Are profits driving inflation?

Rafael Wildauer, Karsten Kohler, Alexander Guschanski and Adam Aboobaker

In the context of the recent increase in corporate profitability in many countries, the argument that corporate profits are a key driver behind consumer price inflation rates in excess of 10% is gaining prominence (Weber et al. 2022; Weber and Wasner 2022; Storm 2022; Unite 2022, 2023). However, both corporate profitability (as measured by corporate profit margins) and consumer price inflation are endogenous variables. This blog argues that the task at hand is to analyse what determines both of these, not whether one causes the other. To understand the surge in corporate profitability, the blog draws on the heterodox theories of markup pricing and conflict inflation. The blog also previews insights from a forthcoming paper the authors are working on, which will develop some of the arguments in full detail.

Markup pricing

Mark up pricing is a well-established approach to modelling firm behaviour especially in Post-Keynesian macroeconomic models (for textbook treatments see Hein 2014, Lavoie 2014, Blecker and Setterfield 2019; see Blanchard et al. 2017 outside PK) and is the standard approach in finance and business accounting (Burns et al. 2013, Drury 2018). Firms’ markups over their input costs are crucial for determining both aggregate inflation rates and firms’ profit margins. If firm i follows a markup pricing approach, (because it’s practically impossible to calculate marginal costs and that’s what managers are taught at business schools), it will set its target price ($latex p_i^T$) as the markup up ($latex \theta^T_i$) over average total costs ($latex ATC_i$). Average total costs consist of variable total cost and fixed costs. Abstracting from intermediate inputs other than energy, variable total costs ($latex VTC_i$) can be defined as unit labour costs (defined as the average wage rate $latex w_i$ divided by average labour productivity $latex v_i$) plus unit energy costs (defined as the average energy intensity $latex \delta$ times the price of energy $latex p_E$). Fixed costs ($latex F_i$) represent cost components which do not vary in the short term such as supervisory labour, depreciation, interest expenses, etc.).

(1) $latex p_i^T = (1+\theta_i^T) ATC_i$

(2) $latex ATC_i = VTC_i + F_i $

(3) $latex VTC_i = \frac{w_i}{v_i} + \delta p_E $

Target markups are determined by a variety of factors of which two are especially important: Firstly, the degree of competition in the economy or sector (Kalecki 1965). Less competition enables firms to increase markups. Secondly, if there is limited space for quantity adjustment, firms’ target markups go up (Flaschel and Skott 2006). In other words, increased rates of capacity utilisation provide another source for rising markups. The bottlenecks observed during and after COVID are an example of a supply-side induced increase in capacity utilisation, but capacity utilisation can also go up due to shifts in consumer demand.

We can use this framework to define the firm’s target profit margin as unit profits (price minus unit costs) relative to unit sales (which are simply the price). Simplifying shows that a firms’ target profit margin is entirely determined by its target markup:

(4) $latex r_i^T = \frac{p_i^T – ATC_i}{p_i^T} = \frac{\theta_i^T}{1+\theta_i^T}$

Crucially, the target profit margin can differ from a firms’ actual or realised margin, which depends on actual rather than target prices:

(5) $latex r_i = \frac{p_i – ATC_i}{p_i}$

Such realised profit margins measure the distribution of revenues between three groups: workers in sector i, firms in sector i, and intermediate suppliers to sector i. By contrast, the profit share of sector i, defined as profits divided by value added, i.e. net of intermediate inputs, measures the distribution of value added created in sector i between capital and labour. In simple one sector models both definitions are equivalent because there is no role for intermediate inputs. In the following, we will use profit margins to characterise profitability across sectors and the aggregate profit share as a broad measure of the income distribution between capital and labour across the entire economy.

