Don't Ask People Why Prices are Rising

When I see economists that I’ve never met before in public, they usually greet me with “hey, you’re the Jones Act guy” or “hey, you are the price theory guy.” Once upon a time, they greeted me as “hey, you are one of those nominal GDP targeting guys.” I’ve been a one-trick pony three times now, which is sort of impressive, I guess.

One of the reasons that I have advocated for nominal GDP targeting is my experience reading debates about the causes of inflation in the 1970s. Some people insisted that the inflation was due to supply-side factors, such as high oil prices and unions demanding higher wages. Others insisted that inflation was caused by monetary policy. This seemed like a really difficult issue for a central bank. If the problem is a supply shock, then tightening monetary policy will bring down inflation, but lead to a greater decline in economic activity. On the other hand, if the problem is that monetary policy is too loose, then a tighter monetary policy is exactly what is needed.

Nominal GDP targeting removes the need to make this determination. A supply shock will cause prices and economic activity to move in opposite directions. So nominal GDP won’t change much, if at all. A change in demand will cause prices and economic activity to move in the same direction, which means that there will be a clear increase or decrease in nominal GDP following the change in demand. With a nominal GDP target, the central bank only responds if nominal GDP differs from its target. Thus, the central bank will safely ignore supply shocks and doesn’t have to try to figure out in real-time whether it is supply or demand that is changing.

Distinguishing between a supply shock and a change in demand at the aggregate level is a potential problem for central banks. Yet, at the microeconomic level, this is also a problem for those trying to understand what is going on in many markets in the aftermath of shutdowns during the pandemic.

One thing that makes it hard to determine what is going on in real time is that so many things are happening at once. While turning your iPhone off and then turning it back on again often improves its performance, the opposite seems true of the global supply-chain. At the same time, the U.S. government has been using policy to try to mitigate the costs of the pandemic. One example is the government issuing checks to taxpayers. With all of this stuff going on, how do we determine the cause of the sorts of things that we have observed?

This is where price theory comes in. I would argue that a lot of Armen Alchian’s discussions about markets, especially in his textbook with William Allen, was motivated by these information problems. A consistent theme in Alchian’s work is that what looks like a supply shock and what people tell you is a supply shock is often not a supply shock.

In University Economics and its subsequent iterations, Alchian and Allen give the example of a butcher. Since demand fluctuates from day-to-day, the butcher will tend to have an inventory of beef. This inventory acts as a buffer against these day-to-day fluctuations in the demand for beef. On days when demand is high, the inventory will tend to be drawn down. On days when demand is low, there will be more inventory left over. However, suppose that there is an increase in the overall demand for beef (i.e., people are buying more beef, on average, every day). In this case, the butcher will see his inventory drawn down by more than anticipated. The butcher might even run out of beef. As these inventories are drawn down, the butcher will place a bigger order with the meat packer-supplier. The meat packer-suppliers will then see a draw down in inventories as well and will then want to purchase more cattle.

Since, in short-run, the supply of cattle is fixed, this greater competition for a fixed supply of cattle will tend to lead to higher prices for cattle. The meat packer-suppliers will then raise their prices and tell the butcher that they have to raise their prices because the price of cattle has gone up. The butcher will then raise his prices and tell the customer that he is raising his prices because his costs have gone up.

After presenting this example, Alchian and Allen then ask the reader to think about who is responsible for the increase in the price. The answer is clearly the consumers whose demand has risen. They are the ones who set in motion the process by which prices increased. Yet, if we were to ask meat packer-suppliers why prices have gone up, they will blame the cost of cattle. If we ask the butcher why prices have gone up, he will blame the rising prices of the meat packer-suppliers.

In short, if we ask people why prices have gone up, they are likely to blame higher costs or an insufficient supply. However, the terms “excess demand” and “shortage” mean the same thing. Prices go up when there is not enough of the good to go around, but excess demand (or shortages, if you like) can be caused by an increase in demand or a decrease in supply. Thus, the fact that there is not enough to go around doesn’t actually tell us much of anything about the cause of the shortage.

This is an important lesson to keep in mind when reading media reports of higher prices. Sometimes reporters try to determine why prices are rising by talking to people in the supply-chain for that good. However, as I have just explained, people in this supply-chain might give misleading responses — not because they want to be misleading, but because their job isn’t to explain why something is happening. They can only provide information about their circumstances.

But price theory tells you where to look. If prices and quantities are moving in the same direction, it is a change in demand that is driving the price change. If prices and quantities are moving in opposite directions, it is a change in supply that is driving the price change. You don’t need to ask anyone.