Antitrust Policy and Monopsony Power

Photo from the New York Times.

As we discuss in Microeconomics and Economics, Chapter 15, Section 15.6, the U.S. Department of Justice’s Antitrust Division and the Federal Trade Commission have merger guidelines that they typically follow when deciding whether to oppose a merger between two firms in the same industry—these mergers are called horizontal mergers. The guidelines are focused on the effect a potential merger would have on market price of the industry’s output. We know that if the price in a market increases, holding everything else constant, consumer surplus will decline and the deadweight loss in the market will increase. But, as we note in Chapter 15, if a merger increases the efficiency of the merged firms, the result can be a decrease in costs that will lower the price, increase consumer surplus, and reduce the deadweight loss. 

The merger guidelines focus on the effect of two firms combining on the merged firms’ market power in the output market.  For example, if two book publishers merge, what will be the effect on the price of books? But what if the newly merged firm gains increased market power in input markets and uses that power to force its suppliers to accept lower prices? For example, if two book publishers merge will they be able to use their market power to reduce the royalties they pay to writers? The federal antitrust authorities have traditionally considered market power in the output market—sometimes called monopoly power—but rarely considered market power in the input market—sometimes called monopsony power.

In Chapter 16, Section 16.6, we note that a pure monopsony is the sole buyer of an input, a rare situation that might occur in, for example, a small town in which a lumber mill is the sole employer. A monopoly in an output market in which a single firm is the sole seller of a good is also rare, but many firms have some monopoly power because they have the ability to charge a price higher than marginal cost. Similarly, although monopsonies in input markets are rare, some firms may have monopsony power because they have the ability to pay less than the competitive equilibrium price for an input. For example, as we noted in Chapter 14, Section 14.4, Walmart is large enough in the market for some products, such as detergent and toothpaste, that it is able to insist that suppliers give it discounts below what would otherwise be the competitive price.

Monopsony power was the key issue involved in November 2021 when the Justice Department filed an antitrust lawsuit to keep the book publisher Penguin Random House from buying Simon & Schuster, another one of the five largest publishers. The merged firm would account for 31 percent of books published in the U.S. market. The lawsuit alleged that buying Simon & Schuster would allow “Penguin Random House, which is already the largest book publisher in the world, to exert outsized influence over which books are published in the United States and how much authors are paid for their work.”

We’ve seen that when two large firms propose a merger, they often argue that the merger will allow efficiency gains large enough to result in lower prices despite the merged firm having increased monopoly power. In August 2022, during the antitrust trial over the Penguin–Simon & Schuster merger, Markus Dohle, the CEO of Penguin made a similar argument, but this time in respect to an input market—payments to book authors. He argued that because Penguin had a much better distribution network, sales of Simon & Schuster books would increase, which would lead to increased payments to authors. Authors would be made better off by the merger even though the newly merged firm would have greater monopsony power. Penguin’s attorneys also argued that the market for book publishing was larger than the Justice Department believed. They argued that the relevant book market included not just the five largest publishers but also included Amazon and many medium and small publishers “all capable of competing for [the right to publish] future titles from established and emerging authors.”  The CEO of Hachette Book Group, another large book publisher, disagreed, arguing at the trial that the merger between Penguin and Simon & Schuster would result in lower payments to authors. 

The antitrust lawsuit against Penguin and Simon & Schuster was an example of the more aggressive antitrust policy being pursued by the Biden administration. (We discussed the Biden administration’s approach to antitrust policy in this earlier blog post.) An article in the New York Times quoted a lawyer for a legal firm that specializes in antitrust cases as arguing that the lawsuit against Penguin and Simon & Schuster was unusual in that the lawsuit “declines to even allege the historically key antitrust harm—increased prices.” The outcome of the Justice Department’s lawsuit against Penguin and Simon & Schuster may provide insight into whether federal courts will look favorably on the Biden administration’s more aggressive approach to antitrust policy. 

Sources: Jan Wolfe, “Penguin Random House CEO Defends Publishing Merger at Antitrust Trial,” Wall Street Journal, August 4, 2022;  David McCabe, “Justice Dept. and Penguin Random House’s Sparring over Merger Has Begun,” New York Times, August 1, 2022; Eduardo Porter, “A New Legal Tactic to Protect Workers’ Pay,” New York Times, April 14, 2022; Janet H. Cho and Karishma Vanjani, “Justice Department Seeks to Block Penguin Random House Buy of Viacom’s Simon & Schuster,” barrons.com, November 2, 2021; United States Department of Justice, “Justice Department Sues to Block Penguin Random House’s Acquisition of Rival Publisher Simon & Schuster,” justice.gov, November 2, 2021; 

The Economics of Sneaker Reselling

Photo from the New York Times.

Buying athletic shoes and reselling them for a higher price has become a popular way for some people to make money. The mostly young entrepreneurs involved in this business are often called sneakerheads.  Note that economists call buying a product at a low price and reselling it at a high price arbitrage.  The profits received from engaging in arbitrage are called arbitrage profits.  One estimate puts the total value of sneakers being resold at $2 billion per year.

            Why would anybody buy sneakers from a sneakerhead that they could buy at a lower price online or from a retail store? Most people wouldn’t, which is why most sneakerheads resell only shoes that shoe manufacturers like Nike or Adidas produce in limited quantities—typically fewer than 50,000 pairs. To obtain the shoes, shoe resellers use two main strategies: (1) waiting in line at retail stores on the day that a new limited quantity shoe will be introduced, or (2) buying shoes online using a software application called a bot. A bot speeds up a buyer’s checkout process for an online sale. Typical customers buying at an online shoe site take a few minutes to choose a size, fill in their addresses, and provide their credit card information. But a few minutes is enough time for shoe resellers using bots to buy all of the newly-released shoes available on the site.

