Can Recession Feed Inflation? A Conflicting Claims Framework

Abstract

This paper develops a rationale for the recession-induced inflation hypothesis. Within a conflicting claims framework we present a model in which both price leaders and organized workers set their nominal prices on the basis of a desired profit rate and a real wage target respectively. We argue that an absolute cost advantage in concentrated industries (for instance in fixed costs) may provide oligopolistic leaders sufficient margin to raise prices and restore a desired level of profitability during a recession. The resultizng unstable income distribution will set off an inflationary spiral if the firm's advantage in selling its output imparts an upward bias to the flexibility of input prices (specifically wages). Taking into consideration different scenarios for workers' bargaining power we present a simple simulation experiment to analyze the inflation and real wage paths of the economy after a negative output shock. When we endogenize output, we show that for a high degree of the bargaining power, output is likely to converge to a higher steady-state value.

Acknowledgment

Earlier drafts of this paper benefited from comments by Sam Rosenberg and Howard Wachtel. The final version has benefited from suggestions by two anonymous referees.

Notes

¹In Holzman (1950) F is a residual money income comprising mainly rent, royalties and interest payments.

²Competition is defined here as the force that redistributes profits by adjusting prices so as to equalize profit rates.

³However, we should note that if planned investment is considered to be a function of capacity utilization (as some Post-Keynesians would argue), our assumption of a relatively stable and unchangeable profit rate target would be undermined.

⁴In practice, technological barriers seem to play a major role in oligopolistic industries with a relatively homogeneous output. In oligopolistic industries with differentiated products the main barrier to entry is the cost of sales promotion and advertising. Sylos Labini (1984, p. 124) calls the former situation ‘homogeneous’ or ‘concentrated’ oligopoly, and the latter ‘differentiated or ‘imperfect’ oligopoly. In addition to technological and commercial barriers, the industrial organization literature identifies the following as important impediments to entry: intensive R&D, vertical integration, sales networks, finance, and patents and exclusive licenses.

⁵Linear versions of the incumbent and potential entrant cost functions are

where α is the unit variable (and marginal) cost, F is fixed costs and output is q. Production is subject to the constraint that output cannot exceed installed capacity. The subscript 1 denotes the potential entrant and the subscript 2 denotes the incumbent firm. Crucial to our analysis is the assumption that F ₁ > F ₂. Dividing both expressions by q, the unit cost functions are

By definition h (the height of entry barriers) is

Evaluating the differential of h with respect to q we find

which is unambiguously negative implying that a fall in output will be associated with an increase in entry barriers.

⁶It is likely that the onset of a recession would make demand for the typical product less elastic. A recent interview study of price-setting in business found that almost 60% of respondents accepted the premise that the elasticity of demand varies procyclically (Blinder et al., 1998).

⁷Under adaptive expectations wage-earners expected price level is p ^e  = p _t − 1 [1 + ((p _t − 1 − p _t − 2)/ p _t − 1] and substituting this expression into equation (13) yields equation (14).

⁸The target real wage hypothesis has been integrated in orthodox models in which the equilibrium employment level (corresponding to the NAIRU) is determined by means of a price-setting and a wage-setting function (see for instance, Blanchard, 1986; Layard & Nickell, 1986; Carlin & Soskice, 1990). In these models if the real wage target depends on the unemployment rate, there will be only one particular unemployment rate that will allow compatibility between the real wage claimed by unions and the given mark-up.

⁹Indeed Cripps & Godley (1976, p. 342) state that ‘The factors determining the target real wage cannot be formulated with any precision. In particular it has not been perceptibly influenced by the level of unemployment.’

¹⁰In addition, contract and bargaining models make things more complicated by suggesting that there may not be a tight contemporaneous relationship between employment and the desired real wage; see Blanchard & Fischer (1993) for a survey of these models.