Profits Drive Inflation If No Consumer Resistance?
It is a strange opinion that profits—or for that matter wages—“drive” inflation, but it does help an economist maintain a spirit of tolerance and see a pedagogical opportunity in every error. A Wall Street Journal reporter is at it again with a story of yesterday titled “Outsize Profits Helped Drive Inflation. Now Consumers Are Pushing Back.”
The reporter (or perhaps his editor) writes as if it were obvious:
Extraordinary corporate profits were a driving force in last year’s surge in inflation, a pressure that is now easing rapidly as customers push back.
I wrote about that strange idea before (see “Not Very Sophisticated Thinking About Inflation,” EconLog, May 3, 2023), but I just discovered a similar story from the same journalist who had inspired my first reaction. I will not repeat everything I said in my previous post, but let me emphasize a few points with a special focus on yesterday’s story.
If increasing profits were “driving” inflation a year ago, why didn’t businesses “drive” it earlier? Why don’t they always drive inflation to increase their profits? Indeed, why don’t they “drive” hyperinflation to make hyper-profits?
The reason is simply and rather obviously that “they,” which means each individual business, cannot charge the prices they want to increase profits. The journalist implicitly counters that it is because consumers have just now started “resisting.” But why don’t they always resist? A passing knowledge of economics suggests the answer: consumers do always resist. A consumer tries to get the lowest price possible and each business tries to get the highest price it can charge. Competition (which is entailed by free markets) drives prices down to a level where the typical business earns only a normal return on capital; otherwise, other businesses would enter the market (which is what a free market implies). Consumers who think that the price is too high don’t buy; suppliers who think that it is too low put their money elsewhere.
Another question: Why, instead of profits or wages (which are the price of labor services), isn’t it the price of green peas that drives inflation? Absurd, of course, for that is just one of millions of prices. But it’s the same if you take the price of any other good or service. It is all prices together that “drive” inflation; more exactly, their simultaneous increase is inflation (as opposed to up or down changes in relative prices). Why do all prices rise together? In other words, what drives inflation? That is the real question (of which I said a few words in my previous post). Saying that it is this or that price that causes inflation confuses cause and effect: the cause is inflation; the effect is that all prices rise–over and above their relative changes.
Profits, that is, returns higher than the normal return necessary to attract capital, is a residual: whatever remains after revenues and costs have been accounted for is left to the owner (the “residual claimant” as the theory of the firm calls him or them). But it is a bias of the ex-post accounting mind to consider a residual as a cause of the total.
Consider the following analogy, even if it is imperfect like all analogies. You bake a delicious cake for yourself. It then strikes you that some people may want it more than you do. You go to a homeless tent settlement and tell the occupants: “Cut for yourself the pieces you want,” thinking that you will eat whatever is left if anything. Strangely (given that your beneficiaries don’t pay anything for your charity), a residual piece is left, which you happily gobble. It doesn’t make economic sense to say that the cake was all eaten because of your piece, that your selfishness “drove” the complete eating of the cake.
Without theoretical guidance, wrong questions are asked and wrong answers are given. Trying to explain why consumers did not resist inflation earlier, the WSJ story opines, citing “many economists,” that consumers were confused by “the surge in energy and food prices” after the Russian invasion of Ukraine:
Many economists think that the second surge, coming on top of the pandemic, led to such confusion among consumers about where prices should be that they briefly became more accepting of above-cost price rises.
Consumers are never “confused” about “where prices should be”; each one is individually concerned about the prices he pays. Every consumer wants to pay as little as possible and never more than what the good is worth to him. Those who doubt the rationality of ordinary consumers should consider how quickly the the price increases of brand-new cars after the pandemic rapidly led many of them to turn to the used-car market (see my post “Do Used Car Prices Vindicate Adam Smith,” February 11, 2022). It is remarkable how efficient ordinary people are in their private activities if they are free, often more than armchair social analysts can be in their pronouncements.
The reporter also writes:
There is a broad consensus among economists that the role of profits in fueling inflation is one feature of the recent inflationary episode that made it different from the 1970s.
I don’t know about the supposed broad consensus, but I note that seven months ago the journalist invoked only “some economists.” The broad consensus seems to be mainly among those whom journalists interview. To be fair, our WSJ friend does mention a few economists, including “researchers of the Bank of England,” who may softly disagree with the supposed “consensus.”
To crown this theory-less analysis, it is even not clear that profits are actually decreasing: see Justin Lahart, “How Rising Profits Could Prevent the Economy From Faltering,” Wall Street Journal, December 3, 2023. Good economic analysis does not provide a magic crystal ball, but bad analysis muddles the present as well as the future.
It seems to me, although I have no hard evidence, that economic voodoo has never been as prevalent in the financial press (at least in the Wall Street Journal and the Financial Times) as it is now. I just ran into another example, again in the Wall Street Journal of this morning (perhaps because it is my major breakfast newspaper!), where the author calls “deflation” the decrease of some prices, the mirror error of calling “inflation” the increase of some other prices: “Goods Deflation Is Back. It Could Speed Inflation’s Return to 2%,” December 3, 2023).
This post was reprinted by permission of Liberty Fund, Inc. It originally appeared at Econlib on December 3, 2023. Liberty Fund is a private educational foundation dedicated to increased knowledge of a society of free and responsible individuals.