            In addition to reselling shoes on their own sites, many sneakerheads use dedicated resale sites like StockX and GOAT. These sites have greatly increased the liquidity of sneakers, or the ease with which sneakers can be resold. In effect, limited-edition sneakers have become an asset like stocks, bonds, or gold because they can be bought and sold in the secondary market that exists on the online resale sites. (We discuss the concepts of primary and secondary markets for assets in Macroeconomics, Chapter 6, Section 6.2 and in Microeconomics and Economics, Chapter 8, Section 8.2.)

            An article in the New York Times gives an example of the problems that bots can cause for retail shoe stores. Bodega, a shoe store in Boston, offered the limited-edition New Balance 997S sneaker on its online site. Ten minutes later, the shoe was sold out. One of the store’s owner was quoted as saying: “We got destroyed by bots. It was making it impossible for our average customers to even have a shot at the shoes.” Although the store had a policy of allowing customers to buy a maximum of three pairs of shoes, shoe resellers were able to get around the policy by having shoes shipped to their friends’ addresses or by having a group of people coordinate their purchases. An article on bloomberg.com described how one reseller along with 15 of his friends used bots to buy 600 pairs of Adidas’s Yeezy sneakers from an online site on the morning the sneakers were released. Adidas has a rule that each customer can buy only one pair of its limited-edition shoes, but the company has trouble enforcing the rule. 

            Shopify and other firms have developed software that retailers can use to make it difficult for resellers to use bots on the retailers’ sites. But the developers of bot software have often been able to modify the bots to get around the defenses used by the anti-bot software. 

            In contrast with owners of retail stores, Nike, Adidas, New Balance, and the other shoe manufacturers have a more mixed reaction to sneakerheads using bots scooping up most pairs of limited-edition shoes shortly after the shoes are released. Like the owners of retail stores, the shoe manufacturers know that they risk upsetting the typical customer if the customer can only buy hot new shoe releases from resellers at prices well above the original retail price. But an active resale market increases the demand for shoes, just as individual investors increased their demand for individual stocks when it became possible to easily buy and sell stocks online using sites like TD Ameritrade, E*Trade, and Fidelity. So manufacturers benefit from knowing that most of their limited-edition shoes will sell out. One industry analyst singled out “The durability of Nike’s … ability to fuel the sneaker resale ecosystem ….” as a particular strength of the company. In addition, manufacturers may believe that the publicity about limited edition shoes rapidly selling out may spill over to increased demand for other shoes the manufacturers sell. (In Microeconomics and Economics, Chapter 10, Section 10.3 we note that some consumers may receive utility from buying goods that are widely seen as popular and fashionable.)

            In the long run, is it possible for sneakerheads to make a profit reselling shoes? It seems unlikely for the reasons we discuss in Microeconomics and Economics, Chapter 12, Section 12.5. The barriers to entry in reselling sneakers are very low. Anyone can list shoes for sale on StockX or one of the other resale sites. Waiting in line in front of a retail store on the day a new shoe is released is something that anyone who is willing to accept the opportunity cost of the time lost can do. Similarly, bots that can be used to scoop up newly released shoes from online sites are widely available for sale. So, we would expect that in the long run entry into sneaker reselling will compete away any economic profit that sneakerheads were earning.

            In fact, by the summer of 2022, prices on reselling sites were falling. In just the month of June, the average price of sneakers listed on StockX declined by 20 percent. Resellers who had stockpiled shoes waiting for prices to increase were instead selling them because they feared that prices would go even lower. And new limited-edition shoes were taking longer to sell out. According to an article in the Wall Street Journal, “A pair of Air Jordans released on July 13 [2022] that might have once vanished in minutes took days to sell out from Nike Inc.’s virtual shelves.” One reseller quoted in the Wall Street Journal article indicated that entry was the reason that prices were falling: “You don’t want prices to go down, but they’re going down anyways, just because of how many people are selling in general.”

            Although a seemingly unusual market, sneaker reselling is subject to the same rules of competition that we see in other markets. 

Sources: Inti Pacheco, “Flipping Air Jordans Is No Longer a Slam Dunk,” Wall Street Journal, July 23, 2022;  Shoshy Ciment, “Sneaker Reselling Side Hustle: Your Guide to Making Thousands Flipping Hyped Pairs of Dunks, Jordans, and Yeezys,” businessinsider.com, May 3, 2022;  Teresa Rivas, “A Strong Sneaker-Resale Market Is Another Boon for Nike,” barrons.com, May 24, 2022; Curtis Bunn, “Sneakers Are So Hot, Resellers Are Making a Living Off of Coveted Models,” nbcnews.com, October 23, 2021; Daisuke Wakabayashi, “The Fight for Sneakers,” New York Times, October 15, 2021; and Joshua Hunt, “Sneakerheads Have Turned Jordans and Yeezys Into a Bona Fide Asset Class,” bloomberg.com, February 15, 2021.

Senator Elizabeth Warren vs. Economist Lawrence Summers on Monetary Policy

Senator Elizabeth Warren (Photo from the Associated Press)

Lawrence Summers (Photo from harvardmagazine.com)

As we’ve discussed in several previous blog posts, in early 2021 Lawrence Summers, professor of economics at Harvard and secretary of the treasury in the Clinton administration, argued that the Biden administration’s $1.9 trillion American Rescue Plan, enacted in March, was likely to cause a sharp acceleration in inflation. When inflation began to rapidly increase, Summers urged the Federal Reserve to raise its target for the federal funds rate in order to slow the increase in aggregate demand, but the Fed was slow to do so. Some members of the Federal Open Market Committee (FOMC) argued that much of the inflation during 2021 was transitory in that it had been caused by lingering supply chain problems initially caused by the Covid–19 pandemic. 

