Price Theory as an Antidote

Or, why that recent paper on markups and inflation doesn't say what people think

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Over the last several years, the economics profession has embraced something called the “credibility revolution.” The idea is that we now have empirical tools that allow us to test for causal inference. These tools give us the ability to identify the causal effect of some policy or some variable on some outcome. These are no doubt valuable tools. However, a byproduct of this revolution has been the devaluation of economic theory (if you don’t believe me, check in on the market for theorists). For some, this so-called credibility revolution has created the impression that one can simply let the data speak.

This sentiment is understandable. There is a sense in which theory is just like a theory, man. But the evidence, well that is the evidence.

On the other hand, data do not and cannot speak. In order to come up with an empirical model or test a hypothesis, one needs to have a theory.

Perhaps the primary value of price theory is that it is an antidote to bad arguments — or maybe not bad arguments, but rather ideas that do not hold up well under closer scrutiny. Price theory disciplines one’s thinking.

This is true no matter the question. For example, people often ask why I write so much about both price theory and macroeconomic topics. After all, isn’t price theory about microeconomics? My answer is largely what I wrote in the last paragraph. Price theory disciplines one’s thinking, even for macroeconomic questions. I often lament that the microeconomic foundations of modern macroeconomics aren’t the same as price theoretic foundations. But that is another post for another day. Today is better spent using price theory to examine a topic currently in the news.

A prime example of the value of the discipline provided by price theory is the recent discussion of markups and inflation. Recent research has argued that markups account for over half of the increase in the recent inflation. But what does this mean? If you think about this as a causal argument, it seems to suggest that inflation is caused by firms increasing their prices. But prices rising on average over time is the definition of inflation, not the cause of inflation. Also, if we are thinking in terms of causation, markups seem like a weird place to focus attention with regards to inflation. Prices have been rising across the board and across the developed world. Thus, if rising markups caused the rise in inflation, one would need to explain why firms, across the board, suddenly and simultaneously increased markups.

Although the idea that inflation was caused by a sudden, simultaneous increase in greed markups is rather silly, this doesn’t mean that evidence of rising markups has nothing important to tell us about the world. For example, much of the debate about inflation has largely been about whether inflation has been caused by supply-side factors or monetary policy. Some have argued that supply chain issues in the aftermath of the pandemic, coupled with higher commodity and energy prices caused by Russia’s invasion of Ukraine explain the increase in inflation. Others (like me) have argued that rising inflation is caused by unprecedented growth in the money supply. Perhaps what is going on with markups can help us to disentangle these arguments.

In fact, I would argue that a simple application of price theory suggests that the behavior of markups can tell us something about whether inflation is supply-driven or demand-driven — but it might not be the story that has been going around.

One argument that I have heard is that the evidence of rising markups supports the idea of supply-side factors being the dominant driver of inflation. The argument, so far as it goes, is that supply-side factors primarily drive up costs. In response to these rising costs, firms not only raise their prices, but also use the opportunity to raise their markups. Thus, higher markups imply that inflation is supply-driven. (Brian addressed some of these arguments previously.)

While that story might sound reasonable enough, a basic application of price theory tells us that this is wrong. If markups are rising, it must be because demand is increasing. Rising markups cannot be explained by rising marginal costs. The logic is as follows.

One way to think about perfectly competitive firms (i.e. firms with zero market power) is that they take price as given and they choose how much to produce given the price they observe. They choose the quantity of production to maximize profit. For these firms price will always equal marginal cost if they are maximizing.

Firms with market power get to set their own price. However, since they face a downward-sloping demand for their product, they cannot just set the price at whatever level they want. Their choice of the price will determine the quantity demanded for the product. One way to think about these firms is that they set their price, taking the demand curve as given, to maximize their profit.

For both types of firms, profits are maximized when marginal revenue is equal to marginal cost. However, for the price-setting firm, the price will be above marginal cost (i.e., there is some markup above the marginal cost of production). To see why, consider the figure below.

The curve labeled D in the figure is the demand curve. It captures the typical negative relationship between price and quantity demanded. The curve labeled MR is the marginal revenue curve. Notice that because of the downward-sloping demand curve, the marginal revenue generated by the firm at any given quantity of production is less than the price. It is straightforward to see why. If the price was fixed and the firm increased production by one unit, the marginal revenue from that additional unit of production would simply be the price. However, with downward-sloping demand, the willingness to pay of consumers is decreasing for each additional unit of the product. As a result, the marginal revenue will necessarily be less than the price.

From our discussion thus far, we know two things that are important: (a) marginal revenue is less than the price, and (b) if firms maximize profits, then marginal revenue will equal marginal cost. If price is greater than marginal revenue and marginal revenue is equal to marginal cost, then the price is also greater than marginal cost (i.e., there is a markup).

Now, let’s see how much we can get from just this information.

To make things simple, let’s imagine that the marginal cost is constant (i.e., independent of the quantity of production). This can be illustrated as the marginal cost curve labeled MC in the figure above, where c is the marginal cost no matter the quantity of production. Note that, given this marginal cost, the firm maximizes profit by producing a quantity, Q*, and charging a price, P*. This is the profit-maximizing quantity of production because it is the quantity that equates marginal revenue with marginal cost.

If we think that rising markups are caused by supply-side disruptions, we can examine this idea in the context of our graph. Notice from the figure that the markup is the vertical distance between the demand curve and the marginal revenue curve at the point at which the marginal cost curve intersects the marginal revenue curve.

Given that understanding, consider what happens as marginal cost increases. On the figure, the curve labeled MC would shift up. The point at which the marginal revenue and marginal cost curves intersect would be up and to the left of the intersection point illustrated in the figure. But as the intersection point moves up and to the left, the vertical distance between the demand curve and the marginal revenue curve gets smaller. This means that the markup gets smaller. Since one moves up and to the left along the marginal revenue curve as marginal costs rise, this necessarily implies that markups get smaller as marginal costs rise. Thus, increasing markups cannot be explained by higher marginal costs.

The intuition for this result is straightforward. If a firm sees its cost for the next marginal unit of production increase by $5, the firm would like to pass on that cost to the consumer. But higher prices reduce the quantity demanded for the product. As a result, the firm cannot pass along the entire additional cost if it also wants to maximize its profit. To maximize profit, it can only pass along some of the increase in marginal cost. The price of the good therefore rises less than the cost and the markup gets smaller.

But if rising costs can’t explain higher markups, then what does?

The answer is simple: an increase in demand. As demand rises for the firm’s product, that means the marginal willingness to pay for each unit is rising. Holding the marginal cost constant, this implies a higher markup.

To summarize, higher markups are inconsistent with rising marginal costs, but are consistent with increases in demand. Given that we are seeing higher markups coinciding with higher inflation, this suggests that the recent bout of inflation has been demand-driven. (A conclusion we have come to before.)

Now, in reality, it is likely that both marginal costs have been rising (due to supply-side factors) and demand has been increasing due to expansionary monetary policy. Nonetheless, the fact that we see higher markups suggests that the effects of the demand-side factors are larger in magnitude.

Finally, I realize that someone might critique this argument on the grounds that I used a rather simple model with a linear demand curve and question whether that is a realistic assumption. But this really just gets back to the point of my post. If the “supply-side factors are driving higher markups” story doesn’t make sense in the context of this simple model, what conditions would have to be necessary for it to make sense? Price theory must discipline our thinking.