Viewpoint: Does Monopoly Cause Inflation?

Every time inflation speeds up, someone tries to revive the old idea that it is somehow linked to the size of corporations, which is said to be a sign of monopoly pricing. Statistics are freely tossed around that have nothing to do with competition—for example, that "only" a thousand "giant" corporations produce over half of all private goods and services. And it is then simply asserted that large corporations set prices arbitrarily, regardless of demand. This is, for example, a major theme of Almost Everyone's Guide to Economics by John Kenneth Galbraith and Nicole Salinger.

Even if every industry in the country were a pure monopoly, however, with no possibility of substitution between them, it would still have no effect whatsoever on the rate of inflation. A monopoly sells less than a competitive firm and thus charges a higher price by restricting supply. But it doesn't pay to keep charging more and more for less and less, year after year. At some point, the loss of sales offsets the added revenue from a higher price. So the monopoly finds the optimal combination of price and volume to get the most profit.

Once a monopoly has found the profit-maximizing blend of volume and price, there is no incentive at all to raise that price and lose sales, unless costs or demand go up. For a price increase to be profitable, demand for the monopoly's product must go up (meaning that people are willing to buy more units at any given price than before) or its supply of the product must go down (meaning that the costs of producing each unit have risen, reducing the amount that the firm can profitably sell at any given price).

If costs are increasing throughout the economy, that is generally a sign of excess demand for final products that is reflected in excess demand for labor and materials used in the production process. And if demand (spending) is increasing rapidly throughout the economy, that clearly has nothing to do with the size of firms or the degree of competition.

A second line of defense suggests that the many alleged monopolies have little incentive to resist large wage increases because they can simply hike prices to cover the cost. If prices are raised beyond the profit-maximizing point, however, sales and profits would decline for a monopoly just as they would for a competitive firm. A so-called wage-price spiral cannot continue without being validated by an increase in the supply of money to finance the increases. Otherwise, the real value of people's money would fall with the rising prices, thus slowing spending and creating an ever-increasing glut of products, services, and unemployed workers.

Another variation on the theme suggests that a slowdown in spending, resulting from slower money growth, does not reduce prices because large corporations escape the market's discipline. According to this theory, it is only by causing unemployment and thereby reducing wage gains that there was any effect on inflation from the slowing of demand in the 1975-76 period.

There's one problem with this theory, though: it bears no relationship to the facts. The rise in consumer prices for nonfood commodities slowed from 13.2 percent in 1974 to 6.2 percent in 1975; similar producer prices slowed from 20.5 percent to 6.7 percent; but hourly wage gains rose from 7.9 percent in 1974 to 8.4 percent in 1975. Prices didn't actually fall, on average, because the increases in spending only slowed down a bit—from 11.6 percent in 1974 to 8.1 percent in 1975.

There is no need to get involved in the complex reasons why a sudden slowdown in money and spending is typically reflected first in declining output and only later in slowing inflation. It can simply be observed that, since this phenomenon is clearly not confined to big corporations or monopolies, the monopoly theory does not explain it.

If only some product, service, or labor markets are assumed to be monopolized, and others are not, the irrelevance of monopoly becomes even clearer. Consumers might then spend a larger share of their incomes on monopolized goods and services, but that would necessarily reduce demand for goods and services from competitive sectors. Everyone can't simultaneously spend more money on everything unless there is more money to go around. Higher prices in monopolized areas of the economy would thus be offset by lower prices in competitive areas, leaving no net effect on measures of average prices. Similarly, if a union could raise wage rates in some trade by restricting entry, those foreclosed from such job opportunities would be compelled to seek work elsewhere—thus increasing the supply of labor in other occupations and depressing those wages. Average wage rates would be unaffected.

In short, monopoly might explain why a particular price is relatively high at any moment in time. But monopoly cannot explain why that price, much less the average of all prices, is rising continually, year after year. Nor can monopoly explain why inflation is higher or lower at various times and places, unless the degree of monopoly is subject to huge and sudden gyrations. The structure of US industry and labor markets was surely not much different in 1974 than in 1964, but the inflation rate was 10 times higher.

There is no credible evidence that elements of monopoly are particularly significant in the US economy, except where monopolies or cartels have been deliberately created by government regulation (Postal Service, airlines, trucking, utilities, occupational licensing laws, etc.). But even if it could be shown that monopoly was a pervasive phenomenon, the monopoly theory of inflation would still fail the most elementary tests of logic.

Alan Reynolds is a vice-president of the First National Bank of Chicago.