The word above is on everyone’s mind these days. There is a lot of panic around rising prices. But what is Inflation and how can we understand it? In this post I want to present a simple mental model and work through some sources of Inflation – because not all inflation is the same.
Inflation is defined with respect to the rise in price of a basket of products. These could be consumer products or wholesale products. The key idea is to track the price of that basket. If the price is rising we call it inflation and the rate of change of this price is the often quoted ‘rate of inflation’.
Central Banks usually target an inflation rate slightly greater than 0%. Bank of England for example targets the rate to be in 0-2% range. But why do we need this to be a small positive number? Why can’t we freeze the prices? Won’t that be good for all? Let us try and understand this using a simple model.
The Price Model
To understand inflation we need to first understand how products and services are priced. That will help us understand how it can change.
When we consume anything – be it a service (e.g. Uber ride) or a product (e.g. chocolate bar) we pay a price that includes all the factors that went into production. The common factors are stated in the image above: Land, Capital (money and goods), Labour (skilled and unskilled), Raw Materials and Energy.
The price also includes the perceived value of the product or service, margins, cost of hidden services (e.g. HR, Legal, Finance) and tax costs. This is above the cost of production.
Input factors underlined in green can change very quickly due to various factors. It is said that current bout of inflation is due to rising energy prices (oil and gas) caused by the Ukraine war.
There are also hidden Services that are part of production (e.g. logistics) that are impacted by rising factors such as fuel costs.
Price = Perceived Value + Cost of Input Factors + Cost of Hidden Services + Margins + Taxes
Furthermore, Demand for a product along with its Price gives us one part of the Profit equation. After all aim of a selling a product or service is to make a Profit – which means the Demand and the Price should provide enough money to not only cover the outflows in terms of costs, margins and taxes but also to generate a return for the shareholders.
Origins of Inflation: Supply Side
Now we start looking at the Supply Side (from producers point of view) sources of price rise (inflation). A common thread in all these is ‘expectation’. If as a producer I expect people can pay a bit more I will try and raise the price before the competition catches on and make that bit of profit. Similarly, if as a seller I expect my input costs to rise (e.g. rise in interest rate, raw material costs or salary increases to retain talent).
Profit Motive and Perceived Value
Price can increase if I as a producer I feel:
- there is extra money for people to spend (e.g. during a lockdown) and
- the Perceived Value of my product is significant
- supply is reducing
- the Perceived Value of my product is significant
then I know increasing the price should not badly impact demand. And since the above information is not secret if many producers increase their prices it can lead to wider price rise as knock on effects kick in. Perfect case in mind: hand sanitisers during the early days of Covid-19 pandemic.
While not a driver for inflation – one example where we can see two different producers copying each other is the pricing of Apple smartphones compared with Samsung smartphones. In the beginning Apple devices were more expensive than Samsung Galaxy S devices. Now Samsung Galaxy S series is more expensive given that they have no ‘iPhone 13 mini’ equivalent and are therefore firmly aimed at the value buyer.
Factor of Production Price Increase/Supply Decrease
This is where the web of inputs and outputs transmits price rise from source to target (i.e. our pockets). It is also lot easier to understand. For example: fuel gets more expensive (e.g. due to a war) that leads to wholesale food price increase (as logistics depends on diesel) which leads to an increase in retail price of food and eating out. This leads to people demanding higher salaries to compensate which in turn starts impacting other industries (as their skilled / unskilled labour cost increases). Because salaries don’t rise as quickly as prices people end up cutting expenditure.
Rising Cost of Capital
If the cost of capital increases (i.e. rise of interest rates) then not only do producers find it hard to borrow money to expand, the consumers find it hard to borrow money to buy things (e.g. houses, cars, phones). Producers find it harder to repay debts (e.g. commercial loans, mortgages) and are forced to raise prices.
If there is an expectation for prices to rise they will rise. For example, in the current scenario where there is massive press coverage of pending energy price rise, businesses will start raising prices because energy bills and other costs are difficult to trim down quickly. Cost of living increases will also force labour costs to go up which will accelerate price rise.
Origin of Inflation: Demand Side
The other side of inflation is Demand Side (from the Consumers point of view). The standard story is when there is too much money in the market the ‘value of money goes down’ therefore you have to pay more for the same product. But I see that the same as expectation driven. Consumers don’t set the price, they set the demand where possible. I say where possible because you can only reduce expenses to an extent. The way money floods the market is also asymmetric.
The ‘right’ price is not a single thing. As I explained with my pricing model various objective and subjective factors go into setting the price.
Therefore Demand Side inflation can be thought of as a game. Producers and Consumers are trying to find what is the ‘right’ price that maximises the return for Producers and benefit for Consumers (or so called utility). The rules of the game are simple:
- If the price falls below a certain level where Producers don’t generate any surplus at that level of Demand (i.e. their income) then there is no point in continuing to Produce otherwise the Producer won’t be able to Consume anything (unless they have other sources of income)
- if the price rises above a certain level where it impacts more and more people thereby Demand reduces to an extent that Producers no longer generate any surplus (at that price level) then there is no point in continuing to Produce
- therefore the game is to maintain the price between the two extremes while compensating for external influence (e.g. cost of capital, perceived value etc.)
Why a small positive number for Rate of Inflation?
This is because if there is expected growth in demand only then will there be a real growth in supply (no one will Produce excess goods unless they can be sold). With that in mind, for there to be expectation of growth in demand either the prices must fall or more money must be made available to buy the excess goods. Since it is difficult for prices to fall (especially given the Profit Motive and the fact that excess demand for Input Factors is likely to increase those prices) more money must be made available. With more money being made available we are seeding inflation.
What if we kept strict price controls?
What if there was a product P which didn’t depend on any imports. Not even for energy or logistics (no diesel trucks) or any outsourced service. I bet you are finding it difficult to think of many (any?) such products?
But let us assume there are products like that and we can keep prices of all the input factors constant (and the input factors going into producing those input factors and so on constant as well – it is a web at the end of the day).
So with that magic in place if we kept producing P at a fixed price then to still avoid inflation we must keep demand the same. Why? Because if demand is increasing (say due to population increase or expectation of shortage) and we don’t increase supply then there is an opportunity for arbitrage. People can buy and fixed price but sell at higher price to someone with greater need. Now if we increase supply to match the demand – we will transmit that demand down the supply web (i.e. we will need more input factors etc.) and at the end we will end up with someone owning raw materials (like oil, ore, IPR etc.) who will need to spend more money (e.g. wages, capital) to extract more. They won’t be able to transfer the increased demand down the web because they are at the edge. Now at that point these edge producers have an option to not raise prices: either get additional labour, output without increasing salary, interest bill or to reduce the profit margin. Assuming they reduce the profit margin (as generally people won’t work more for the same salary or accept less interest for a loan) they will avoid a price rise.
But what happens when the demand rises again (population keeps on increasing). There will come a time when profit cannot be reduced any further – and it will not be worth the edge producers while to remain in business. This is what happened during Covid-19 where the edge producers (in China) stopped producing at same levels – leading to price shocks around the world.
Hopefully I have peeled back some of the confusion around Inflation and its sources.
Some key points:
- Inflation is driven more by expectation than anything else
- Shocks can kick start inflation but it is the expectation that those shocks give rise to that really ramps up the price rise
- Shock -> Expectation -> Panic is the perfect storm for price rise
- Early inflation can lead to arbitrage opportunities where people buy cheap, hold and sell at a higher price
Thank you for reading!