Inflation, followed by poverty and social inequality are currently the most pressing issues that concern people around the world. Canada has not remained immune to the rising cost of living and continues to struggle with an inflation rate above the two percent target favored by the Bank of Canada.
Canada’s inflation hit 8.1 percent in June, the highest in more than 40 years. Although the rate fell slightly after that, it was still 6.8 percent in November and fell to 6.3 percent in December.
High prices divert wealth from consumers to owners of large companies and widen the pay gap between CEOs and employees. My research shows that consumer prices are higher than they should be. This is even without factoring in inflation, due to a less studied phenomenon: compound markup.
Less competition than you think
Many economists rely on philosopher Adam Smith’s metaphor of the invisible hand to understand how the market economy works. According to Smith, the invisible hand is the natural force that drives individuals to unconsciously make economic decisions that are best for society.
This economic philosophy maintains the view that competition is ubiquitous in market economies such as North America and Western Europe. Competition causes producers to undercut other producers’ prices until prices become low enough to compensate producers only for their costs and time.
But as my research shows, low prices are the exception rather than the rule. Such news should surprise those who believe in the power of the invisible hand to push prices to the lowest possible level.
While Adam Smith still advocated free market principles, including the invisible hand, he was aware that monopolies could arise that would prevent competition and drive up product prices.
Prices much higher than production costs
The concept of markup, which is how often a price exceeds the cost of production, is not new. Government organizations that monitor the markets already exist to prevent big companies from colluding against consumers by maintaining artificially high prices.
In the economics literature, only one product at a time or a few slightly differentiated products, such as Adidas and Nike, are considered when measuring markup. Existing theories and estimates ignore that marks multiply as raw materials, ingredients and components move from one company to another in the production chain.
One company sells an overpriced part to a second company, that second company integrates it into their unfinished product, then sells it for a profit to a third company, and so on. By the time the finished product reaches the consumer, the price has increased several times in succession.
Take the bread market. My research implies that the price of bread includes substantial profit margins that go to a handful of large companies. To produce bread you need wheat, which is also sold in competitive markets because all wheat is the same and there are many wheat producers.
However, to produce wheat one needs fertilizers, usually sold in highly uncompetitive markets by large companies such as Nutrien Ltd., heavy equipment sold by large companies such as John Deere, pesticides, seeds and other inputs from markets that are dominated by large companies. .
Tractors need computer chips, steel, aluminum and tires that also come from big companies. Batteries require rare earth metals, which come from only a few world producers. Each additional step in the production chain adds an extra layer of profit to the price of the final product – hence the compound markup.
The price increases for consumers are abnormally high
To determine the markups of different industries compared to the cost of production, I compared the market price of products to the “natural” cost of production. This natural cost is district-specific and takes into account the average cost of rent, profit and wages for certain districts.
My idea of compound markup compares market prices to this concept of natural costs, because a fair price would equal these costs in a monopoly-free economy.
To do this, I measured the overprice of complex end products such as electronics and transportation services, taking into account all the overpriced components that the end product contains. For the data I used input-output tables, which show sales flows of intermediate goods from one industry to another. The results of this calculation are the composite markers.
A compound mark-up of three means that the price of the final product is three times the natural cost, taking into account all intermediate stages. The conventional markup, on the other hand, takes into account only the final stage of production, in which the final product is assembled and sold to a consumer.
These results indicate that prices for many of the goods and services we all need are up to five times higher than the natural cost of production. The owners of large companies make abnormally high profits at the expense of consumers.
Rethinking Market Competition
There is indeed an invisible hand at work in the supermarket, but Adam Smith would not recognize it. The real invisible hand is there to benefit the producer, not the consumer, contrary to Smith’s belief. Concerned groups have long seen fair trade as a goal in international markets, but not so much in our daily lives and not in the context of composite prices.
Governments, consumers and consumer organizations could use this kind of research to promote more competition in markets, advocate for fair trade within a country and rethink policies on income inequality.
Large firms tend to monopolize intermediate markets even more than they do in final commodity markets. That is why government antitrust agencies, such as Canada’s Competition Bureau, must monitor markets for intermediate goods such as fertilizers, farm equipment and rare earths – not just consumer goods markets.