The case against 'greedflation'

The latest economics buzzword is 'greedflation' - the idea that firms exploit inflation by raising prices to create excessive profits (for example, see here). Aside from being a cool portmanteau and inspiring new memes, I just don't see it. In fact, I've said so. I wrote an article in The Conversation about it last month, and I was interviewed on RNZ's The Detail podcast last week (see also here, and similar points picked up by the New Zealand Herald's Front Page podcast here). I was pretty clear on The Detail - I'm a greedflation skeptic. This post outlines the theoretical and practical reasons why I believe that greedflation is an illusion.

First, let's consider how firms price their products. As I teach in my ECONS101 class, we assume that firms with market power are trying to maximise profits. If the firm sells a single product at a single price-per-unit, the profit-maximising quantity is the quantity where marginal revenue is exactly equal to marginal cost. As shown in the diagram below (which assumes a constant-cost firm, a point I will return to later), the profit-maximising quantity is QM. To sell the quantity QM, the firm sets the price equal to PM, because at that price the quantity of the product that consumers want to buy is exactly equal to QM. The difference between the price PM and the firm's costs PS is the firm's mark-up. The firm's producer surplus (profit) is equal to the area of the rectangle CBDF.

Now, once the profit-maximising price is set, there is no reason for the firm to deviate from that price. If the firm raises the price above PM, then by definition their profits must decrease (because PM is the price that maximises profits, so any other price must decrease profits for the firm). So, here we have the first theoretical case against greedflation - a firm that is already profit-maximising has no incentive to increase prices, because they are already maximising profits. It makes no sense for the firm to try and 'trick' consumers into paying a higher price, because consumers would buy less of the good.

Now, consider what would cause the firm to change the price it sets. First, a firm would likely change prices if its costs change. This is shown in the diagram below. If the firm's costs decrease from MC0 to MC1, then the profit-maximising price decreases from P0 to P1. This also works in reverse - if the firm's costs increase, then the profit-maximising price increases. This would not be 'greedflation'. Most proponents of the idea agree that a firm that is passing on higher costs to the consumer is not exploiting the consumer. Moreover, the research of Nobel Prize winner Daniel Kahneman and others shows that consumers see higher prices as 'fair' when they are driven by higher costs.

Second, a firm would likely change prices if demand changes. This is shown in the diagram below. When demand is shown by the curve D0, the profit-maximising price is P0, but when demand increases to D1, the profit-maximising price increases to P1, even though costs are the same. Is this 'greedflation'? Perhaps, if the firm tries to hide its increase in price behind a smokescreen of 'it's because of inflation'. Moreover, Kahneman's research (noted above) does show that consumers find price increases that arise from demand changes to be unfair. On the other hand, economists expect firms to increase prices when demand is high. It's how markets work on a routine basis, and isn't unique to a time of higher-than-usual inflation.

Third, a firm would likely change prices if consumers' price elasticity of demand changes. Price elasticity of demand is the consumer's responsiveness to a change in price. When demand is more price elastic, the demand curve is flatter, and the firm's optimal mark-up is lower. This is shown in the diagram below. If the demand curve is D0, then the profit-maximising price is P0, but if the demand curve was more elastic (D1), then the profit-maximising price is lower (P1), even though costs are the same. Why would demand become less elastic? There are many factors that affect the price elasticity of demand. However, most of them are fairly static and don't change much. The availability of substitutes, though, can change. When there are fewer substitutes available, as would happen if competition in the market decreased, that would make demand less price elastic, and raise the profit-maximising price for remaining firms in the market. Is this 'greedflation'? Again, perhaps, if the firm tries to hide its increase in price behind a smokescreen of 'it's because of inflation'. But I'd still argue that this is a routine consequence of a decrease in competition, and not unique to a time of higher-than-usual inflation. This explains the case of Air New Zealand, for example, which has been raised as an example of 'greedflation' in New Zealand. Jetstar wound down its services during the pandemic, reducing competition in the market for domestic air travel, and not surprisingly, Air New Zealand raised domestic airfares.