At the beginning of 2022, most members of the FOMC became convinced that in fact increases in aggregate demand were playing an important role in causing high inflation rates.  Accordingly, the FOMC began increasing its target for the federal funds rate in March 2022. After two more rate increases, on the eve of the FOMC’s meeting on July 26–27, the federal funds rate target was a range of 1.50 percent to 1.75 percent. The FOMC was expected to raise its target by at least 0.75 percent at the meeting. The following figure shows movements in the effective federal funds rate—which can differ somewhat from the target rate—from January 1, 2015 to July 21, 2022.

In an opinion column in the Wall Street Journal, Massachusetts Senator Elizabeth Warren argued that the FOMC was making a mistake by increasing its target for the federal funds rate. She also criticized Summers for supporting the increases. Warren worried that the rate increases were likely to cause a recession and argued that Congress and President Biden should adopt alternative measures to contain inflation. Warren argued that a better approach to dealing with inflation would be to, among other steps, increase the federal government’s support for child care to enable more parents to work, provide support for strengthening supply chains, and lower prescription drug prices by allowing Medicare to negotiate the prices with pharmaceutical firms. She also urged a “crack down on price gouging by large corporations.” (We discussed the argument that monopoly power is responsible for inflation in this blog post.)

 Summers responded to Warren in a Twitter thread. He noted that: “In the 18 months since the massive stimulus policies & easy money that [Senator Warren] has favored & I have opposed, the inflation rate has risen from below 2 to above 9 percent & workers purchasing power has, as a consequence, declined more rapidly than in any year in the last 50.” And “[Senator Warren] opposes restrictive monetary policy or any other measure to cool off total demand.  Why does she think at a time when there are twice as many vacancies as jobs that inflation will come down without some drop in total demand?”

Clearly, economists and policymakers continue to hotly debate monetary policy.

Source: Elizabeth Warren, “Jerome Powell’s Fed Pursues a Painful and Ineffective Inflation Cure,” Wall Street Journal, July 24, 2022.

Solved Problem: High Prices and High Revenue in the U.S. Car Industry

Production line for Ford F-series trucks. Photo from the Wall Street Journal.

Supports: Microeconomics, Chapter 6, Section 6.3 and Chapter 15, Section 15.6, Economics Chapter 6, Section 6.3 Chapter 15, Section 15, and Essentials of Economics, Chapter 7, Section 7.7 and Chapter 10, Section 10.5.

In July 2022, an article in the Wall Street Journal noted that “The chip shortage and broader supply constraints have hampered vehicle production … Many major car companies on Friday reported U.S. sales declines of 15% or more for the first half of the year.” But the Wall Street Journal also reported that car makers were experiencing increases in revenues. For example, Ford Motor Company reported an increase in revenue even though it had sold fewer cars than during the same period in 2021.

  1. Briefly explain what must be true of the demand for new cars if car makers can sell 15 percent fewer cars while increasing their revenue.
  2. Eventually, the chip shortage and other supply problems facing car makers will end. At that point, would we expect that car makers will expand production to prepandemic levels or will they continue to produce fewer cars in order to maintain higher levels of profits? Briefly explain. 

Solving the Problem

Step 1: Review the chapter material. This problem is about the effects of price increases on firms’ revenues and on the ability of firms to restrict output in order increase profits, so you may want to review Chapter 6, Section 6.3, “The Relationship between Price Elasticity of Demand and Total Revenue” and Chapter 15, Section 15.6, “Government Policy toward Monopoly.” 

Step 2: Answer part a. by explaining what must be true of the demand for new cars if car makers are increasing their profits while selling fewer cars. Assuming that the demand curve for cars is unchanged, a decline in the quantity of cars sold will result in a move up along the demand curve for cars, raising the price of cars.  Only if the demand curve for new cars is price inelastic will the revenue car markers receive increase when the price increases. Revenue increases in this situation because with an inelastic demand curve, the percentage increase in price is greater than the percentage decrease in quantity demanded. 

Step 3: Answer part b. by explaining whether we should expect that once the car industry’s supply problems are resolved, car makers will continue to produce fewer cars.  Although as a group car makers would be better off if they could continue to reduce the supply of cars, they are unlikely to be able to do so. Any one car maker that decided to keep producing fewer cars would lose sales to other car makers who increased their production to prepandemic levels. Because this increased production would result in a movement down along the demand curve for new cars, the price would fall. So a car maker that reduced output would receive a lower price on its reduced output, causing its profit to decline. (Note that this situation is effectively a prisoner’s dilemma as discussed in Chapter 14, Section 14.2.)

The firms could attempt to keep output of new cars at a low level by explicitly agreeing to do so.  But colluding in this way would violate the antitrust laws, and executives at the firms would risk being fined or even imprisoned. The firms could attempt to implicitly collude by producing lower levels of output without explicitly agreeing to do so. (We discus implicit collusion in Chapter 14, Section 14.2.) But implicit collusion is unlikely to succeed because firms have an incentive to break an implicit agreement by increasing output. 

We can conclude that once the chip and other supply problems facing car makers are resolved, production of cars is likely to increase.

Sources: Mike Colias and Nora Eckert, “GM Says Unfinished Cars to Hurt Quarterly Results,” Wall Street Journal, July 1, 2022; and Nora Eckert, “Ford’s U.S. Sales Increase 32% in June, Outpacing Broader Industry,” Wall Street Journal, July 5, 2022.

An Index to Measure Supply Chain Problems

Photo of the Port of Los Anglese from the Wall Street Journal.

