Category: demand factors

Cause and Effect

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May 26, 2024

by Stephen Stofka

This week’s letter is about the causes of inflation. Inflation can be easily described as a mismatch between supply and demand but that is a tautology that does not explain how the mismatch occurred. For hundreds of years, scholars and academics have identified various components of inflation’s causal web but identifying a primary cause has inspired enthusiastic debate. In the past century, economists have built sophisticated mathematical models which failed to predict a subsequent episode of inflation or predicted an inflation that did not occur. Economic models predicted that large government support during the financial crisis fifteen years ago would lead to higher inflation. It did not. Some economists were surprised at the extent and strength of the inflationary surge following the pandemic. In hindsight, turning off the world’s economic supply engine for even a short time was likely to have a strong effect on prices.

In The Power of Gold, Peter Bernstein (2000) recounts the causes that sixteenth century scholars gave for the persistent inflation in Europe during the 1500s. Those factors included “the decline of agriculture, ruinous taxation, depopulation, market manipulation, high labor costs, vagrancy, luxury and the machination of businessmen” (p. 191). Five hundred years later, most factors are relevant today in an altered form. With more sophisticated analytical tools, economists have developed a better understanding of these causal influences but that understanding has not led to better inflation forecasting. These factors can be grouped into those that affect supply or demand. Missing from that list was war, a common cause of inflation that distorts both supply and demand.

Prior to the severe cooling of the Little Ice Age in the 1600s, England and northwest Europe experienced a cooler climate that affected harvests. In an economy that relied mostly on agriculture, a poor harvest, or decline in agriculture was a supply constraint that pushed up prices. The demand / supply relationship is a fraction that helps explain a change in price. A lower supply, the denominator in that fraction, equals a higher price. Repeated waves of the plague and other general pandemics led to a depopulation that reduced the work force and pushed up the subsistence wages paid to workers. Employment in the U.K. has still not recovered from pre-pandemic levels, contributing to slightly higher inflation in the U.K. compared to the U.S.

High labor costs are the essence of a cost-push theory of inflation. When there is not enough supply of labor, workers are able to command higher wages. In many businesses, labor is an employer’s highest cost. Because employers markup all production costs, that markup increases the rise in prices. If employees get an extra $1 wage and the employer marks it up 50% to cover operating expenses, required taxes, fixed investment and profit, then the price will rise $1.50. The additional wage income will increase demand, resulting in a wage-price spiral that further exacerbates inflation. Any policy that reduces the supply of labor can be included in a cost-push theory of inflation.

Vagrancy, or homelessness, was a new phenomenon in the 16th century as Europe emerged from the feudal system in which workers were bound to the properties they cultivated. Policies that tolerated idleness of any sort reduced the work force and gave workers more bargaining power. Scholars of that century would be puzzled by modern day unemployment insurance which “rewards” workers for idleness. The mathematics of probability and risk that makes any insurance program feasible was barely in its infancy. By the late 17th century, Blaise Pascal and Pierre de Fermat had developed probability analysis, giving pools of underwriters gathered in coffee houses near London’s Royal Exchange the mathematical tools to sell insurance policies on many risky events (Bernstein, 1996, 63, 90).

Ruinous taxation consisted of import taxes and the debasement of hard metal currencies by the sovereign as a substitute for taxation. Import taxes on necessary commodities increased production costs, creating a cost-push effect. To repay debts incurred during war campaigns, rulers debased the currency by mixing base metals with gold or silver. In the 4th century B.C., Dionysius of Syracuse in Sicily had all the coins in his kingdom restamped to double their value so he could pay his debts (Bernstein, 2000, 48). Monetarists claim that an excess supply of money is the root cause of inflation. The economist Milton Friedman, never one to equivocate, stated flatly that inflation was “always and everywhere a monetary phenomenon.” In the Wealth of Nations, Smith (1776; 2009) noted that gold discoveries in the Americas had driven prices higher in England. A higher supply of money of any form will increase demand so this root cause is a subset of demand-pull theories of inflation.

Popular and scholarly opinion often points an accusing finger at the business class, whose conspiratorial machinations are thought to be responsible for rising prices. Historian Barbara Tuchman (1978, 163-165) described the power that merchants had acquired as the Third Estate under feudalism in 14th century France. Because many merchants were free citizens of a town and not subject to the rule of a noble, they enjoyed wealth and privileges like that of nobles, and at the expense of the workers who regarded them with scorn and envy. In Part 1, Chapter 10 of the Wealth of Nations, Smith wrote “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” Responding to the global inflation following the Covid-19 pandemic, some op-ed writers and Twitter threads were convinced that collusion by business interests was the primary cause of the inflation.

The reasoning and analysis by thinkers of centuries past did not include the role of expectations in fostering and feeding inflation. Expectations are a key part of some prominent models because supply and demand operate on different time scales. The companies that make up the supply chain must anticipate the level of demand for a product or service before the demand manifests. Each year, the risk of being wrong increases in an economy marked by technological change and rapidly evolving tastes. Inflationary expectations needs a bit more space and will have to wait until next week. Have a good holiday weekend!

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Photo by Elias Kauerhof on Unsplash

Keywords: expectations, money, taxation, unemployment, supply, demand, cost-push, demand-pull

Bernstein, P. L. (1998). Against the Gods, the Remarkable Story of Risk. John Wiley & Sons.

Smith, A. (2009). Wealth of Nations. Classic House Books.

Tuchman, B. W. (1978). A Distant Mirror: The calamitous 14th Century. Alfred A. Knopf.

