Dec 16, 2022
Few economists would deny that supply-side disruptions have been a significant driver of inflation. Rising input costs and shortages created real constraints for corporations and prevented them from fully accommodating strong demand for consumer goods, such as automobiles and furniture, as the global economy emerged from the pandemic. Supply chain issues also slowed production and made it more difficult to get goods into the hands of consumers.
Unregulated corporate power to raise prices opportunistically without accountability allowed corporations to come out of the crisis ahead while consumers struggled to get by.
These shortages and rising costs were real, and some people in the economy were bound to lose out. But not everyone paid the same price. What's become clear over the last two years is that families and workers suffered the consequences - all while big corporations enjoyed windfall profits.
A potential loser could have been corporations. All else being equal, higher production costs eat away at corporate profit margins because companies have to pump in more money to produce the same amount of goods. And indeed, both input costs and labor costs for businesses have risen since 2021. However, corporate profit margins have skyrocketed despite rising cost pressures, reaching their highest level in 70 years in 2021. The scale of this profit growth was stunning. By the second quarter of 2022, for example, profits for nonfinancial corporations had increased nearly 100% over the course of the previous year, far exceeding pre-pandemic profit levels and margins. Meanwhile, the average worker was unable to command strong enough wage growth to keep up with rising prices, resulting in declining purchasing power for many households in 2021. Unlike large corporations, consumers were forced to absorb product shortages and a higher cost of living.
So what gives? How did corporations still achieve such strong margins and record-breaking profits in the face of shortages, bottlenecks, and rising costs?
Fundamentally, This Is a Story About Power
The proximate cause of higher profit margins is simple but often overlooked: extraordinary price hikes above and beyond what can be justified by rising costs. Large corporations had the flexibility to pass sudden and dramatic price hikes onto consumers - more than making up for their rising input costs.
This is by design. After decades of deregulation, rampant mergers and acquisitions, and lax antitrust enforcement, megacorporations have amassed the power to raise prices indiscriminately with little consequence when temporary cost spikes threaten profit margins.
Unfortunately, this supply crisis played out very differently for households struggling to get by. Shortages and high prices for essentials like baby formula and gasoline left consumers no choice but to accept these higher prices or go without. So, how did corporations turn a supply-side inflation crisis into a profit opportunity at the expense of households?
Corporations Are Bragging About Record Profits on Earnings Calls
Corporate executives are taking full advantage of recent crises to charge customers more and pad their profit margins - and they are admitting it on their earnings calls. Comprehensive and ongoing research and analysis of corporate earnings calls by the Groundwork Collaborative provides hundreds of examples of executives bragging about their ability to use crises such as the pandemic, supply chain problems, and war in Ukraine as cover to hike prices beyond what their input costs would justify.
As early as last summer, executives at Kroger told their investors, "a little bit of inflation is always good in our business," because it allowed them to increase their prices to account for inflation and then markup their prices, even more, using the general increase in prices as cover. While executives initially found inflation to be a useful smokescreen for their markups, they quickly found additional opportunities.
And these companies are clear that their price increases are more than offsetting the increased prices they're paying for their inputs. In October, the CEO of Mattel, which sells popular toys like Barbies and Hot Wheels, said the company was benefiting from "pricing actions and cost savings, which more than offset significant cost inflation."
Even as input costs have begun to come down in recent months and global supply chains slowly unsnarl, companies like PPG, a paint company, are clear that prices will not come back down. In April, when asked what the company will do as the cost of raw materials declines, PPG's CEO said, "...we're not going to be giving this pricing back."
Corporate earnings calls offer us a rich qualitative dataset that shows how corporate executives deliberately raised prices above and beyond their input costs to rake in record profits off the backs of consumers. These data, which corporate executives have so readily provided on their earnings calls, are reinforced when we look at the numbers.
Corporations Are Extracting More From Consumers Than Ever Before by Charging Higher Markups
The standard measure used by economists to capture the balance of power between consumers and corporations is the markup, the difference between the price a corporation charges to consumers and the cost it pays in production. Intuitively, if a corporation can get away with charging a higher markup of price above production cost, it pockets a larger chunk of consumers' income for every unit it sells.
A recent study from the Roosevelt Institute dives into corporate financial data to measure the change in markups that corporations charged consumers in 2021. The study shows that despite rapidly rising input costs, corporations were able to raise prices so much that they dramatically increased the markups they charged consumers.
And this was no small change. Corporations increased markups to the highest level ever recorded and achieved by far the largest single-year increase in markups -- more than 2.5 times the next-largest single-year spike.
The study also found that larger, more powerful corporations were able to increase prices the most. Corporations that charged higher markups before the pandemic increased their markups by more than weaker firms, lending empirical support to the idea that pre-existing market power amplified inflation. Moreover, markups increased by the most at the top of the distribution of markups. This means that the most powerful corporations increased their pricing advantages over both their customers and other corporations with less market power.
Researchers at the Federal Reserve Bank of Boston also found that corporations in more concentrated industries increase prices more in response to cost shocks than those in sectors with more competitors. Their estimates suggest that industry consolidation in the United States since 2005 has amplified the ability of corporations to pass cost increases onto consumers in the form of higher prices by 25%. This suggests that concentration may have played a quantitatively meaningful role in worsening the inflationary impact of supply disruptions.
Corporations Have Always Been Greedy; But Not Always in the Same Way
Of course, as many critics of the corporate power hypothesis have pointed out, corporations have always been greedy and have always tried to rip off consumers. Why weren't they already extracting as much as they could get away with before the pandemic? Were they simply leaving extra profit on the table?