In economics, index numbers play an important role in gauging the state of the economy. For instance, rather than measure inflation by looking at the price of one or a few goods and services, we use the consumer price index (CPI), which combines the prices of many goods and services into a single number. (In Macroeconomics, Chapter 9, Section 9.4 and Economics, Chapter 19, Section 19.4, we discuss how the Bureau of Labor Statistics constructs the consumer price index.) Similarly, the S&P 500 provides an index of stock prices and the Federal Reserve compiles an index of industrial production that measures the output of factories, mines, and utilities.

            The advantage of indexes is that they provide broader measures of an economic variable. Important as the price of gasoline is in the average family’s budget, the prices of food, clothing, and other goods and services are also important. So, the CPI is a better measure of inflation than is just the price of gasoline.

            But in some cases it can be difficult for economists to construct an index. This problem is particularly likely when an index would not be comprised of similar data, such as prices of goods and services in the case of the CPI. For example, when the Covid–19 pandemic first began to affect the United States in March 2020, the U.S. economy began to experience “supply chain problems.” News articles reported supply chains problems persisting into the summer of 2022. These reports highlighted specific problems, such as shortages of semiconductors that reduced automobile production and ships being backed up at ports leading to delays in U.S. firms receiving imported products. Just as we don’t want to measure inflation by looking only at gasoline prices, we don’t want to measure supply chain problems by looking only at shortages of semiconductors. It would be better to use an index that summarizes what is happening with supply chains in a way that’s analogous to how the CPI summarizes what is happening with the price level. But the very different aspects of supply chain problems make constructing an index that summarizes these problems more difficult than constructing the CPI. 

            Economists at the Federal Reserve Bank of New York have tried to overcome these technical difficulties in devising an index of supply chain problems: the Global Supply Chain Pressure Index (GSCPI). Here’s the New York Fed’s description of the economic data included in the index:

“The GSCPI integrates a number of commonly used metrics with the aim of providing a comprehensive summary of potential supply chain disruptions. Global transportation costs are measured by employing data from the Baltic Dry Index (BDI) and the Harpex index, as well as airfreight cost indices from the U.S. Bureau of Labor Statistics. The GSCPI also uses several supply chain-related components from Purchasing Managers’ Index (PMI) surveys, focusing on manufacturing firms across seven interconnected economies: China, the euro area, Japan, South Korea, Taiwan, the United Kingdom, and the United States.”

Some more detail on components of the index that may be unfamiliar: The Baltic Dry Index (BDI) and the Harpex indexes both measure rates shippers charge firms to move cargo by sea. (Note that the name “Baltic” has historical significance but doesn’t mean that the index covers only the price of shipping in the Baltic Sea.) The Purchasing Managers’ Index (PMI) is derived from surveying purchasing managers at firms around the world about such aspects of their businesses as order backlogs, new orders, delivery time of goods from suppliers, inventories, and costs.  

The following figure shows movements in the GSCPI from January 1998 through June 2022 and is derived from data on the New York Fed site.  Higher values indicate more supply chain problems in the world economy. Movements in the index indicate that supply chain problems reached a peak in April 2020 during the height of the initial disruptions caused by the pandemic. Supply chains then improved through September 2020 before worsening again. The worst reading for the index occurred in December 2021. Supply problems then eased during the first half of 2022, although the index still remained high in June 2022. (Note that the values on the vertical axis are standard deviations from the average values of the index over the whole period. The standard deviation is a statistical measure of how spread out values of a series are relative to the series’ average value. That the value for the index during the first half of 2022 was two to four standards deviations above the average of the index indicates that supply chain problems were much more severe than normal.)

Sources: Liz Young, “Companies Face Rising Supply-Chain Costs Amid Inventory Challenges,” Wall Street Journal, June 21, 2022; Ana Monteiro, “Supply Constrainst a Headache for U.S. Firms as Outlook Dims,” bloomberg.com, June 2, 2022; and Federal Reserve Bank of New York, Global Supply Chain Pressure Index, https://www.newyorkfed.org/research/gscpi.html.

Be Careful When Interpreting Macroeconomic Data at the Beginning of a Recession

On Friday, July 8, the Bureau of Labor Statistics (BLS) released its monthly “Employment Situation” report for June 2022. The BLS estimated that nonfarm employment had increased by 372,000 during the month. That number was well above what economic forecasters had expected and seemed inconsistent with other macroeconomic data that showed the U.S. economy slowing. (Note that the increase in employment is from the establishment survey, sometimes called the payroll survey, which we discuss in Macroeconomics, Chapter 9, Section 9.1 and Economics, Chapter 19, Section 19.1.)

Data indicating that the economy was slowing during the first half of 2022 include the Bureau of Economic Analysis’s (BEA) estimate that real GDP had declined by 1.6 percent in the first quarter of 2022. The BEA’s advance estimate—the agency’s first estimate for the quarter—for the change in real GDP during the second quarter of 2022 won’t be released until July 28, but there are indications that real GDP will have declined again during the second quarter.  For instance, the Federal Reserve Bank of Atlanta compiles a forecast of real GDP called GDPNow. The GDPNow forecast uses data that are released monthly on 13 components of GDP. This method allows economists at the Atlanta Fed to issue forecasts of real GDP well in advance of the BEA’s estimates. On July 8, the GDPNow forecast was that real GDP in the second quarter of 2022 would decline by 1.2 percent.