The Price Box

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April 2, 2023

by Stephen Stofka

This week’s letter is about prices. If you’ve have ever been a business owner – even a micro business like delivering papers – you are aware that price is a label on a box. My wife and I have a cat, Ellie, and we keep all of her toys in a cardboard box in the living room. The price of one product – $24.99 – is like a label on all the objects in that box.

Inside that price are supply factors, the costs of making and distributing the product and the vendor’s costs in selling the product. To a kid delivering papers on a bicycle those costs include broken chains and flat tires and brake repair. There are opportunity costs – what else a kid could be doing when they are out delivering newspapers.[i] The supply of a product entails legal costs and taxes and the institutional costs of maintaining property rights. The court system and the police force are in that price box. Is the market for that product a monopoly or competitive? Trade restrictions and tariffs, supplier subsidies, weather and seasonal factors – It’s in the box.

There are demand components in that box as well. How responsive are customers to changes in price and the trend in income growth. Consumer expectations of price increases or supply shortages for that product and competition from other vendors and goods. Substitutes or complements for the product. Consumer subsidies like low interest loans, mortgage loan government guarantees, bankruptcy laws and favorable tax laws. Time itself is in the box. Our tastes and desires change with the years and that’s in the box.

There is a calculation procedure in linear algebra where a bunch of numbers get multiplied and added together to give just one number. That’s what a price is. It is a piece of information that unfolds into an origami of the structure of our society, government and economy. If uncovers our moral values and the relationships of power within our society.

Economists of the Austrian School of Economics stress that prices help organize production and consumption decisions. They reject the emphasis on regulation as a director of resources. They sometimes refer to Adam Smith’s “invisible hand,” the idea that people seeking their own well-being can act for the benefit of everyone. Prices work in that world. The drive to seek our own well-being has a darker side that Smith explored throughout his book, The Wealth of Nations. In that world, isn’t there a need for regulations to curb individual appetites? Those who craft and enforce the regulations are themselves seeking their own well-being.  

We often say that “no one is above the law.” However, everyone wants to “get around the price,” and the politically powerful are able to do so. Smith advocated a free market only as a last resort after documenting the many instances where policymakers – “magistrates” and “council members” – wrote laws that favored the rich and influential. He was in favor of a well-regulated economy that ensured fair and equitable rules for everyone but there is no one capable of that. Smith found relationships of power corrupted most rule-making.

In Part 1, Chapter 7, he explains the price advantage enjoyed by those who secured a monopoly for their product or service. They were then able to charge the highest price. In Chapter 8, capitalists had contrived to have laws written that permitted the combining of capital but did not permit workers to form unions to increase their bargaining power. Business owners regularly colluded with each other to keep wages low. Smith writes “whoever imagines … that masters [employers] rarely combine, is as ignorant of the world as of the subject.” This from a man who studied the wages and prices in Europe and the colonies. Chapter 10, he notes the Statute of Apprenticeship laws that restricted the free movement of labor from one town to another and from one company to another. The weaving of plain linen and plain silk were similar skills but linen weavers were not allowed to transfer to another company to weave silk. In Chapter 11, he documents how French vineyard owners got a law passed that prevented any new vineyards. This preserved the vineyard owners pricing power. There were money policies and trade rules that preserved the power of the politically powerful in Britain at the expense of the American colonists. The American colonists were allowed to harvest raw materials but were required to ship them to British manufacturers to make the final products from those inputs. The book was published in 1776, the same year that the colonists finally got fed up and declared their independence.

Because prices direct production and consumption, so many of us want to alter that direction for own benefit. In the past weeks I have written that social, political and economic behavior is better understood as a recursive function where the output from the function becomes the input to the next call of the function. As some parties in the free market successfully alter the rules that govern the costs that are in the price box, that raises the call for regulation from those who are disadvantaged by that alteration. So policymakers and regulators write rules that rearrange the costs as a corrective to the distortions committed by the people and companies that they regulate.

Economic purists may envision a market of prices that work like an Antikythera mechanism, directing resources for the general well-being. Economic students are taught the ideal of the perfectly competitive market even though it rarely exists. Aircraft wing designs are tested in a wind tunnel without an engine powering the wing. This eliminates distortions in the interaction between wind and wing. Isaac Newton envisioned a universe without gravity and friction – both of them “unbalanced forces” – to derive the first law of motion. Too much deductive economic theory is founded on the assumption that a social science like economics can be tested with the same methods used in the physical sciences.

Socialist purists clamor for ever more regulation to fix an endless supply of injustice in the market. They open up the price box and see all the dark forces that Smith wrote about – monopoly and collusion and greed and bigotry that harms the general well-being. They claim that regulators and lawmakers are able to overcome their self-centered impulses and act in accordance with democratically created law. To paraphrase Smith, whoever imagines that to be the case is as “ignorant of the world as of the subject.” He did not have a cynical view of human nature but a realistic view of the natural contradictions of human nature.  

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Photo by Katrin Friedl on Unsplash

Keywords: supply costs, demand factors, Austrian Economics, price theory, regulations

[i] Conventional economic theory too often assigns little or no value to leisure. Tate & Fegley (2020) argue that leisure is a complementary good to labor the way that mustard is a complementary good to a hot dog. They countered the neo-classical assumption that people would work all of their waking hours if they were paid enough.  

Fegley, T., & Israel, K.-F. (2020). The disutility of Labor. Quarterly Journal of Austrian Economics, 23(2), 171–179. https://doi.org/10.35297/qjae.010064