Market Power and Inflation
Ilhan Dögüs
Independent Economist, ilhandogus@gmail.com
Post-COVID-19 inflation sparked two important debates. The first one between mainstream and heterodox economists — specifically on whether current inflation is driven by excess demand. The second debate is taking place now within the heterodox community and focuses on whether market power has any role to play on currently rising prices. In other words, is current inflation profit-led?
According to the first debate, a central question is whether demand-suppressing policies are needed, and what damage they could do if inflation is not the result of excess demand. Much has already been said in this blog about this issue.
I would like to say something about the second debate: is current inflation profit-led?
There is increasing evidence now pointing in that direction. First, according to Josh Bivens of the Economic Policy Institute, profit margins in the United States have contributed to post-Covid inflation by a staggering 53.9% relative to 11.4% pre-Covid, whereas unit labour costs contributed less than 8% (compared to 61.8% pre-Covid inflation). Similarly, Konczal and Lusiani of the Roosevelt Institute report a sharp increase in the price markup in the USA after 2020, especially for firms in the top 10th percentile.
Before discussing the role of market power in explaining current inflation, however, let’s clarify a few things, specifically on how pricing decisions vary across sectors depending on the level of capital-intensity of production and the price-elasticity of demand (how sensitive the demand for a given good is to changes in prices). Specifically, let us consider the following 4 questions.
Q1: Is there one type of goods?
No…
Yet the mainstream approach assumes an economy with only one firm and one good. The consequence is that wages are considered only as a cost. Cast aside is the notion that wage costs for one firm is a source of demand for another firm.
Some goods are easily reproducible and storable (durable goods) hence their prices are determined mainly by the changes in their costs and some are not (foods, services, housing, utilities, oil, gas etc) and thus their prices are demand-driven.
Q2: Is there one type of production?
No… Some firms and sectors run business in a capital-intensive manner. That means they use more machines and technology than labour to produce goods. Hence the share of fixed costs within total costs is high for these firms. For some firms the share of variable costs (such as raw materials and labour) is high as they employ labour-intensive production techniques.
Q3: Do all firms react to changes in demand for their goods in the same way?
No…
Capital-intensive firms prefer to increase output more than prices if demand rises, and cut prices if demand falls — in order to absorb the fixed costs and to take advantage of low levels of unit costs at high levels of production. Additionally, as these goods are storable, firms reduce their prices to destock (disinvest). The higher the capacity of production, the higher the ability to reduce unit costs by way of producing more.
On the other hand, if production is labour-intensive, then firms tend to raise prices more than output if demand rises, and they cut production if demand decreases (Toporowski, 2005). This is due to the fact that as the unit costs increase with output due to the higher share of variable costs, profits would not proportionally increase with output.
Q4: Does suppressing wages and increasing unemployment work to curb inflation?
It seems not.
Demand-suppressing policies (like increases in interest rates and cut in public expenditures) can only curb inflation if the decline in prices of capital-intensive durable goods is greater than the increase in prices of labour-intensive non-durable goods (foods, utilities etc). But this rarely happens, as a decline in income diverts demand from durable goods towards non-durable goods, due to what is called ‘the hierarchy of needs’. As depicted by the blue line in Figure 1, as the US-economy grows and unemployment falls (an increase in income), the share of income dedicated to the purchase of durable goods by households’ increases as their income rises. This can certainly have a negative impact on inflation as unit costs for durable goods decline due to expanded production and as demand for food-goods declines relatively.
But in the case of a contraction of the economy, unemployment rises; the share of expenditures devoted to food increases, while the share devoted to durable goods declines. As such, inflation rises as the economy slumps.
Given the above discussion, let’s now turn our attention to the matter at hand: the role of market power in current inflation. The crucial issues regarding the relationship between market power and inflation are price elasticity of demand and level of capital-intensity of production. Both will impact the reaction of the firm to changes in demand very differently.
First of all, prices are the sum of three main factors: unit labour costs, cost of raw materials, and the markup charged over costs. If a firm increases its mark-up by raising its price as opposed to reducing its unit costs, this might lead to a short-run profit-led inflation although in the medium- and long-run capital-intensive concentrated markets might be disinflationary as explained below.
And now for one last salient question: Do markups and prices always rise together?
It seems a profit-led inflation occurs when labour-intensive sectors and non-storable goods prevail.
The increase in the cost of inputs might be pushed onto households through higher prices if production cannot be expanded, and provided the price elasticity of demand is low enough (consumers won’t reduce purchasing the good so much in response to price increases). This is mostly the case for not reproducible and storable goods, such as foods, utilities, housing and for labour-intensive sectors as they work mostly closer to full capacity. However, as the increase in demand for durable goods produced by capital-intensive production techniques is met with increases in output rather than increases in prices, and as their price elasticity of demand is higher (that is to say, more sensitive to prices) than labour-intensive non-durable goods, then coexisting of inflation and rising markup is mostly the case where labour-intensive sectors and non-durable goods overcome durable goods and capital-intensive sectors.
This explains well what we are currently experiencing: profit-led inflation in the post-Covid era. Contraction in production due to supply chain disruptions did not allow firms to absorb the increases in costs of transportation, energy and raw materials by way of expanding production. Firms in the durable goods sector had to raise their prices to some extend to survive. On the other hand, firms producing food, utilities, housing and energy (gasoline) managed to raise their prices (including their markup) as the inelastic demand for their goods increased. Findings by David Macdonald for Canada and Servaas Storm for the USA suggest that contributions of foods, housing, gasoline etc. to inflation is higher than durable goods. Peter Coy, (NY Times, June 22, 2022) also stresses that “among the sectors with big markups were real estate, mining, quarrying and oil and gas extraction”.
And a quick conclusion:
So the debate amongst heterodox as to the nature of current inflation seems to be quite clear, as least to me: there appears to be strong evidence that inflation is profit-driven.
All in all, economic policies aimed at fighting inflation need to focus on shifting the composition of consumption expenditures towards durable goods by way of increasing employment and incomes of workers and thereby making markets more competitive. In that sense, fiscal tools, such as public investment and public employment, more generous unemployment insurance etc. seem much more effective than monetary policy.