Two consecutive quarters of declining real GDP seems inconsistent with employment strongly growing. At a basic level, if firms are producing fewer goods and services—which is what causes a decline in real GDP—we would expect the firms to be reducing, rather than increasing, the number of people they employ. How can we reconcile the seeming contradiction between rising employment and falling output? One possibility is that either the real GDP data or the employment data—or, possibly, both—are inaccurate. Both GDP data and employment data from the establishment survey are subject to potentially substantial future revisions. (Note that because they are constructed from a survey of households, the employment data in the household survey aren’t revised. As we discuss in the text, economists and policymakers typically rely more on the establishment survey than on the household survey in gauging the current state of the labor market.) Substantial revisions are particularly likely for data released during the beginning of a recession. 

In Macroeconomics, Chapter 9, Section 9.1 (Economics, Chapter 19, Section 19.1), we give an example of substantial revisions in the employment data. Figure 9.5 (reproduced below) shows that the declines in employment during the 2007–2009 recession were initially greatly underestimated. For example, the BLS initially reported that employment declined by 159,000 during September 2008. But after additional data became available, the BLS revised its estimate to a much larger decline of 460,000.

Similarly, in Macroeconomics, Chapter 15, Section 15,3, in the Apply the Concept “Trying to Hit a Moving Target: Making Policy with ‘Real-Time Data’,” we show the BEA’s estimates of the change in real GDP during the first quarter of 2008 have been revised substantially over time. The BEA’s advance estimate of the change in real GDP during the first quarter of 2008 was an increase of 0.6 percent at an annual rate. But that estimate of real GDP growth has been revised a number of times over the years, mostly downward. Currently, BEA data indicate that real GDP actually declined by 1.6 percent at an annual rate during the first quarter of 2008. This swing of more than 2 percentage points from the advance estimate is a large difference, which changes the picture of what happened during the first quarter of 2008 from one of an economy experiencing slow growth to one of an economy suffering a sharp downturn as it fell into the worst recession since the Great Depression of the 1930s.

The changes to the estimates of both employment and real GDP during the beginning of the 2007–2009 recession are not surprising. The initial estimates of employment and real GDP rely on incomplete data. The estimates are revised as additional data are collected by government agencies. During the beginning of a recession, these additional data are likely to show lower levels of employment and output than were indicated by the initial estimates. If the U.S. economy is in a recession in the second quarter of 2022, we can expect that the BLS and BEA will revise their initial estimates of employment and real GDP downward, which—depending on the relative magnitudes of the revisions to the two series—may resolve the paradox of rising employment and falling output. 

Or it’s possible that the U.S. economy is not in a recession. In that case, the employment data may be correct in showing an increase in the number of people working, and the real GDP data may be revised upward to show that output has actually been expanding during the first six months of 2022. Economists and policymakers will have to wait to see which of these alternatives turns out to be the case.

More on Hidden Inflation

This yogurt remained the same price although the container shrank from 5.3 ounces to 4.5 ounces.

Each month, hundreds of employees of the Bureau of Labor Statistics (BLS) gather data on prices of goods and services from stores in 87 cities and from websites. The BLS constructs the consumer price index (CPI) by giving each price a weight equal to the fraction of a typical family’s budget spent on that good or service. (CPI is discussed in Macroeconomics, Chapter 9, Section 9.4 and in Economics, Chapter 19, Section 19.4.) Ideally, the BLS tracks prices of the same product over time. But sometimes a particular brand and style of shirt, for example, is discontinued. In that case, the BLS will instead use the price of a shirt that is a very close substitute.

A more difficult problem arises when the price of a good increases at the same time that the quality of the good improves. For instance, a new model iPhone may have both a higher price and a better battery than the model it replaces, so the higher price partly reflects the improvement in the quality of the phone. The BLS has long been aware of this problem and has developed statistical techniques that attempt to identify which part of the price increases are due to increases in quality. Economists differ in their views on how successfully the BLS has dealt with this quality bias to the measured inflation rate. Because of this bias in constructing the CPI, it’s possible that the published values of inflation may overstate the actual annual rate of inflation by 0.5 percentage point. For instance, the BLS might report an inflation rate of 3.5 percent when the actual inflation rate—if the BLS could determine it—was 4.0 percent.
As the inflation rate increased beginning in the spring of 2021, a number of observers pointed to hidden inflation that was occurring. There were two main types of hidden inflation:

  1. The quality of some services was declining
  2. Some packaged goods contained smaller quantities at the same price

Here’s one example of the deteriorating quality of some services. Because during 2021 and 2022 many restaurants were having difficulty hiring servers, it was often taking longer for customers to have their orders taken and to have their food brought to the table. Because restaurants were also having difficulty hiring enough cooks, they also limited the items available on their menus. In other words, the service these restaurants were offering was not as good as it had been prior to the pandemic. So even if the restaurants kept their prices unchanged, their customers were paying the same price, but receiving less.
Alan Cole, a former senior economist with the Congressional Joint Economic Committee, discussed these other examples on his blog: “hotels clean rooms less frequently on multi-night stays, shipping delays are longer, and phone hold times at airlines are worse.” In a column in the New York Times, economics writer Neil Irwin made similar points: “Complaints have been frequent about the cleanliness of [restaurant] tables, floors and bathrooms.” And: “People trying to buy appliances and other retail goods are waiting longer.”

A column in the Wall Street Journal on business travel by Scott McCartney was headlined “The Incredible Disappearing Hotel Breakfast.” McCartney noted that many hotels continue to advertise free hot breakfasts on their websites and apps but have stopped providing them. He also noted that hotels “have suffered from labor shortages that have made it difficult to supply services such as daily housekeeping or loyalty-group lounges,” in addition to hot breakfasts.
In all of these cases, the actual prices of the services had increased more than had the listed prices because the deterioration in quality meant that people were receiving less for their money.


