Technology and subsides: how much longer can equipment costs keep falling?
Thu 26 Feb 2015 by Matt Nolan.

The last 15 years have seen an unprecedented decline in the cost of plant and machinery equipment relative to the price of other goods and services in the economy.  What does this decline mean?  Is it sustainable?  And what are the reasons why this trend may start to reverse?

The history of plant and machinery costs

Between 1990 and 2001, the cost of plant and machinery equipment (P&M) rose a little more slowly than the price of goods and services – with the capital goods price index (CGPI) measure of P&M costs rising by an average of 1.4%pa, while the consumers price index (CPI) rose by 1.8%pa.  Transport prices rose in line with consumer good prices during this period as well, climbing by 1.8%pa.

The price of these investment products was rising roughly in line with the return on final output and labour costs, while the cost of non-residential buildings grew more slowly (about 1.0%pa) as the industry adjusted from the late-1980s boom.  All in all, the 1990s was an incredibly stable time in terms of the variety of prices of inputs used by firms – implying that as no individual input became much more cost effective, the types of production processes that were efficient for a firm remained relatively unchanged during this time.

Having said that, the 1990s were not a stable time for the New Zealand economy.  The New Zealand economy was trying to recover after the economic crises and reforms of the 1980s and early 1990s, and unemployed and misallocated resources were being shifted.  However, this adjustment was occurring in the face of a benign global environment, with the costs faced by firms rising at a relatively steady and predictable rate.

As Graph 5.14 shows, movements in the value of the New Zealand dollar during this period had an effect on the ratio of consumer good prices to the cost of plant and machinery equipment.  A stronger dollar made imported plant and machinery equipment relatively cheaper than general goods and services.

Graph 5.14

Between 1996 and 2001, the sharp drop in the NZ dollar against the US dollar translated into a 1.8%pa average increase in plant and machinery equipment prices.  Consumer price growth was weaker, so the real cost of P&M rose at an average of 0.3%pa during this period.  However, there was a sizable divergence in prices between different asset types.

During this period, the price of engine, generator, and primary sector manufacturing equipment rose by well in excess of 3.0%pa.  Furthermore, the cost of (insulated wire) spiked, rising at an average rate of 7.3%pa.  However, while primary (and some manufacturing) sectors were seeing their capital costs spike, television and radio transmitters and apparatus and computer machinery experienced price declines in excess of 3.0%pa.

Following 2001 everything changed.  The exchange rate swung upwards again, but plant and machinery costs relative to goods and services prices fell well below where they would have been had the dollar sat at the same level it was at in 1996.  And they continued to fall.

Although sharp declines in the dollar during 2006 and 2008/09 (which were later reversed) temporarily pushed up the relative price of plant and machinery equipment, they were not enough to stem the persistent downward trend in the cost of this form of investment.

Plant and machinery equipment was becoming cheaper at the same time as labour costs and non-residential building and rental costs were rising well ahead of inflation.  As a result, firms within the economy should have been changing to take into account the fact that plant and machinery equipment was becoming relatively cheaper.  The shift has encouraged the production of goods and services and modes of production that use a greater proportion of plant and machinery equipment.

This substitution can be seen in the data.  New Zealand’s working-age population grew by 1.5%pa between 2001 and 2014, while the real net stock of non-residential building fixed capital rose at 2.0%pa, and the real net stock of plant and machinery capital rose at 3.9%pa.

Although the sharpest price declines have occurred in computer and office equipment (falling at average rates of 8.2%pa and 1.8%pa respectively) and among television, radio and phone equipment (falling at 2.4%pa), there have been broad-based reductions in plant and machinery prices.  Of the 32 plant and machinery capital good subtypes, 27 have experienced price rises below the rate of increase in consumer good prices. 

How much of this drop in plant and machinery equipment costs is genuine?  And can we expect the low prices or sustained declines to continue going forward?

Caveats on plant and machinery costs

When interpreting capital goods prices we initially have to be a bit careful.  A key point is that the CGPI relates to the price of a fixed bundle of fixed assets at a point in time when purchasing them new – it does not relate to the price (or productivity) of existing assets.

However, the biggest point is around hedonic adjustment.  Hedonic adjustment is when goods prices are controlled for quality (or specification) differences.  Hedonic adjustment Statistics NZ to make a product category that involves a number of goods with a variety of attributes (eg computers that have different processors with different speeds) and to then adjust the price index for an improvement in that good or asset.  As far as technology leads to an improvement in the quality of a product (or its ability to produce output), this change is equivalent to a price cut for that asset.

