Firms are greedy, but that isn’t the reason for inflation

With prices rising an increasing number of people are looking for a scapegoat. Fairly “obviously” the blame should be on those who are increasing prices – namely firms. This outbreak of greed is then being used as an explanation for why firms are increasing prices, and the suggestion is that – instead of cutting government spending or increasing interest rates, the solution is to break up monopolies.

Now I have no problem with breaking up monopolies, and I’m a huge fan of clear competition policy. But this isn’t going to deal with the “inflation” problem we are talking about. Let’s chat about it.

An earlier post here on “price controls” discusses a number of specific matters in more detail, but I think a higher level discussion would also be useful. To that end, I thought I’d share a twitter response I made to some bloke going on about corporate greed and inflation:

As you may have noticed in earlier posts, I haven’t given up on the transitory narrative (based on central banks managing expectations), but as Michael Reddell notes the outlook for this narrative does keep worsening:

I did your first year econ course, you said monopolists were price setters, so we need market power to get greed to influence prices – checkmate

Nice, and I hope you enjoyed the course. Sadly you are only remembering the words that we use, not the full nature of the content with that response – sometimes the way economists name things mean they can be misinterpreted.

A “price taking” firm only has the incentive to charge the market price – this does not mean they have to accept some fixed mark-up on cost, it means that market conditions determine the price they are incentivised to sell at!

If overall demand for a product rose, and we were looking at a product where new firms could not enter instantaneously, then this would lead to an increase in the market price – which would then be charged by our little competitive firms. They would earn supernormal profits which should, in time, lead to entry by other firms – this is what drives down the price again (if demand remains high). If there is uncertainty about future demand, then that acts as a additional cost for entry – which implies that higher demand may be met with higher profits in the case of perfect competition.

For a variety of market structures and levels of competition, higher demand would be expected to lead to higher prices and profits – the puzzle often was that, in the case of firms with market power, this was not the case! Instead, we would see their tacit collusion break down, leading to countercyclical margins and less price variability in situations with large oligopolistic firms.

So in other words, we do not need market power to get price and profit change when we have an increase in demand in the economy (relative to productive capacity) – and imperfect competition can actually reduce the relevance of this.

Now, in the current situation we have both significant fiscal spending (government demand) extremely low interest rates and a movement out of lockdown bring consumer spending into the current period (private demand) and disrupted supply chains for goods making the durable items and petrol that people are trying to buy more scarce.

In that situation, it would be good for people to delay purchases a bit – implying higher interest rates, and high prices (relative to future prices) serve that purpose.

But if they just didn’t lift prices there wouldn’t be inflation

No if prices never changed we would never have measured inflation – this also implies wages would never change as well mind.

But what would then happen is that when there is excessive demand the number of products would need to be rationed in some other way – lines, black market activity, empty shelves. Suddenly people that very much value a product would not find that it costs more – they would find that they can’t even buy it.

When demand is insufficient these fixed prices would imply that firms would see their stock building up, and without the ability to cut prices to clear stock they will simply produce much less – implying that larger layoffs and business failures would occur.

This is not to say that the current increase in demand may not propagate through prices in the way firms with market power behave. A clearly communicated “shock” that gives a firm the ability to wink and nod at other firms that it will “lift prices” may allow firms to collude, leading to price increases that would not have been possible with competition. This is the tacit collusion that we chatted about in the prior post, and a million other times here. And the empirical evidence tends to show that this does not occur usually during period of high demand.

And what about changes in relative prices – supply chain disruption is far from even across industry and product types, and so prices need to change to represent that scarcity. If there is less fuel available we want the price of fuel to be higher, so that those with a lower use value of that fuel self ration. Knowing that certain individuals may be in a vulnerable position to changes in fuel prices we may act to support their incomes, but not blunt that price signal.

Now monetary policy does aim to reduce the variability in prices – but it is doing so by reducing the variability in demand, not by telling prices to stay put.

Conclusion

Blaming the current increase in the price level, and the spectre of future inflation, on the greed of someone powerful achieves two things – it makes it a morality play, and it means that we think we can punish the “bad dudes” in order to solve the problem. But these things are not true.

Making a popular boogey man might be good politics – but it doesn’t help the wellbeing of a nations citizens. As Chris Conlon says:

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