In addition to deterioration in the quality of services, hidden inflation during this period also took the form of consumers buying some packaged goods in which the quantities had been reduced, although the price was unchanged. For example, in June 2022, an article by the Associated Press noted that:


• “A small box of Kleenex now has 60 tissues; a few months ago, it had 65.”
• “Chobani Flips yogurts have shrunk from 5.3 ounces to 4.5 ounces.”
• “Earth’s Best Organic Sunny Days Snack Bars went from eight bars per box to seven, but the price listed at multiple stores remains $3.69.”


An article in the Wall Street Journal observed that: “Shrinkflation, as economists call it, tends to be easier for companies to pass on to consumers. Despite labels that show price by weight, research shows that most customers look at only the overall price.”


The BLS does try to adjust the measurement of the CPI for shrinkflation, which it can do because the BLS keeps careful track of the quantities included in the packaged goods that are included in its survey.


But the BLS makes no attempt to adjust the CPI for the deterioration in the quality of services because doing so would be very difficult. As Irwin observes: “Customer service preferences—particularly how much good service is worth—varies highly among individuals and is hard to quantify. How much extra would you pay for a fast-food hamburger from a restaurant that cleans its restroom more frequently than the place across the street?” And an economist at the BLS noted that, “We do not capture the decrease in service quality associated with cleaning a [hotel] room every two days rather than one.”


As we noted earlier, most economists believe that the failure of the BLS to fully account for improvements in the quality of goods results in changes in the CPI overstating the true inflation rate. This bias may have been more than offset during 2021–2022 by deterioration in the quality of services resulting in the CPI understating the true inflation rate. As the dislocations caused by the pandemic gradually resolve themselves, it seems likely that the deterioration in services will be reversed. But it’s possible that the deterioration in the provision of some services may persist. Fortunately, unless the deterioration increases over time, it would not continue to distort the measurement of the inflation rate because the same lower level of service would be included in every period’s prices.


Sources: Dee-Ann Durbin, “No, You’re Not Imagining It—Package Sizes Are Shrinking,” apnews.com, June 8, 2022; Annie Gasparro and Gabriel T. Rubin, “The Hidden Ways Companies Raise Prices,” Wall Street Journal, February 12, 2022; Alan Cole, “How I Reluctantly Became an Inflation Crank,” fullstackeconomics.com, September 8, 2021; Scott McCartney, “The Incredible Disappearing Hotel Breakfast—and Other Amenities Travelers Miss,” Wall Street Journal, October 20, 2021; and Neil Irwin, “There Is Shadow Inflation Taking Place All Around Us,” New York Times, October 14, 2021.

Was the High Inflation of 2021–2022 Due to Shifts in Aggregate Demand or Shifts in Aggregate Supply?

Man surprised by inflation in food prices.

To answer the question in the title:  Negative supply shocks—shifts to the left in the short-run aggregate supply (SRSAS) curve—and positive demand shocks—shifts to the right in the aggregate demand (AD) curve—both contributed to the acceleration in inflation that began in the spring of 2021. But were the aggregate supply shifts, such as the semiconductor shortage that reduced the supply of new automobiles, more or less important than the aggregate demand shifts, such as the expansionary monetary and fiscal policies?

Adam Hale Shapiro of the Federal Reserve Bank of San Francisco used a basic piece of microeconomic analysis to estimate the contribution of shifts in aggregate supply and shifts in aggregate demand to inflation during this period. He looked at the prices of the more than 100 categories of goods and services in the personal consumption expenditures(PCEprice index. The PCE price index is a measure of the price level similar to the GDP deflator, except it includes only the prices of goods and services from the consumption category of GDP. Changes in the PCE price index are the Federal Reserve’s preferred measure of the inflation rate because that index includes the prices of more goods and services than are included in the consumer price index (CPI).

Shapiro explains how he used microeconomic reasoning to determine whether prices in one of the more than 100 categories of goods and services were increasing because of shifts in supply or because of shifts in demand:

“Shifts in demand move both prices and quantities in the same direction along the upward-sloping supply curve, meaning prices rise as demand increases. Shifts in supply move prices and quantities in opposite directions along the downward-sloping demand curve, meaning prices rise when supplies decline.”

 For example, the figure on the left shows the effect on the market for toys of an increase in the demand for toys. (We discuss how shifts in demand and supply curves in a market affect equilibrium price and quantity in Chapter 3, Section 3.4 of Economics, Macroeconomics, and Microeconomics.) The demand curve for toys shifts to the right from D1 to D2, the equilibrium price increases from P1 to P2, and the equilibrium quantity increases from Q1 to Q2. The figure on the right shows the effect on the market for toys if the price increase results from a decrease in the supply of toys rather than from an increase in demand. The supply curve shifts to the left from S1 to S2, the equilibrium price increases from P1 to P2, and the equilibrium quantity decreases from Q1 to Q2

Shapiro used statistical methods to determine the part of a change in price or quantity that was unexpected. He took this approach in order to focus on short-run changes in these markets caused by shifts in demand and supply rather than long-run changes resulting from “factors such as technological improvements, cost-of-living adjustments to wages, or demographic changes like population aging.” In some cases, the quantity or the price in a market were very close to their expected values, so Shapiro labeled the cause of a price increase in this market as “ambiguous.”

Shapiro notes that: “Categories that experience frequent supply-driven price changes include food and household products such as dishes, linens, and household paper items. Categories that experience frequent demand-driven price changes include motor vehicle-related products, used cars, and electricity.”

The following figure shows Shapiro’s results for the period from January 2020 through April 2022. The height of each column gives the inflation rate in the month measured as the percentage change in the PCE price index from the same month in the previous year. For example, in March 2022, the inflation rate was 6.6 percent. The height of the yellow segment is the part of inflation in that month attributable to increases in demand, the height of the green segment is the part of the inflation in that month that is attributable to decreases in supply, and the height of the green segment is the part of the inflation that Shapiro can’t assign to either demand or supply. In March 2022, increased in demand accounted for 2.2 percentage points of the total 6.6 percentage point increase in inflation. Decreases in supply accounted for 3.3 percentage points, and the remaining 1.2 percentage points had an ambiguous cause. 

