Two weeks ago, the IMF has tweeted the following: “Rising corporate profits were the largest contributor to Europe’s inflation over the past two years” in relation to a new IMF paper (“Euro Area Inflation after the Pandemic and Energy Shock: Import Prices, Profits and Wages”) by Niels-Jakob Hansen, Frederik Toscani, and Jing Zhou. We have already talked about EA markups in a note (here). Unfortunately, the IMF tweet is misleading and we keep getting questions such as “can you please explain me in simple terms why it is wrong to say that the increase in EA prices is explained by corporate profits as suggested by the IMF charts?” The below should clarify any doubt.
The issues
The rise in unit profits does not (necessarily) mean what most people think. Hansen et al. (2023) contains a chart (Figure 1 below) that is generally interpreted in the wrong way. Figure 1 shows the Euro area GDP deflator decomposition into unit taxes (green bars), unit profits (blue bars), and unit labor costs (red bars). Figure 1 shows that unit profits have increased in recent quarters prompting most people to think something like “corporate profits are the cause of inflation” (or “greedflation”). Unfortunately, there are two main issues: (i) the relation between unit profits and consumers’ prices cannot be interpreted as causal, and most importantly (ii) an increase in unit profits does NOT (necessarily) imply an increase in corporate margins (“greed”). We explain (i) and (ii) in details below.
Figure 1. Euro area GDP deflator decomposition
Why the relation between unit profits and the GDP deflator is not causal?
The relation plotted in Figure 1 (GDP Deflator = Unit Profits + Unit Labor Costs + Unit Taxes (1)) is a national accounts identity, not a causal link. As Hansen et al. (2023) write explicitly at page 7, “this accounting identity does not allow for any causal interpretation”. The reason is that in order to establish a causal link, unit profits should be exogenous in equation (1) and the direction of causality should run only from unit profits to the GDP deflator. Nevertheless, it is pretty obvious that unit profit depends on the price charged: the causality can also (in fact, does) run in the opposite direction. Therefore, as mentioned, equation (1) is nothing but an identity and no causality can be established.
Why an increase in unit profits does NOT (necessarily) imply an increase in corporate margins?
Unit profits can increase either because the markup (corporate margin) rises or because the marginal cost increases. We explain this point with an example. In macro textbooks it is generally assumed that the price of an item is equivalent to a constant markup over the marginal cost. This is in line with what managers/retailers say about pricing, something like “we decide our price by computing the cost of making this product and apply our margin on top of that”. Algebraically, this is expressed as P = Eta *MC, where P is the price of an item, “Eta” is the markup and “MC” is the marginal cost.
Assume that producing an item has a (marginal) cost of 100. Assume there is a unique good/firm in the economy, there are no labor costs and no taxes and that the firm charges 10% on top of MC as its margin. It follows that the final price of the good sold is 110 = 1.1*100. The (nominal) unit profit in this example is equal to 10, as it is nothing but the product between the firms’ margin (markup) and its marginal cost. As Hansen et al. (2023) write at page 13: “It is immediately clear that unit profit can increase without a change in the markup, simply because MC increases”. But let us continue with the example to make things ultra clear. Assume now that an energy shock occurs and that the firm does not change its markup (“Eta”). For instance, assume that because of the energy shock, the marginal cost doubles from 100 to 200. What happens to P? The new price is equal to 10%*200 = 220. After the shock, P doubles (inflation rate 100%) and nominal unit profit doubles as well from 10 to 20. The increase of unit profits in this example is due to an increase of MC, while the markup has remained unchanged.
If we had to plot the evolution of the deflator and its contributions of this economy (like in Figure 1), we would see an increase in inflation associated to a proportional increase of unit profit. Many people would erroneously interpret this evidence as “firms’ profits have gone up and are causing inflation”. It should now be clear why such a statement is wrong: there is no causal link and the increase in unit profit in our example is driven by the increase of the marginal cost, not of the firm’s margin. The reader should also notice that while the nominal value of unit profit has gone up (from 10 to 20), the real value has remained constant (indeed, the markup has not moved). This is another source of confusion in the debate: most people take the increase of nominal unit profits as a measure of “corporate greed” without understanding this is precisely what inflation is about: driving up nominal but not (necessarily) real quantities.
(For a discussion about the algebra and more general cases under different production functions the reader can refer to Colonna et al. (2023) and to Section 3 in this ECB Economic Bulletin).
Is there a conflict between corporate margins and wages?
Yes, and this is a crucial feature of inflation. In our example, the firm nominal unit profit increases while the real unit profit is unchanged: the firm has protected its margin. On the other hand, nominal wages (which we assumed equal to 0) generally do not increase together with inflation and real wages fall, at least initially. This is what we have observed in several countries in this cycle. Once workers realize that they have lost purchasing power, they start asking for higher nominal wages so that real wages can catch up with prices. This is the absence of the idea that “inflation is conflict”, which dates back to the work of Michał Kalecki.
Why is it important to distinguish between an increase of unit profits due to the markup vs the marginal cost?
There are higher chances of a fast(er) disinflation if markups are elevated. The reason is that if the increase in P is due to elevated markups, part of the disinflation can come from a normalization of firms’ margins. On the other hand, if markups are low and stable, it is harder for firms to absorb wage increases (by lowering the markup) without increasing prices again.
What is the evidence for the EA/US?
Higher markups have contributed to the inflation runup in the US, maybe in some sectors in Germany but not in Italy. The evolution of markups is presented in Colonna et al. (2023). There is evidence that markups have increased in the US. For Germany, the evidence is mixed as markups seem to have increased but only in a few sectors. For Italy, there is no evidence that the increase in prices is driven by higher markups as they seem to have remained stable. In summary, there is some evidence that profits might be higher (in real terms) in the US. For the Euroarea, the data seems to suggest that higher (nominal) unit profits are mainly driven by higher marginal costs.
Conclusion
There is a lot of confusion in the debate. The sources of confusions are misunderstanding about the following: (i) there is NO causal link between unit profit and deflators as some keep assuming, (ii) unit profits can increase even if the markup remains constant, (iii) higher unit profits can be driven by higher (marginal) costs despite what most think, (iv) a higher unit profit for the Euro area seems to be driven (mainly) by higher energy costs, (v) the charts going around refer to nominal variables, not to real variables, (vi) the IMF tweet is wrong/misleading. Hopefully, this note has clarified all doubts.