of underinvestment earlier in the decade, combined with steadily rising demand.

In 1970 and 1975, however, chemical industry pricing contradicted the competitive model. In 1975, volume declined for the first time in many years, while prices showed an almost 20 per cent increase over the elevated levels of 1974.

The author points out that, as industries mature, they generally evolve from a noncompetitive first stage (beginning with the development of a new product by a single producer), through a competitive second stage, to a noncompetitive third stage. Only in the second stage, when patents expire or rivals develop equivalent technologies, do capacity and demand determine price. In the third stage, the high cost producers drop out until the remaining number of firms is small enough that they can regulate entry by maintaining profitability at a constant threshold level, placing more emphasis on fluctuations in cost than on fluctuations in demand. Competition exists, but it exists between current producers and candidates for entry, rather than among producers.

The author’s examination of the data suggests that pricing in the chemical industry has been based on unit production costs all along. Under this interpretation, unit costs of production, hence selling prices, should rise about three per cent a year. For the near term, however, with the big surge in costs largely past and volume steadily increasing, price increases will be minor and profit growth unexciting.

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