1. Wait, but it's pretty easy to show that for a monopolist facing isoelastic demand, the cost passthough is > 1, so that would suggest that with market power, markups could increase (how likely, idk). However, profits must fall (on average)
2. In any oligopoly model, an industry-wide cost shock will have a greater impact on firm i's price than a shock affecting i only. It's therefore not surprising that earnings calls sound more positive when shocks are industrywide than when they are idiosyncratic, per Weber's paper.
3. Raising rival's costs: if a cost shock affects the whole industry, it seems possible that those with a competitive advantage can earn a higher profit because amplified competition amplifies their advantage. However, this cannot happen on average.
Great post! I love the idea of looking for testable predictions to distinguish between competing theories.
I just have one quick question. Doesn't the price elasticity of demand also matter for what will happen to profits in a competitive market? Steven Landsburg actually makes this point when considering the consequences of supply shocks for profits in his Price Theory textbook (excerpt linked below). His argument suggests rising costs would actually be more likely to increase profits in competitive markets than in markets where firms have price setting power.
To illustrate this point, Landsburg considers the gasoline market. In 1999, the price of crude oil nearly tripled. This led to an increase in gasoline prices and higher profits for U.S. gasoline producers. How could gasoline producers earn more profit despite higher input costs? Reporters and politicians attributed this rise in profits to gasoline producers exploiting monopoly power to charge higher prices. Landsburg argued that this didn't make sense. For higher prices to raise firm profits, they would have to increase total revenue more than crude oil prices are raising costs. However, higher prices will only increase revenue when demand is inelastic. Monopolists never produce on the inelastic portion of the demand curve. If gasoline producers were able to earn more revenue by raising prices, that must mean they were on the inelastic parts of the demand curve and thus not monopolists. By contrast, nothing prevents a competitive market from having supply intersect demand where demand is inelastic. So, in Landsburg's telling, rising profits actually suggest gasoline producers are more competitive than monopolistic. He summarizes his argument as "rising costs can lead to rising profits only in the absence of monopoly power."
If Landsburg is right, maybe observing rising profits in tariff-affected industries would be more consistent with standard competitive theory than Weber's sellers' inflation theory?
Sellers’ inflation, it would seem to me, faces a similar constraint as would a monopolist: namely elastic demand. Not many products are like eggs and salt.
Nice post!
1. Wait, but it's pretty easy to show that for a monopolist facing isoelastic demand, the cost passthough is > 1, so that would suggest that with market power, markups could increase (how likely, idk). However, profits must fall (on average)
2. In any oligopoly model, an industry-wide cost shock will have a greater impact on firm i's price than a shock affecting i only. It's therefore not surprising that earnings calls sound more positive when shocks are industrywide than when they are idiosyncratic, per Weber's paper.
3. Raising rival's costs: if a cost shock affects the whole industry, it seems possible that those with a competitive advantage can earn a higher profit because amplified competition amplifies their advantage. However, this cannot happen on average.
Great post! I love the idea of looking for testable predictions to distinguish between competing theories.
I just have one quick question. Doesn't the price elasticity of demand also matter for what will happen to profits in a competitive market? Steven Landsburg actually makes this point when considering the consequences of supply shocks for profits in his Price Theory textbook (excerpt linked below). His argument suggests rising costs would actually be more likely to increase profits in competitive markets than in markets where firms have price setting power.
To illustrate this point, Landsburg considers the gasoline market. In 1999, the price of crude oil nearly tripled. This led to an increase in gasoline prices and higher profits for U.S. gasoline producers. How could gasoline producers earn more profit despite higher input costs? Reporters and politicians attributed this rise in profits to gasoline producers exploiting monopoly power to charge higher prices. Landsburg argued that this didn't make sense. For higher prices to raise firm profits, they would have to increase total revenue more than crude oil prices are raising costs. However, higher prices will only increase revenue when demand is inelastic. Monopolists never produce on the inelastic portion of the demand curve. If gasoline producers were able to earn more revenue by raising prices, that must mean they were on the inelastic parts of the demand curve and thus not monopolists. By contrast, nothing prevents a competitive market from having supply intersect demand where demand is inelastic. So, in Landsburg's telling, rising profits actually suggest gasoline producers are more competitive than monopolistic. He summarizes his argument as "rising costs can lead to rising profits only in the absence of monopoly power."
If Landsburg is right, maybe observing rising profits in tariff-affected industries would be more consistent with standard competitive theory than Weber's sellers' inflation theory?
Excerpt from Landsburg's Price Theory Textbook:
https://docs.google.com/document/d/15O_lNDsc_16oRNtmz6TizDdoI2x_JcidMOaIhAai6c8/edit?usp=sharing
Sellers’ inflation, it would seem to me, faces a similar constraint as would a monopolist: namely elastic demand. Not many products are like eggs and salt.
Weber should stick to gardening.