Tue Apr 25

It might be tempting to blame inflation on profits, but the reality is still about high demand and short supply

Written by: Michael P. Cameron, Professor of Economics, University of Waikato

Despite the latest inflation figures for New Zealand coming in slightly lower than expected ^[1] by many economists, the rate remains stubbornly high. At 6.7%^[2] for the year to March 2023, the inflation rate is more than double the Reserve Bank’s target range of 1-3%.

But not everyone seems to be feeling the pain of increasing prices.

Major banks ^[3], retailers ^[4], and other ^[5] corporates ^[6] are reporting, or expected to report, record profits this year. It is tempting to ask, as others ^[7] have ^[8] overseas ^[9] and in New Zealand ^[10], to what extent corporates’ mega profits and pricing are driving inflation.

The answer may surprise you. The reality is that corporate profit-making contributes very little to the inflation rate.

Market power and inflation

When a seller has the ability to choose the price, economists say that the firm has market power. But their ability to raise prices is not unlimited. Just consider the case of Arivale ^[11], a health-tech startup in the United States that ultimately failed because it set the initial price of its offering too high.

The extent of market power determines how high a business can set its price above its costs (its markup) in order to maximise its profitability. The optimal markup for a business depends on how sensitive its customers are to price changes.

In markets where customers are very sensitive to price changes, businesses will set lower prices (a lower markup) than in markets where customers are less sensitive to price changes. The optimal markup (as a percentage of the price) won’t change unless there is a change in customers’ price sensitivity.

Higher inflation is unlikely to cause consumers to suddenly become less sensitive to price changes. If anything, they will become more price sensitive and optimal markups should fall. That is why a strong majority (79%) of economists recently polled by the University of Chicago ^[13] disagreed or strongly disagreed that market power was a significant factor in higher US inflation.

If not profit, then what?

So, if businesses aren’t profiting by increasing their markups, what explains the increased profits in a period of high inflation?

There are two other reasons why prices may rise, one of which may contribute to higher profits.

First, businesses may face an increase in demand for the goods or services they provide. With historically low interest rates (until recently), coupled with the wage and other subsidies as we emerged from the pandemic, a lot of money was chasing the same number of goods and services. That sort of increased demand pushes up prices and makes businesses more profitable.

Second, businesses face higher costs ^[15] because of inflation, including wage inflation. When costs are higher, businesses pass on some of those higher costs onto their customers in the form of higher prices. For most businesses, higher prices arising from higher costs will not lead to higher profits.

Taking those two factors together (higher demand leading to increasing prices and profits; and higher costs leading to increasing prices), it is likely that increased profits are not a cause of inflation, but are themselves a consequence of the other underlying causes of higher inflation.

Recent work ^[16] by economists at the Treasury showed that the surge in New Zealand inflation was one-third driven by demand-side factors, one-third by supply-side factors, and the remaining one-third was ambiguous (it could be demand-side or supply-side). All of the recent increases in food prices was able to be attributed to demand-side or supply-side factors. That again suggests that there has been little scope for businesses’ profit-seeking to contribute to inflation.

Periods of high inflation are unwelcome. We may be tempted to blame corporate profits as they represent an easily identifiable target. However, it is unlikely that profits are contributing much, if anything, to the inflation we are currently facing.