We can conclude that, measured this way, the increase in inflation from the spring of 2021 through the spring of 2022 was due more to negative supply shocks than to positive demand shocks.

Source: Adam Hale Shapiro, “How Much Do Supply and Demand Drive Inflation?” Federal Reserve Bank of San Francisco Economic Letter, 22-15, June 21, 2022.

Are the Fed’s Forecasts of Inflation and Unemployment Inconsistent?

The Federal Reserve building in Washington, DC. Photo from the Wall Street Journal.

Four times per year, the members of the Federal Reserve’s Federal Open Market Committee (FOMC) publish their projections, or forecasts, of the values of the inflation rate, the unemployment, and changes in real gross domestic product (GDP) for the current year, each of the following two years, and for the “longer run.”  The following table, released following the FOMC meeting held on March 15 and 16, 2022, shows the forecasts the members made at that time.

  Median Forecast Meidan Forecast Median Forecast 
 202220232024Longer runActual values, March 2022
Change in real GDP2.8%2.2%2.2%1.8%3.5%
Unemployment rate3.5%3.5%3.6%4.0%3.6%
PCE inflation4.3%2.7%2.3%2.0%6.6%
Core PCE inflation4.1%2.6%2.3%No forecast5.2%

Recall that PCE refers to the consumption expenditures price index, which includes the prices of goods and services that are in the consumption category of GDP. Fed policymakers prefer using the PCE to measure inflation rather than the consumer price index (CPI) because the PCE includes the prices of more goods and services. The Fed uses the PCE to measure whether it is hitting its target inflation rate of 2 percent. The core PCE index leaves out the prices of food and energy products, including gasoline. The prices of food and energy products tend to fluctuate for reasons that do not affect the overall long-run inflation rate. So Fed policymakers believe that core PCE gives a better measure of the underlying inflation rate. (We discuss the PCE and the CPI in the Apply the Concept “Should the Fed Worry about the Prices of Food and Gasoline?” in Macroeconomics, Chapter 15, Section 15.5 (Economics, Chapter 25, Section 25.5)).

The values in the table are the median forecasts of the FOMC members, meaning that the forecasts of half the members were higher and half were lower.  The members do not make a longer run forecast for core PCE.  The final column shows the actual values of each variable in March 2022. The values in that column represent the percentage in each variable from the corresponding month (or quarter in the case of real GDP) in the previous year.  Links to the FOMC’s economic projections can be found on this page of the Federal Reserve’s web site.

At its March 2022 meeting, the FOMC began increasing its target for the federal funds rate with the expectation that a less expansionary monetary policy would slow the high rates of inflation the U.S. economy was experiencing. Note that in that month, inflation measured by the PCE was running far above the Fed’s target inflation rate of 2 percent. 

In raising its target for the federal funds rate and by also allowing its holdings of U.S. Treasury securities and mortgage-backed securities to decline, Fed Chair Jerome Powell and the other members of the FOMC were attempting to achieve a soft landing for the economy. A soft landing occurs when the FOMC is able to reduce the inflation rate without causing the economy to experience a recession. The forecast values in the table are consistent with a soft landing because they show inflation declining towards the Fed’s target rate of 2 percent while the unemployment rate remains below 4 percent—historically, a very low unemployment rate—and the growth rate of real GDP remains positive. By forecasting that real GDP would continue growing while the unemployment rate would remain below 4 percent, the FOMC was forecasting that no recession would occur.

Some economists see an inconsistency in the FOMC’s forecasts of unemployment and inflation as shown in the table. They argued that to bring down the inflation rate as rapidly as the forecasts indicated, the FOMC would have to cause a significant decline in aggregate demand. But if aggregate demand declined significantly, real GDP would either decline or grow very slowly, resulting in the unemployment rising above 4 percent, possibly well above that rate.  For instance, writing in the Economist magazine, Jón Steinsson of the University of California, Berkeley, noted that the FOMC’s “combination of forecasts [of inflation and unemployment] has been dubbed the ‘immaculate disinflation’ because inflation is seen as falling rapidly despite a very tight labor market and a [federal funds] rate that is for the most part negative in real terms (i.e., adjusted for inflation).”

Similarly, writing in the Washington Post, Harvard economist and former Treasury secretary Lawrence Summers noted that “over the past 75 years, every time inflation has exceeded 4 percent and unemployment has been below 5 percent, the U.S. economy has gone into recession within two years.”

In an interview in the Financial Times, Olivier Blanchard, senior fellow at the Peterson Institute for International Economics and former chief economist at the International Monetary Fund, agreed. In their forecasts, the FOMC “had unemployment staying at 3.5 percent throughout the next two years, and they also had inflation coming down nicely to two point something. That just will not happen. …. [E]ither we’ll have a lot more inflation if unemployment remains at 3.5 per cent, or we will have higher unemployment for a while if we are actually to inflation down to two point something.”

While all three of these economists believed that unemployment would have to increase if inflation was to be brought down close to the Fed’s 2 percent target, none were certain that a recession would occur.