Computer products and parts provide the clearest area where hedonic adjustment is applied.  On average, the CGPI price of computer products fell 8.2%pa between 2001 and 2014 – or a total of 67%.  This adjustment added to a slower, but still significant, decline in the 1996-2001 period, when the price of computer parts and equipment fell by 3.3%pa (a 16% decline over the five years).

However, computers are not the only category that is hedonically adjusted.  Using the same methodology as statisticians in the United States, Statistics NZ also adjusts the following categories by quality: mechanical machinery, printing machinery, office equipment parts and accessories, non-electrical machinery, telephonic and telegraphic apparatus, radio-telephonic parts, railway equipment, vehicles other than railway equipment, aircraft, and ships.

The US hedonic adjustment that is applied is the best that Statistics NZ can do – they have to adjust these measures for the fact that technology improvements allow plant and machinery equipment to be more productive and do different things.  However, the patterns of improvement they identify don’t make sense for every firm, and for the majority of existing firm types, the CGPI index will overstate the true reduction in new plant and machinery capital costs. 

For some firms, the fact that a computer is now significantly faster than it was ten years ago has not led to a change in the way they use computers, or the part a computer plays in the production process.  As a result, these hedonic adjustments don’t say anything about the replacement costs these firms truly face when their old work systems break down.

Another cost that can often get missed when discussing the cost of fixed capital is depreciation.  The overall depreciation rate for private fixed capital (excluding residential building) was 11% in the March 2014 year – nearly double the 6.4% rate in March 1996.  The increased depreciation rate is partially due to the increasing importance of plant and machinery equipment, given that this type of fixed capital depreciates more quickly than other types (particularly non-residential building).

However, there has also been a significant lift in the implied depreciation rate of plant and machinery equipment, climbing from 9.7%pa in the March 1996 year to 17% in the March 2014 year.  This lift is in a large part due to the growing importance of computers, which themselves depreciate significantly more quickly than other plant and machinery equipment.

Overall, depreciation and the hedonic adjustment involved in creating price indices both imply that the recorded drop in plant and machinery costs may be exaggerated, compared to what many firms have actually experienced.  However, this conclusion does not undermine the fact that, on average, the price of plant and machinery equipment relative to other inputs has fallen.  Relative to the price of goods and services, the costs of plant and machinery equipment used for agriculture, other primary, and manufacturing purposes all fell between 2001 and 2014.

Outlook for costs

When it comes to deciding on the type of production process you want to invest in setting up, and the direction of your business, it is important to have an idea of what the cost of inputs will be in the future.  Will plant and machinery continue to become more cost effective, or are the factors currently holding down plant and machinery prices about to reverse out?

A mixture of technological changes, significant subsidisation of manufactured goods exports overseas (particularly in emerging Asian economies), and an increase in the ability of global firms to produce manufactured products at scale across a geographically large supply chain, are all factors that have made plant and machinery a relatively cheaper input than workers, land, and buildings over the past decade or so.

However, in previous articles on rebalancing in China, and the Asian production chain that New Zealand is currently part of, we have pointed out that we expect the trend of falling imported manufactured goods prices to end relatively soon[1].  Furthermore, as global economic activity picks up, the prolonged period of manufacturing overcapacity that has taken place will give way, leading to rising prices for plant and machinery equipment.

As a result, although technological improvement will continue to improve what can be done with plant and machinery assets, the period of ever-declining costs will soon come to a close.

However, in our latest forecasts, we have revised our outlook for when global plant and machinery costs will begin to climb.  Global growth (outside of the United States) has underperformed, and Chinese authorities appear nervous about their ability to rebalance the growth path of their economy without inadvertently driving up unemployment.  As a result, we expect the associated global overcapacity in plant and machinery production to persist throughout 2015 – maintaining downward pressure on plant and machinery capital costs.

Graph 5.15

In our view, the main risk to our forecasts is that the cost of plant and machinery products remains lower than we have forecast – due primarily to accelerating improvements in technology.  If the P&M costs are lower than we have predicted, it is important to keep in mind that the decline in plant and machinery costs will not be evenly spread between firms.  Instead, the declines will favour firms that are able and willing to move with the latest trends in technology and incorporate these into their production process.

In this case, lower plant and machinery costs are favourable for New Zealand as a whole, but sectors where computerisation and automation will have little effect will not benefit from lower costs.

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