Wednesday 10 August 2022

INFLATION: Critique of the "Cost-Push" Explanation in General

See earlier posts in this series about what doesn't cause inflation:

"The supporters of the various cost-push doctrines recognise the validity of the formula for the general consumer price level*. However, they perceive the role of rising demand in a different way than do the supporters of the quantity theory of money. While the supporters of the quantity theory of money see more monetary demand as the cause of higher prices, the supporters of the cost-push doctrines see it as the cause of greater production and supply. In their view, more demand causes correspondingly more production and supply and therefore does not raise prices. The reason the supporters of the cost-push doctrines believe this is because they see the existence of unemployed labour and idle plant-capacity, and they assume that so long as unemployment and idle capacity exist, the effect of more demand is simply to enable more people to be employed and therefore for production to be increased. 

    "The supporters of the cost-push doctrines are willing to concede that more demand is potentially capable of raising prices. But that, they say, could happen only in the context of an economy operating at full employment and in which, therefore, supply could not be further increased in response to more demand. At that point, they are willing to admit, more demand would not be accompanied by more supply and would thus drive up prices. The expression they use to describe this situation of more demand raising prices at the point of full employment is, of course, 'demand-pull inflation.' At the point of full employment, they say, more demand 'pulls up' prices. This so-called demand-pull inflation is the only potential influence of more demand on prices that they recognise. To them, more demand as a cause of inflation means 'demand-pull inflation.'

    "Observe how the supporters of the cost-push doctrines think. They have decided that more demand is capable of raising prices only at the point of full employment. They have decided that short of full employment, the effect of more demand is not higher prices, but more supply.... The reason rising costs are taken as the explanation is because, in fact, the prices of many [mass-produced] goods are determined in the first instance on the basis of their cost of production, as I showed in Chapter 6 of this book.

    "Of course, I also showed that all prices determined by cost of production are still ultimately determined by supply and demand... Cost of production—and this point is relevant now—is always based on prices, including wages, which are the price of labour....

    "The fact that cost of production is not an ultimate explanation of prices constitutes a major logical deficiency of the cost-push doctrine. Because what the cost-push doctrine is actually claiming is that some prices rise because other prices rise, and it is content to leave matters at that. For example, the supporters of the cost-push doctrine blame inflation on such things as the rise in the price of steel or the rise in wages achieved by various unions. They do not offer any explanation of what makes possible the higher price of steel or the higher wages obtained by the unions. 

    "In fact, as already shown, what the cost-push doctrine boils down to is the claim that certain key prices, and this includes wages, rise arbitrarily, without any explanation other than the greed of those who raise them. The cost-push doctrine, in the last analysis, is a doctrine that tries to blame price increases on some form of arbitrary power. It tells us, in effect, that prices rise simply because some powerful people are making them rise.

    "Now it is true that in our present economic system, that is heavily overlaid with government regulations and controls—i.e., the so-called mixed economy—arbitrary [politically-protected monopoly] power does exist.... But this much can be said right now: The basic reason why arbitrary power on the part of sellers is not a sufficient explanation of rising prices is that such higher prices as it might bring about always cause reductions in the quantity of the good or service that can be sold and, therefore, act as a brake on any further such price increases. This is closely related to an even more fundamental objection, namely, that the cost-push doctrines are equivalent to an attempt to blame inflation on falling supply, which we have already seen is invalid. 

    "In order to prove this equivalence, all that is necessary is to perform a kind of mental experiment in terms of the price-level formula [where P=general level of prices for consumer goods, Dc = aggregate monetary demand for those goods, and Sc = their aggregate supply].

    "Our mental experiment consists simply of this: We assume that monopolistic sellers arbitrarily drive up prices, just as the cost-push doctrine claims. But we also assume that while this rise in prices occurs, there is no change in aggregate demand. We make this second assumption because if the rise in aggregate monetary demand is really not a factor in raising prices, as the supporters of the cost-push doctrine tell us, then its absence can make no difference. 

    "Thus, what we have is a rise in prices and a fixed aggregate demand—a fixed amount of spending. In terms of the elements of our formula P is up, while Dc is fixed. Nothing could be more obvious than the result of this experiment. Namely, Sc must fall in inverse proportion to the rise in P. The higher the monopolistic sellers would drive the price level, the less would be the supply of goods they could sell—in inverse proportion. 

    "Let us appraise the results of this experiment. We see the quantity of goods sold falling to the same extent that the monopolistic sellers force up prices. There is no essential difference between this case and the cases discussed in other posts, in which a fall in supply raised prices—they are mathematically equivalent. A fall in supply is a mathematically indispensable condition for the rise in prices, whenever demand remains fixed. Thus, it is absolutely essential for the monopolistic sellers to reduce the supply of goods or services that are sold, if they are to drive up prices. If they did not do this, they simply could not raise prices. It is precisely because the monopolistic sellers must hold down supply to raise prices, that they want to prohibit other people from selling and to be monopolists in the first place. For example, the reason a monopoly labour union wants to control apprenticeship programs and make it as difficult as possible for people to enter an occupation is that that is a way of restricting supply and thereby making it possible for the union to drive up wages. In the face of a fixed demand, the mere fact of establishing higher wages or prices for the labour or goods that are sold serves to reduce the supply that is sold in inverse proportion. The unions and the other monopolists want to restrict as far as possible the supply that is or potentially could be offered by competitors, in order to minimise the reduction in the quantity that they themselves can sell. 

    "The fact that the various cost-push doctrines are the same as an attempt to blame inflation on falling supply totally invalidates them. Because it means that all of the objections raised previously against falling supply as a cause of rising prices apply with equal force against cost-push as a cause of rising prices."

~ George Reisman from pages 907-9 of his book Capitalism: A Treatise on Economics. Read it online here, or buy it here (currently at half-price!)

* Essentially that the explanation for general and persistent across-the-board rising prices is an expanding quantity of money allowing these prices to be paid. See formula here: 

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