Not necessarily. Corporations can use their monopoly power to achieve many objectives and, sometimes, sacrifice some pricing power to achieve other goals, such as snuffing out competitors to consolidate market share. At other times, it may be advantageous for them to go all-in on price increases. Economic theory can help us unpack how and when corporations prioritize pricing power above other strategies and what has changed in recent years to incentivize them to increase markups dramatically.
One influential theory of price-setting comes from a model by Nobel Prize winner Edmund Phelps and economist Sidney G. Winter. They emphasize that corporations face tradeoffs when setting prices. They want to hike prices to extract more profit from consumers in the short run, but over the long run, consumers can punish corporations for inflated prices by reducing their spending and switching to cheaper competitors. It just takes time.
For example, consumers may be able to move into a cheaper house or switch to a discount grocery store if rents or food prices go up. Eventually, this behavior can hurt a company's bottom line as aggressive price hikers lose market share. Because of this tradeoff, in normal times, corporations do not exercise all of their pricing power. Instead, they forgo some profits today to maintain a greater market share and ensure higher sales volumes tomorrow. However, corporations' latent pricing power also gives them a cushion to opportunistically ramp up prices when the benefits of short-run extraction from consumers outweigh the downsides.
Take Walmart and Target, whose executives had long pursued a strategy of increasing market share by keeping prices low. Initially, both companies expressed a strong commitment to keeping prices low, but as investors saw how widespread and successful price hikes had been across the retail industry, both companies experienced brutal selloffs. Within three months, both companies had raised their prices. Investor pressure is an important - and underexplored - factor in the story of recent inflation and the subject of a future blog post.
These incentives to opportunistically exert pricing power can help explain why markups rose by so much and why households ultimately ended up paying the cost of constrained supply (and then some). Costs rose temporarily, threatening profit margins. But corporations - especially large ones - had the flexibility to front-load price hikes to recoup lost profits via higher markups before consumers could adjust. And because consumer income and spending increased at the same time, consumers were able to spend more and absorb higher price increases. This flexibility to lean into pricing power matters because it allows large corporations to shift any additional cost burden onto consumers.
Shortages and Rising Costs... But for Whom?
On the other hand, consumers have little recourse when their cost of living rises, especially for essential goods and services. Skyrocketing prices on food or shelter leave consumers with limited options. They must simply absorb higher prices, or in the worst case scenarios, lose their home or struggle to feed their children. In economic theory, this is called "inelastic demand," which means that demand for essentials stays high, regardless of price, because consumers won't - or can't - cut back.
Megacorporations that sell essentials, from food manufacturers like Tyson Foods to insulin producers like Sanofi and Novo Nordisk, have more pricing power and, therefore, can charge higher markups. And when there are real shortages in consumer products like baby formula or cars, consumers are often forced to simply go without (and often cannot compensate for higher prices with sufficient wage increases -- this is a deeper problem, which I will explore in a future post). As a result, consumers are forced into impossible choices at the whims of profit-hungry megacorporations.
While inelastic demand always amplifies corporate pricing power - even in the most basic Econ 101 model - consumers may be even slower to respond to price increases in an environment of economic chaos where many prices change at once. Households are facing a series of overlapping crises that restrict how they can adjust behavior in response to higher prices.
The CEO of Hostess highlighted unusual sluggishness in consumer price responses, noting that "we're also seeing consumers experience a lot of disruptions. And it's a large range of variability as we flow throughout the year. They're losing benefits. They're moving to a normalized COVID environment. They haven't fully recognized they were absorbed [sic] pricing." Meanwhile, executives at Procter & Gamble "take comfort" in "the short-term reaction of the consumer as [they] take pricing" because "we see a lower reaction from the consumer in terms of price elasticity than what we would have seen in the past... in the range of 20% to 30% lower than what we would have expected based on historic data."
This slow adjustment by consumers can lead to a "rockets and feathers" phenomenon, in which corporations can immediately raise prices on consumers as their input costs go up, but as costs begin to fall, they can still take advantage of consumers by keeping prices elevated. This rockets and feathers dynamic has attracted attention at the highest level of policymaking. Lael Brainard, vice chair of the Federal Reserve, recently noted that "reductions in markups could also make an important contribution to reduced pricing pressures... Although we are hearing some reports of large retailers planning markdowns due to excess inventories, we do not have hard data at an aggregate level suggesting that businesses are reducing margins in response to more price sensitivity among customers."
This phenomenon is corroborated in earnings calls over and over again. Take Kraft Heinz, whose CFO predicted on their Q2 earnings call that the company's margins would increase because "as we continue to price inflation, the inflation events that start to ease, that might put us in a better position for us to continue to recover the margin." Meanwhile, the CEO of Autozone reassured investors by noting that "following periods of higher inflation, our industry has historically not reduced pricing to reflect lower ultimate cost." In short, even as the legitimate supply forces driving prices up start to ease, prices for consumers stay sky-high.
The recent crisis has revealed how fragile and vulnerable our economy is to supply disruptions. In the long run, we must build a better system that can adapt and prove resilient in times of emergency. But the current crisis did not need to be as painful as it was. Unregulated corporate power to raise prices opportunistically without accountability allowed corporations to come out of the crisis ahead while consumers struggled to get by. Economic theory and our policy response must account for corporations' role in transforming supply shocks into higher prices if we want to mitigate the damage already done and build a better response going forward. In future blog posts, I will further explore the shortcomings of our theory of inflation and the damage done by the status quo policy response.
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