spotty and unspotty

markets are islands in the stream, that is what they are

I have attached a post-it note to my computer saying “Don’t use the Stack to continue arguments from social media” but a) that’s a rule to be broken and b) I haven’t actually started this one yet, although I have been identifying targets in my head. It’s about “greedflation”, and the link to the subject matter of “Back of Mind” is that the debate that economists are having over that concept is hamstrung by a problem of representation.

By which I mean that a straightforward statement like “yes, corporations have suddenly decided that they want to raise prices and boost their margins, that is a significant part of what is going on here” is extremely difficult to formulate in the normal language of economics without sounding nonsensical or self-contradictory. And when you divide through by the pejorative word “greed”, that’s what we’re talking about – to what extent is the current price level being driven by specific and intentional decisions of firms?

And the problem is located exactly there – the concept of firms as decision-making entities. Ronald Coase won his Nobel Prize for addressing the theoretical problem of why companies exist at all; that would be a digression, but what sticks in the mind is his description of corporations as “islands of central planning, in a sea of markets”. A big methodological commitment of a lot of economics is that you concentrate on the ocean rather than the islands, presuming that the decision-making processes that take place within those firms will sort themselves out, and that they will, in equilibrium, just reflect the overall conditions of the market rather than creating those conditions.

It’s also possible to observe that markets themselves are heterogeneous. Some markets are what you might call “spot markets” – things like second hand cars, apples and natural gas. In a spot market there’s little role for relationships, interactions are limited and not repeated and goods aren’t differentiated, so there’s no reason to take anything into account when setting the price than (your estimation of) the balance of supply and demand. You might contrast those with “contract markets” like management consulting, defense procurement and mobile phones, where unit sizes are larger, people deal with the same customers repeatedly, the competitive structure is complex and where, consequently, pricing is only one of a number of parameters that you take into account as part of an overall strategy that might look forward quite a number of stages in terms of anticipated reactions.

There is no such sharp distinction, of course. Plenty of people deal with natural gas and even apples on the basis of long term contracts, while you can pick up a burner phone on a spot basis if you like. But you can assign things to a continuum and make reasonable judgements about whether any given price is something that’s part of the ocean of spot markets, or one of the islands of contract markets.

I think that the key to understanding a role for greedflation is to realise that the islands are more important than the ocean, even though in my estimation most actual markets are more spot-like. The reason for this is that the islands are where there is a role for strategic decision making not directly related to contemporaneous supply and demand, but because of the nature of the islands, this is where expectations are formed and have their effect. In an inflationary episode, the majority of prices will be rising because of supply and demand conditions in spot markets, but those supply and demand conditions will themselves be responding to decisions made within the islands of planning, in firms and in the islands of decision-making, in contract markets. These are the places where people are actually thinking about pricing and about the future. If you take out the g-word, it’s quite natural to understand that the markup element of pricing contains within it a material proportion of pricing that is the subject of strategic decisions, and that these strategic decisions are affected by all sorts of considerations, of which immediate supply and demand are often a relatively minor element.

This is really easy to see on the other side of the equation. Labour markets are much less spotty than goods markets, so there’s much less resistance to thinking of them as being subject to strategic and subjective considerations. It’s hardly controversial at all to say that a lot of the time, big union settlements have importance well beyond the proportion of actual union members. And it’s actually banal to note that unions behave strategically and politically, and that understanding the wage side of inflation has to take into account the power, morale and popular acceptance of unions – even down to being aware of the personal characteristics and relationships of individuals.

Why wouldn’t it be the same on the other side? But, as numerous embarrassing central bank gaffes have recently shown, it’s difficult for economists to think this way. Methodological choices can have policy consequences.