Does it seem like there’s a disconnect between reports of record earnings by large companies and warnings from the same companies that they need to raise prices to cover their higher costs? Indeed, at the same time companies are telling investors that the inflationary economy is allowing them to make huge profits, they’re telling customers that the same inflationary economy is causing costs to rise and that prices will likely go higher. So, what’s going on? How can companies earn record profits, yet still need to raise prices? Is inflation forcing them to raise prices or allowing them to make bigger profits? And why aren’t other companies entering the market and undercutting the bigger companies? Economic theory tells us that companies are raising their prices because they choose to do so, not because of inflation. So, while it’s true that costs for labor, raw materials, and other inputs have been rising rapidly across the world, companies are raising their prices much more than their costs have increased. This is reflected in net margins. A company’s net margin is the percentage of profits the firm earns from every dollar of sales. The past year has seen net margins at companies like Unilever, P&G, and Kimberly Clark rise to historically high levels. In other words, the gap between cost and profit is significantly higher than usual. Moreover, even as many economists expect that many of the factors contributing to higher labor costs and rising input costs such as disruptions in the global supply chain will moderate, companies are indicating that future price hikes are likely.
Normally, when companies keep raising prices, an opportunity is created for smaller, more efficient companies to enter the market. However, the pandemic has thrown a curve ball into this typical scenario thanks to the actions of the Federal Reserve. Early in 2020, at the start of the pandemic, the Federal Reserve committed to buying debt from U.S. companies. The goal was to stabilize what was anticipated to be a period of great uncertainty. For large companies, this policy decision turned out to be a once-in-a-life- time opportunity to borrow huge amounts of money at a very low cost. For smaller companies, however, the Federal Reserve’s policy decision had a much less positive outcome. While large companies were able to fill their coffers with cheap cash, smaller companies, unable to access the Federal Reserve’s money, found their capital costs rising. Now, the larger companies are using their borrowed funds to push smaller companies out of the market or to acquire them. Indeed, their strategy effectively insulates them from the type of competition that might normally force lower prices. This, together with the fact that industries have become highly concentrated in recent years, means that larger companies know that they can continue to raise prices without worrying that new competitors could enter the market and undercut them. So, while new actions by the Federal Reserve to raise interest rates might lower inflation, slowing the rise in costs for labor and other inputs, it seems likely that large companies will continue to raise prices, generating even greater returns for their investors.
Discussion Questions:
1. What is inflation? How is it linked to price?
2. Discuss the 2020 decision by the Federal Reserve to buy debt from larger firms. What was the goal of this policy? What were the unintended consequences of the policy? Consider your response from the perspective of various stakeholders including investors, consumers, and labor.
3. Since the start of the pandemic, many large companies like P&G and Unilever have posted record profits. Now, many of those same companies are warning of future prices hikes. Why do these companies keep raising prices if they are earning record profits? How high can companies push prices before it affects demand?
Sources:
WSJ.com: Big Companies Thrive During Periods of Inflation, Photo by fernandozhiminaicela on Pixabay.com