Ok, so we've established the conditions where firms with market power would increase prices (higher costs, higher demand, lower competition). However, as I note in my ECONS101 class, pricing in the real world is not as simple as that shown in the diagrams above. First, firms often don't know for sure what their demand curve is, and so they won't know for sure what their marginal revenue curve is, and so setting the price at the quantity where marginal revenue is exactly equal to marginal cost is difficult in practice. However, that doesn't mean that firms can't set a price at all. It just means that they can't always do it perfectly. A good manager has a fundamental understanding of their market, which means that they understand in relative terms how price elastic or price inelastic the demand for their product is. They can use that fundamental understanding to set the mark-up. They won't get it perfectly correct, but they shouldn't systematically get it wrong (if they did, they wouldn't be a manager for long). Then having set the price using their fundamental understanding, they adjust the price occasionally to take account of changing costs or changing market conditions. For example, they raise prices if their costs increase, or they lower prices if a new competitor opens down the street from their store.

Second, firms don't change their prices every time that market conditions change. That's because of menu costs - literally, the costs associated with changing prices. Menu costs may be low if all they require is changing some settings in the point-of-sale system, but can be higher if they require printing and attaching new price labels. Firms prefer to avoid these costs, as well as avoiding the uncertainty for consumers that constantly changing prices cause, so they tend to increase prices only infrequently.

Both of those real-world pricing problems mean that firms will often increase their prices by more than is justified by a strict accounting of an increase in their costs. Perhaps they are 'catching up' on an increase in costs from a few months earlier. For example, say that the firm has costs that go up from $10 to $12 to $15 from Month 1 to Month 2 to Month 3, but they keep their price the same at $20 from Month 1 to Month 2, and then raise it to $30 in Month 3. If you were looking for 'greedflation', you might then see evidence in favour of it between Month 2 and Month 3, when price increased by 50% but costs only increased by 25%. However, you are ignoring the previous month, when costs increased but the firm didn't change their price.

So, that's the theoretical and practical cases against 'greedflation'. I simply don't think that firms are hiding price rises behind a smokescreen of high inflation. There isn't much incentive for them to do so. Is there empirical evidence to support the idea of 'greedflation'? Quite the contrary. In the latest issue of AEA Papers and Proceedings, this article (ungated earlier version here) by Christopher Conlon (New York University) and co-authors looks at the relationship between changes in firms' mark-ups and changes in prices (as measured by the producer price index, deflated by the consumer price index). They note that:

Our starting point is the observation of Syverson (2019) that for markups defined as price over marginal costs (μ ≡ P / MC), an approximation provides

(1) ΔP ≈ Δμ + ΔMC.

Therefore, increases in markups should yield increases in prices unless they are offset by marginal costs changes.

Using annual data from CompuStat on revenue and cost-of-goods-sold for nearly 8000 firms, and covering the period from 1980 to 2018, as well as quarterly data from 2018 to 2022, Conlon et al. find that their data:

...do not reveal a strong correlation between markup and price changes during the sample periods.

In other words, price changes are not driven by changes in markups, which leaves changes in marginal costs as the explanation. In other words, there is no evidence of 'greedflation'. However, that doesn't mean that changes in competition are implicated solely, either. Conlon et al. note that:

A second explanation, proposed by Syverson (2019), is that if cost of goods is more similar to average costs than marginal costs, then we need to also adjust for the scale elasticity AC/MC,:

(3) μ ≡ P/MC = P/AC × AC/MC

So, if prices are increasing at the same rate as mark-ups, then that could be because average costs are increasing, or it could be because the ratio of average costs to marginal costs is increasing. That would happen if there were a re-balancing of costs from variable costs (MC) to fixed costs (a component of AC). Conlon offer some evidence from other studies that supports this argument. However, that's not 'greedflation' either.

The case against 'greedflation' is strong. Just because it makes a nice meme, that doesn't mean that it is true.