How are realised profit margins determined? First, average total costs (ATC) influence profit margins. Shocks to energy prices raise the cost of firms that use energy as an input and thus play a crucial role for profitability. Second, actual prices are the result of a dynamic price-setting process, in which firms aim to roll over changes in cost onto prices. However, this is a tricky business as a key component of their cost, nominal wages, are likely to respond to any increase in prices. This dynamic feedback mechanism, where firms aim to raise prices whereas workers respond by raising nominal wages is the heart of the theory of conflict inflation. Realised profit margins are an outcome of this process.

Markup pricing and conflict inflation

The theory of conflict inflation (early contribution Rowthorn 1977, Hein 2014, Blecker and Setterfield 2019),  states that the growth rate of price i ($latex \pi_{i,t} = \frac{\Delta p_{i,t}}{p_{i,t-1}}$) is a function of the gap between realised profit margins and target profit margins:

(6) $latex \pi_{i,t,} = \psi (r_i^T – r_{i,t})$

In other words, firms increase prices if their realised profit margin ($latex r_{i,t}$) falls short of their target ($latex r_i^T$). The parameter $latex \psi$ represents how quickly firms respond to lower than desired profit margins. It depends on the degree of competition between firms and the extent of product market regulation and price regulations in the private sector.

Workers on the other hand have some degree of control over nominal wages due to individual and collective bargaining agreements and labour laws. They aspire to a certain standard of living (in the form of a target real wage $latex \omega_i^T$), which is influenced by historical and social norms. Workers raise nominal wages when there is a gap between actual real wages ($latex \omega_i$ and their socially accepted level ($latex \omega_i^T$). Therefore, the growth rate of nominal wages ($latex g_{i,t} = \frac{\Delta w_{i,t}}{w_{i,t-1}}$) can be modelled as:

(7) $latex g_{i,t} = \phi (\omega_{i,t} – \omega_i^T)$

The parameter $latex \phi$ represents workers’ ability to achieve nominal wage increases. It depends on their bargaining power, which in turn may be affected by the level of unionization, labour protection laws and the degree of centralized bargaining in the economy.

Combining the theory of markup pricing with the theory of conflicting claims over national income yields a framework in which the equilibrium inflation rate ($latex \pi$) depends on the price-setting strength of firms ($latex \psi$) and bargaining power of workers ($latex \phi$) as well as their claims on aggregate national income (represented by the target profit margin and target real wage). A permanently higher claim by either of the groups triggers a temporary bout in inflation after which the economy settles on a higher equilibrium inflation rate. This process could be dubbed a ‘wage-price spiral’ if the impulse starts from an increase in workers’ nominal wages or a ‘price-wage spiral’ if it is driven by an increase in firms’ pricing. Such an inflationary episode will result in a shift in the distribution of income between firms and workers, whose outcome depends on the relative bargaining power of firms and workers.

The current inflationary episode

We can now use this framework to analyse the current inflationary episode and the drivers of increased corporate profit margins. Are profit margins driven by increased markups or other factors? We can identify several important channels that possibly help explain the inflationary surge over the last two years.

  1. Energy price spikes triggered by the Russian invasion of Ukraine allowed firms in the energy sector to increase their realised profit margins. Insofar as energy prices are determined in international markets, a sudden increase in those prices will generate windfall profits in domestic energy sectors, as can be readily observed by the oil majors’ record profits. If firms in non-energy sectors keep their markups constant, such an energy price shift can lead to increasing profit shares (although not profit margins) in these sectors. Thus, energy price shocks reduce the aggregate labour share and increase aggregate inflation.
  2. Increases in the rate of capacity utilisation can encourage firms to increase their markups. In the current macroeconomic environment three events could have led to this effect. Firstly, the pandemic led to supply bottlenecks in certain sectors which meant that firms struggled to meet high levels of demand, enabling them to increase markups. Secondly, the pandemic also led to a shift in consumer spending patterns, in favour of goods relative to services. In the US this shift seemed to be more persistent than in other countries (Storm 2022, Bernanke and Blanchard 2023). Thirdly,  both the pandemic and the energy shock triggered large fiscal responses especially in high income countries. Bernanke and Blanchard (2023) argue that the combined response amounted to 15% of GDP in the US. Such fiscal programmes may lead to increased rates of capacity utilisation,
  3. However, profit margins can also increase if markups and energy prices remain constant as recently pointed out by Marc Lavoie. In the context of higher capacity utilisation, realised profit margins increase even if markups stay constant because fixed costs are spread over a higher volume of output.
  4. Finally, there is the argument that some firms used the aggregate inflation caused by the pandemic and the energy shock to increase their markups (Weber and Wasner 2023). In an environment where many prices increase, some firms might be able to not only pass on increased costs (with constant markups) but to also increase their mark ups. Microeconomically, this could work through a fall in the elasticity of consumer demand. The idea is that consumers accept price increases beyond those justified by constant markup pricing because they have internalised a higher aggregate inflation rate. However, it is an open question whether this mechanism applies in the aggregate as the fall in real wages will constrain aggregate demand and thus place limits on how much firms can push up prices.

