US firms' profits shrink as sales dwindle, costs of raw material soar.
-April 22, 2008, The Straits Times
http://www.straitstimes.com/Money/Story/STIStory_229811.html

Companies are more pessimistic, and more plan to cut hiring and investment: Survey

WASHINGTON - THE combination of slower sales and soaring expenses for raw materials is taking a harsh toll on companies in the United States, an influential survey has shown.

For the first time since 2003, companies reporting falling profit margins outnumbered those with increases in the past three months, according to the National Association for Business Economics (Nabe).

Almost two-thirds said they paid more for raw materials in the first quarter, the most since 2004.

US companies also grew more pessimistic in the first quarter, as the intensifying credit crisis and slump in housing weakened sales, the survey found.

Six per cent of the firms said demand improved last quarter, down from 20 per cent in the previous three months and the fewest since the 2001 recession.

The report, which also shows more companies planned to slow hiring and investment this year, reinforces concern that the US economy is in, or may slide into, a recession.

'Companies have pulled in their horns,' said Mr Ken Simonson, the chief economist for the Associated General Contractors of America and point man for the business group.

'They are finding it hard to pass through higher materials costs, and profits are getting squeezed,' he added.

Almost 40 per cent of the businesses reported they were hurt by stricter borrowing rules compared with just over a quarter in the prior survey in January.

Seventy per cent of the firms said their annual forecast for the year had dimmed. The Nabe survey, taken between March 24 and April 8, included responses from 109 members of the business economists group.

While employment still increased, fewer companies planned to add workers in the next six months compared with the January survey, and more businesses planned to reduce staff, the report showed.

The outlook for investment also remains soft.

About 28 per cent of the firms planned to increase capital spending in the next 12 months, down from 40 per cent in the January survey.

A majority of firms said the government's fiscal stimulus program and the Fed's rate cuts would have no effect on their business, the survey showed.

Sixty-nine per cent of the survey respondents said the Fed's moves to reduce borrowing costs and improve access to credit have no influence, the report showed.

'This is a warning sign that we may not get the quick pickup that people are looking for in the second half,' Mr Simonson said.

Thirty per cent of those polled predicted the economy would contract in the first six months this year, up from one out of 10 in January.

Bloomberg News

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As we can see, this article show one of the many effects the rising prices of commodities such as oil has on firms.

First, let's have a look at the price elasticity of oil.
Oil may have substitutes such as natural gas. However, many companies still rely on equipment which use oil, and natural gas cannot be mass produced to meet the need of these firms at the moment. Hence, to these firms, oil has no substitutes. Also, due to the large consumption of oil, supplies of oil are drastically decreasing.This also means that there is an almost vertical supply curve, as supplies of oil are very limited. These factors lead to oil being price inelastic.

Since we know that oil is price inelastic, the prices of oil will gradually rise as the supply decreases unless new resources are found.

So, why are firms making less profits as oil prices rise?
With the steady rise in oil prices, firms have to either cut down on the quantity of their goods produced, absorb the price increase or transfer the price increase of oil to consumers.
In the first case, producers will be producing less goods, resulting in a decrease in toatal revenue, and hence a decrease in total profits.
In the second case, producers produce the same quantity of a good at a higher price, and therefore will experience a decrease in total revenue with an increase in total costs, leading to a decrease in profits.
In the latter case, demand for the goods decreases due to the increased price, hence leading to lowered total revenue, which may translate to decreased profits.

This can also be explained using External Diseconomies of Scale (Higher Input Prices).
As the industry expands, the demand for factors of production rises resulting in much higher input prices, due to the supply of raw materials and oil being price inelastic, leading to higher costs of production.

There is also the issue of stricter borrowing rules. These have caused increasingly limited funds available to firms, and hence a decrease in the amount of capital firms have. Hence, many firms are hurt by the limit placed on the amount of money they can invest in production, as shown in the survey (40% of firms surveyed).

Due to this decrease in profits by firms, firms will have to retrench workers to cut costs, employ less new workers or decrease salaries of workers. Therefore, this may lead to a recession as many firms are affected by the spiralling price of oil and other raw materials.

Please correct me if there are any errors in my post. Thanks!

-yichen