What might explain the apparent inconsistency in the FOMC’s forecasts of inflation and unemployment? Here are three possibilities:

  1. Fed policymakers are relatively optimistic that the factors causing the surge in inflation—including the economic dislocations due to the Covid-19 pandemic and the Russian invasion of Ukraine and the surge in federal spending in early 2021—are likely to resolve themselves without the unemployment rate having to increase significantly. As Steinsson puts it in discussing this possibility (which he believes to be unlikely) “it is entirely possible that inflation will simply return to target as the disturbances associated with Covid-19 and the war in Ukraine dissipate.”
  2. Fed Chair Powell and other members of the FOMC were convinced that business managers, workers, and investors still expected that the inflation rate would return to 2 percent in the long run. As a result, none of these groups were taking actions that might lead to a wage-price spiral. (We discussed the possibility of a wage-price spiral in earlier blog post.) For instance, at a press conference following the FOMC meeting held on May 3 and 4, 2022, Powell argued that, “And, in fact, inflation expectations [at longer time horizons] come down fairly sharply. Longer-term inflation expectations have been reasonably stable but have moved up to—but only to levels where they were in 2014, by some measures.” If Powell’s assessment was correct that expectations of future inflation remained at about 2 percent, the probability of a soft landing was increased.
  3. We should mention the possibility that at least some members of the FOMC may have expected that the unemployment rate would increase above 4 percent—possibly well above 4 percent—and that the U.S. economy was likely to enter a recession during the coming months. They may, however, have been unwilling to include this expectation in their published forecasts. If members of the FOMC state that a recession is likely, businesses and households may reduce their spending, which by itself could cause a recession to begin. 

Sources: Martin Wolf, “Olivier Blanchard: There’s a for Markets to Focus on the Present and Extrapolate It Forever,” ft.com, May 26, 2022; Lawrence Summers, “My Inflation Warnings Have Spurred Questions. Here Are My Answers,” Washington Post, April 5, 2022; Jón Steinsson, “Jón Steinsson Believes That a Painless Disinflation Is No Longer Plausible,” economist.com, May 13, 2022; Federal Open Market Committee, “Summary of Economic Projections,” federalreserve.gov, March 16, 2022; and Federal Open Market Committee, “Transcript of Chair Powell’s Press Conference May 4, 2022,” federalreserve.gov, May 4, 2022. 

Does Majoring in Economics Increase Your Income?

Image by Andrea D’Aquino in the Wall Street Journal.

Studying economics provides students in any major with useful tools for understanding business decision making and for evaluating government policies. As we discuss in Chapter 1, Section 1.5 of Microeconomics, Macroeconomics, and Economics, majoring in economics can lead to a career in business, government, or at nonprofit organizations. Many students considering majoring in economics are interested in how the incomes of economics majors compare with the incomes of students who pursue other majors.

            The Federal Reserve Bank of New York maintains a web page that uses data collected by the U.S. Census to show the incomes of people with different college majors. The following table shows for economics majors and for all majors the median annual wage received by people early in their careers and in the middle of their careers. The median is a measure of the average calculated as the annual wage at which half of people in the group have a higher annual wage and half have a lower annual wage. “Early career” refers to people aged 22 to 27, and “mid-career” refers to people aged 35 to 45.  The data are for people with a bachelor’s degree only, so people with a masters or doctoral degree are not included.  

 Median Wage Early CareerMedian Wage Mid-Career
Economics majors$55,000$93,000
All majors$42,000$70,000

The table shows that early in their careers, on average, economics majors earn an annual wage about 31 percent higher than annual wage earned by all majors. At mid-career, in percentage terms, the gap increases slightly to 33 percent.

            How should we interpret these data? In Chapter 1, Section 1.3, in discussing how to evaluate economic models, we made the important distinction between correlation and causality. Just because two things are correlated, or happen at the same time, doesn’t mean that one caused the other. In this case, are the higher than average incomes of economics majors caused by majoring in economics or is majoring in economics correlated with higher incomes, but not actually causing the higher incomes. It might be true, for instance, that on average economics majors have certain characteristics—such as being more intelligent or harder workers—than are students who choose other majors. Because being intelligent and working hard can lead to successful careers, students majoring in economics might have earned higher incomes on average even if they had chosen a different major.

(Here’s a  more advanced point about identifying causal relationships in data: The problem with determining causality described in the previous paragraph is called selection bias. Students aren’t randomly assigned majors; they choose, or self-select, them. If students with characteristics that make it more likely that they will earn high incomes are also more likely to choose to major in economics, then the higher incomes earned by economics majors weren’t caused by (or weren’t entirely caused by) majoring in economics.)

            Economists Zachary Bleemer of the University of California, Berkeley and Aashish Mehta of the University of California, Santa Barbara have found a way to evaluate whether majoring in economics causes students to earn higher incomes. The authors gathered data on all the students admitted to the University of California, Santa Cruz (UCSC) between 2008 and 2012 and on their incomes in 2017 and 2018. To major in economics, students at UCSC needed a grade point average (GPA) of 2.8 or higher in the two principles of economics courses. The authors compared the choices of majors and the average early career earnings of students who just met or just failed to meet the 2.8 GPA threshold for majoring in economics. The authors use advanced statistical analysis to reach the conclusion that: “Comparing the major choices and average wages of above-and-below-threshold students shows that majoring in economics caused a $22,000 (46 percent) increase in annual early-career wages of barely above-threshold students.” 

            The authors attribute half of the higher wages earned by economics majors to their being more likely to pursue careers in finance, insurance, real estate, and accounting, which tend to pay above average wages.  The authors note that their findings from this study “imply that students’ major choices could have financial implications roughly as large as their decision to enroll in college ….”

Sources: Federal Reserve Bank of New York, The Labor Market for Recent College Graduates, https://www.newyorkfed.org/research/college-labor-market/index.html; and Zachary Bleemer and Aashish Meta, “Will Studying Economics Make You Rich? A Regression Discontinuity Analysis of the Returns to College Major,” American Economic Journal: Applied Economics, Vol. 14, No. 2, April 2022, pp. 1-22.