Which of these channels are relevant will most likely vary across countries (and also over time as we move forward). Importantly, however, all 4 channels lead to higher inflation and increased realised profit margins (at least in some sectors). Channels 2, and 4 also come with higher markups while channels 1 and 3 work even with constant markups.

Importantly, all of these channels are cases of a ‘price-wage spiral’ where the underlying cause of higher inflation is an increase in the gap between firms’ desired and realised profit margins. Nominal wages might then respond as workers attempt to defend their real wages, but the underlying impulse emerges from firms starting to raise prices. Empirical evidence of falling real wages and increasing profit margins suggests that firms have been able to at least partially enforce their increased claims on national income. While there are several theoretically plausible channels through which firms increase margins and markups in the current macroeconomic environment, it is clear that there has been a surge in US corporate profitability which is higher than at any point in the last 40 years suggesting that firms are currently at the winning end of the conflict inflation game.

What about the role of wages in the current inflationary environment?

What about wages? Aren’t wages contributing to inflation? Crucially, there is no contradiction between rising nominal wages, falling real wages, and rising profits. Even if workers manage to raise nominal wages somewhat, for the reasons discussed above, firms might be able to increase prices even more, shifting the distribution of income in their favour.

Theoretically there could be a situation where a heavily unionised workforce pushes firms to increase nominal wages at a faster pace than prices, thus depressing profit margins and raising real wages. This could also lead to an uptick in the inflation rate. This would be the case of a ‘wage-price spiral’. However, the fact that we currently observe increasing nominal wages does not indicate we are in such a situation. Given strong corporate profits, it is unconvincing to argue that this is a good description of the current situation. Thus, while rising nominal wages are bound to add to total inflation when firms pursue mark-up pricing, they are clearly not the root cause of the current inflation. Instead, a more plausible assessment of the last two years is a situation in which inflation increased due to a combination of factors starting with rising energy prices and disruptions caused by the pandemic, which then allowed some firms to increase their markups and therefore contribute to the current high rates of inflation.

A key prediction implied by the theoretical framework utilised in this blog is that price-wage spirals are likely to shift the income distribution against workers. With conflict over the distribution of income being the key driver of inflation, we can expect inflation to remain elevated until some of the distributional conflict is resolved. The conventional monetary policy paradigm calls for higher interest rates that raise unemployment and reduce the bargaining power of workers, thereby worsening the adverse distributional outcomes for workers. However, other policies are conceivable, for example a corporate tax on windfall profits in the energy sector whose revenues are transferred to support worker households at the lower end of the income distribution. Another example is price controls and caps on well-defined products (rent, basic food times; see Weber and Wasner 2023). Such policies would not only mitigate some of the adverse distributional effects for workers, it may also curb the conflict inflation process.

Overall, the combination of markup pricing and conflict inflation provides a fruitful conceptual framework to think about the problems of inflation and distribution in the current context. Such a framework suggests that the current inflation indeed is the result of a price-wage spiral rather than a wage-price spiral. This means a worsening distribution of income for workers, which requires a much stronger focus on distributional outcomes when choosing inflation reducing policies.


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