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


Despite the fact that the latest inflation figures for New Zealand are rising slightly lower than expected according to many economists, the rate remains stubbornly high. Bee 6.7% 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 feel the pain of rising prices.

Big banks, shopkeepersAnd other businesses report or are expected to report record profits this year. It’s tempting to ask, like others to have abroad And in New Zealandthe extent to which corporate mega-profits and prices drive inflation.

The answer may surprise you. The reality is that corporate profits contribute very little to inflation.

Market power and inflation

When a seller has the ability to choose the price, economists say the company has market power. But their ability to raise prices is not unlimited. Just consider the case of Arivalea health tech startup in the United States that ultimately failed because the initial price of its offering was too high.

The degree of market power determines how high a company can set its price above its costs (the mark-up) to maximize its profitability. The optimal mark-up for a company depends on how sensitive its customers are to price changes.

Read more: Four reasons why inflation will remain stubbornly high for some time to come

In markets where customers are very sensitive to price changes, companies will charge lower prices (a lower surcharge) than in markets where customers are less sensitive to price changes. The optimal mark-up (as a percentage of the price) will not change unless there is a change in customers’ price sensitivity.

Higher inflation is unlikely to make consumers suddenly less sensitive to price changes. If anything, they will be more price sensitive and optimal markups should fall. That is why a large majority (79%) of economists recently questioned by the University of Chicago strongly disagreed or strongly disagreed that market power was a major factor in higher US inflation.

If it’s not a profit, then what?

So if companies don’t make a profit by increasing their markups, what accounts for the higher profits in a period of high inflation?

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

First, companies may face increased demand for the goods or services they provide. With interest rates historically low (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 kind of increased demand drives up prices and makes companies more profitable.

Read more: Modern monetary theory: The rise of economists who say huge national debts are not a problem

Second, companies are facing higher costs by inflation, including wage inflation. When costs are higher, companies pass on part of those higher costs to their customers in the form of higher prices. For most companies, higher prices due to higher costs do not lead to higher profits.

If we take these two factors together (increased demand leads to rising prices and profits; and higher costs lead to rising prices), it is likely that higher profits will not cause of inflation, but are themselves a consequence of the other underlying causes of higher inflation.

Recent work by Treasury economists showed that the increase in inflation in New Zealand was one third caused by demand-side factors, one third by supply-side factors, and that the remaining one-third was ambiguous (it may be demand side or supply side). -side). All recent increases in food prices could be attributed to either supply or demand factors. This again suggests that there has been little room for corporate profit to contribute to inflation.

Periods of high inflation are unwelcome. We may be tempted to blame corporate profits because they are an easily identifiable target. However, earnings are unlikely to contribute much or nothing to the inflation we are currently facing.

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