Competition and Inflation
Competition and Inflation
Clearing up a common misconception - with micro theory (!)
Policymakers in both Argentina (top image, it reads “Horacio Rodríguez Larreta on inflation: we need to go after monopolies and allow real competition”) and the United States, as well as pundits like Robert Reich or Richard Wolff, have recently made comments to the tune of “inflation can be attributed to a lack of competition in the economy”. I think that it misses the mark.
The fundamental problem here is a confusion between the price level and inflation. The price level is the average price in the economy. If there are only two goods, one that costs 10 and one that costs 5, and their market shares are 75% and 25% respectively, then the price level is 51. If the price of the first product increases 10% (to 11), and the price of the second one 40% (to 7), then the price level increases to 9 - that is, an 80% increase. Inflation is the change of the annual price level, calculated as either the weighted average of individual price changes or the change in the weighted average of prices2.
How does competition play into this? Well, let’s go back to prices. Under perfect competition, there are many sellers and many buyers, so companies can’t make a profit and prices equal costs. If competition is imperfect, either because there are too few people on either side of the bargain (monopoly and monopsony, for instance), because the markets don’t work properly (externalities, public goods), because there’s additional costs that can’t really be put into prices (fixed costs, transaction costs), because each side doesn’t have complete information about the product, or because the products aren’t similar enough to perfectly compete (monopolistic competition), then prices can be greater than marginal costs and companies turn a profit. The difference between prices and costs is known as the mark-up.
The markup isn’t insensitive to market conditions. If there’s many companies in one market, it’s lower, because a price that is too high risks losing too many customers. Similarly, if the customers are very responsive to price changes, the mark-up is also lower (i.e. the price elasticity of consumption is high), which is why pricing abuses are fairly common in the pharmaceutical market but not in, say, the soft drink market. And companies might collude to increase their prices by competing less, although it’s fairly complicated to determine whether or not the collusion will actually work.
So less competition means, generally, a higher price level (there’s a few cases where this isn’t true, though) absent things like innovations or natural monopolies (markets where it’s extremely inefficient to have more than one company, because costs are so high). But how does that reflect on inflation? Well, a high or low price level that is stable doesn’t have an impact on inflation. Yes, it would sure be nicer to buy things more cheaply, but it’s not really all that important. So, say, the ketchup market being really concentrated and the hot dog market being fairly competitive won’t really say a lot about the inflation rate, if both are subject to the same macroeconomic factors.
But imagine that there are two shocks: the price of tomatoes (the only input in ketchup) increases a lot, while the price of sausages and bread (the inputs of hot dogs) don’t change. Because ketchup is a concentrated market, the impact of inflation depends on how able companies are to raise prices. If consumers are really fickle, and won’t buy any ketchup if it’s too expensive, then the ketchup makers might suck it up (since they make enough of a profit to afford the hit). If elasticity is fairly low across both sectors, then ketchup makers can really jack up costs because they also don’t face much competition within the industry either - if there was a mayonnaise industry, they could be in trouble if they raised prices. But for instance, if hot dogs suffer the same supply-side shock, and consumers won’t just eat plain ketchup, then ironically the hot dog makers might be more able to raise prices even though they have more competition. So how much competition is in a market, coupled with how elastic the consumption of a particular good is, might tell you the impact of a price change of inflation, but it can’t really tell you if inflation would be lower or higher.
There are direct ways in which competition could affect inflation. First, if the economy suffers a lot of mergers (and they don’t reduce costs) then the price level will be higher - and because this price level readjustment is assumed to happen in one moment, inflation in that moment will be higher. Likewise, increasing competition in the economy will lower inflation in one period by lowering the price level just one time. Government regulation might play a role: if the amount of chekcs on one company’s ability to raise prices is altered over time, then that will contribute to inflation. For instance, the previous Argentinian government opened up imports of clothing and electronics to lower prices, and the current government closed them back up - so both have been really able to move costs onto consumers, since each specific company faces a less elastic demand (and also shortages of intermediate goods, because of local import controls and international supply chain slack).
Secondly, inflation is really related to expectations of inflation, that is, how high people think it will be in the future. Reducing inflation requires people to trust that you’re actually going to do it and not just chicken out. Imagine an anti inflation plan that states that the government will give a million dollars to the owner of each company if they sign a legally binding contract not to raise prices. And assume this works. If the economy has 4 companies, then it’s fairly easy to convince them to go along; if it has 100, then not so much. But if companies shape their expectations by trading with each other, and they only trade with each company once a year, then a more competitive economy is better for inflationary stabilization.
But policymakers don’t make nuanced, comprehensive cases based on one off price level changes and coordination of expectations. They say that profit margins are going up. I don’t really see how that could be the case (maybe nominal profit margins, but not inflation adjusted ones), particularly in a context where demand for basically everything is fairly weak (due to the economic downturn), and where there’s tons of disruptions in the supply chain. This last item means that companies might just have less of their inputs they normally use, fewer workers, more expensive transportation, or might have to run around finding new suppliers. For instance, a few people on Twitter claimed that paper-heavy industries saying they didn’t have enough paper paste to print books was just them covering up collusion - but it’s actually true!
On a personal note, I’d like to mention I’m really busy with university and exams right now, so I’m going to keep posts to a minimum until the end of the month.
Microeconomically inclined readers will point out that the price level is either 2 or 0.5, because one of the goods has to serve as the numeraire for exchanges to be possible. National accounts-minded ones will mention that it’s actually 100, because it’s the base year.
The math is either 0.75*0.1+0.5*0.25, or 10*(1+0.1)+5*(1+0.4). Either way is the same.