Friendship is born at that moment when one person says to another: What! You too? I thought I was the only one.

-C.S. Lewis

Thursday, March 20, 2008


I just read an article that confused me. Kraft and Sara Lee are worried about shrinking profits due to the rising cost of their inputs, namely beef and pork. This is, of course, exactly the opposite of what's happening with the oil-refining industry. The cost of oil has increased by a factor of six over the past several years, yet Exxon and the rest experience record profits. Someone please explain this to me.

Greg said...

Sir Horatio,

I think you're confusing price and cost. The PRICE of oil has been steadily increasing, but the cost of production has not significantly changed (oil companies will say its getting harder to find deposits and exploration costs are increasing, but not 6X!). As much as we'd like to think that the price of oil is market-based, it seems to be primarily the product of OPEC cartel decisions (with an assist from Bush Co.). OPEC can restrain supply, prices rise, production costs remain constant, and profits soar. Demand for oil is pretty inelastic (far more inelastic than anything Kraft and Sara Lee produce) and so consumers keep on the addicted, oil spigot no matter how high prices rise.

Kraft and Sara Lee are experiencing real cost increases (i.e. the cost of inputs). Interestingly, the cost of beef/pork is rising because the cost of corn is skyrocketing (ethanol crowding out the food stock, plus the usual subsidies). Read the Omnivores Dilemma, all roads lead back to corn in the U.S.! In any case, demand for processed food is somewhat elastic and given the impending recession and declining wealth, Kraft/Sara Lee doesn't have much room to increase price to cover rising cost, hence profit margins stay slim.

You Kellogg folk always need us Wharton types to explain these quantitative concept don't ya? =)

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