Analysis: Stop pretending price inflation is a result of “too much” profit

How Prices Are Established

As a rule, a supplier sets the price. After all, it is the supplier who offers the goods to the buyers. So it is the supplier who must set the price of a good before he presents the good to the buyers.

In order to secure the price that will improve his lot, the price that the supplier sets must cover his direct and indirect costs and provide a margin for profit.

By setting the price, the supplier must make as good an estimate as possible regarding whether he will be able to sell his entire supply at the price set.

The process of making the estimate involves the assessment of the possible responses of the buyers and the possible responses of his competitors—other suppliers. If his estimates are accurate, then he makes a profit.

By making a profit, the supplier expands his pool of resources, which in turn enables him to attain more ends. His standard of living improves.

Observe that while the cost of production in some cases would appear to be the main factor in price determination, this is not so.

Ultimately, it is the evaluation of the buyer that dictates whether the price set by the supplier is going to be realized. Every buyer decides in his own context whether the price paid for a good betters his life and well-being.

If the cost of production were the driving factor behind setting market prices, then how can we explain the prices of goods that have no cost because they are not produced—goods that are simply there, like undeveloped land?

Likewise, the cost-of-production theory cannot explain the reason for the high prices of famous paintings.

According to Rothbard, “Similarly, immaterial consumer services such as the prices of entertainment, concerts, physicians, domestic servants, etc., can scarcely be accounted for by costs embodied in a product.”¹

It follows then that businesses striving to make profits cannot cause increases in the prices of goods and services without the consent of consumers.

Defining Price

The price of a thing is the amount of money paid for the thing; for example, the number of dollars per loaf of bread or the number of dollars per shirt. The key driving factors here are the amount of dollars and the quantity of goods.

Now, with all other things being equal, an increase in the amount of money paid for goods and services implies that the price of these goods and services is going to be higher. More money is now paid for these goods and services.

In the absence of an increase in the amount of money, there cannot be a general increase in prices.

If a business raises the price of its goods and consumers have agreed to this increase then consumers are going to have less money to spend on other goods, all other things being equal. Hence, we will have here a specific price increase but not a general increase in prices.

Inflation Is All about Increases in Money Supply

By popular thinking, it is the role of the central bank to guide the economy onto the path of economic and price stability.

If central bank officials anticipate that the economy will fall below the path of economic and price stability, then officials are expected to prevent this decline through monetary pumping.

Conversely, if officials are of the view that the economy is likely to shoot above the stable path, then they are likely to prevent this by reducing the monetary pumping.

In response to covid-19 and in particular the lockdowns and other restrictions, central bank officials expected severe damage to the economy. The economy was expected to fall strongly below the path of stability.

In this case, strong monetary pumping was considered as a welcome move. The strong monetary pumping is believed to have brought the economy onto the stable path.

But monetary pumping cannot generate economic stability. The pumping sets in motion an exchange of nothing for something, or the diversion of wealth from wealth generators to the early recipients of the newly pumped money.

This undermines the process of wealth generation and weakens the prospects for economic growth.

As a rule, because of the monetary pumping, individuals are going to have more money in their pockets, which they are likely to dispose of by buying goods and services. This means a greater amount of money is going to be spent on various goods and services. This means that the prices of goods and services are going to increase, all other things being equal.

Given the massive increase in the monetary pumping, the yearly growth rate of the US money supply jumped to 79 percent in February 2021 from 6.5 percent in February 2020, according to the True Money Supply metric—an average increase of 43 percent.

Allowing for the time lag between changes in money supply and changes in prices, it is not surprising that the momentum of the Consumer Price Index displays massive increase.

Hence, the culprit here is the alleged defender of the economy—the central bank itself. Curiously, very few commentators are mentioning the role of the central bank in fueling general increases in the prices of goods and services.

Note that the massive increase in the growth rate of money supply, coupled with lockdowns and various other restrictions, has intensified the upward pressure on the prices of goods and services.

The combination of not enough savings allocated toward the expansion and the enhancement of the production structure and a strong demand for various goods and services due to the massive increase in money supply has resulted in shortages. After a time lag, prices are therefore likely to increase further to eliminate the shortages that have emerged.

Could Price Controls Resolve the Issue of General Price Increases?

Some commentators are of the view that the government should introduce price controls in order to prevent further increases in the prices of some key consumer goods.

A policy of restricting price adjustments due to the monetary pumping is going to weaken various marginal producers. Consequently, these producers are likely to move to activities which are not subject to government price controls.

As a result, the supply of some key consumer goods will come further under pressure. So rather than benefiting consumers, such a government policy would hurt consumers’ well-being. Hence, a policy of price controls is likely to increase shortages and stifle the production of goods and services.

In fact, this could ultimately lead to the imposition of the price controls on a large variety of economic activities, which in turn is likely to result in the economic system that resembles the former Soviet Union.²

• 1. Murray N. Rothbard, “The Celebrated Adam Smith,” in Economic Thought before Adam Smith, vol. 1 of An Austrian Perspective on the History of Economic Thought (Auburn, AL: Ludwig von Mises Institute, 2006), pp. 433–74, esp. p. 452.
• 2. Ludwig von Mises, “How Price Controls Lead to Socialism,” Mises Wire, Jan. 14, 2016.

Contact Frank Shostak | Frank Shostak‘s consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies.