In chapter “Inflation“, you learned that the American economy saw a period of significant inflation starting in the late 1960s and ending in the 1980s, and this was followed by a period of relatively low inflation (although the pandemic appears to have brought an end to that). You also learned that prices, generally, ran countercyclically prior to around 1983–that is, moving up (or up faster than before) in recessions and down (or up slower) in expansions–, but then became acyclical afterwards–which is to say that price movements appeared to become uncoupled from the business cycle. In these final two sections of the present chapter, we’ll highlight some important reasons for why prices behaved the way they did in these two periods.

Our explanations will draw from heterodox economic theory, but first it is worth considering the orthodox approach, using aggregate supply and demand to explain changes in the overall price level. Now, the nice thing about a supply and demand model, aggregate or otherwise, is that it can explain the cause of a change in price and quantity simply by reasoning backward from the observed changes in price and quantity themselves. If, for instance, prices went up then this must be due to either an increase in demand or a decrease in supply–it simply becomes a question of whether quantity (in the macroeconomic sense, GDP) was rising or falling at the time. The rising inflation of the late 1960s, for instance, when the economy was still expanding, could be explained by an increase in demand stemming from the spending the U.S. government was doing to prosecute the Vietnam War. The argument in this case is that high levels of output cost more to produce per each additional unit and hence will only be produced when there is enough spending to pay for higher prices. In contrast, the inflation of the mid-1970s, during a period of stagnation, could be attributed to the supply shock of increasing oil prices.

But the historical record pokes holes in this approach. For instance, the countercyclicality of prices over the period between World War II and the early 1980s–that is, prices moving in the opposite direction as quantities– suggests that shifts in aggregate supply, not demand, were effectively driving the business cycle. But is this really plausible? And if so, why then did prices stabilize afterwards? Were there no more supply shocks? Not from the rapid globalization or the advent of the internet that took place in this period? To be sure, orthodox economists continue to debate these questions and to proffer a variety of answers that, in essence, revolve around what they think happened to aggregate supply and aggregate demand. Below, however, we’ll look at the alternative, heterodox explanations.

Understanding the cyclicality of prices–that is, how the price level moves with or against the expansions and recessions of the economy–requires a look to how businesses actually behave over the course of the business cycle. And at the core of this behavior is markup pricing. You can learn more about this in Chapter [Costing and Pricing], but for now all we need to consider is that most prices in the economy are determined by businesses setting a price for the product that is some amount above–that is, marked up over–the cost of production. Usually this is a percentage above the unit (that is, average) cost of production at the expected level of output.

For instance, imagine that I expected to produce and sell 1,000 units of my product, which I expect to cost me $4 per unit to produce. Now suppose that I would like–and given the conditions of the market, I think I can get–a 25% margin (rate of profit) on my product, then I will simply charge a price of [latex]$4 \times (1+0.25) = $5[/latex]. And it’s pretty much as simple as that: to get my 25% return I simply added 25% to the cost of production when I set my price.

You probably noticed that the equation we just used to get a $5 price looks a lot like one we were using earlier in the chapter: Total Cost(1 + r) = Total Revenue. That’s not coincidental as we’re still working within the general heterodox framework to understand pricing. But note that here we’re thinking in terms of costs, prices, and revenues per unit rather than total. So in the above example $4 was the expected cost to produce a single unit of the product, and the $5 price wouldn’t give us total revenues, but it would give us the revenue brought in on each unit sold. (Of course, if the expectation of 1,000 units sold were correct, then we could get our total figures for the business simply by multiplying our per-unit numbers by 1,000.)

We’re thinking now in terms of per-unit values because those values can change over the business cycle. Specifically, unit cost changes as the economy expands and contracts and businesses’ output correspondingly increases and decreases. How those unit costs change over the business cycle depends on what period and what economy we’re looking at.

By the mid-20th century, prices for most of the things Americans bought weren’t being set by auction-type markets in which swings in supply and demand set off price adjustments to bring the market into equilibrium. No, they were set by (relatively large) businesses as a markup over unit costs. For those businesses, the cost of production per unit produced depended especially on two things: the price and quantity of labor and materials needed to produce, and the overall cost of running the business beyond the direct costs of production. Let’s consider how those production and operational costs change as the economy expands and contracts.

In terms of labor costs, the evidence suggests a countercyclical pattern due to labor hoarding: the tendency of businesses, especially prior to the 1980s, to keep some employees on the payroll even when business is slow (that is, when sales are down) and there is little for those employees to do. By and large, businesses in this period would not respond to a significant decline in sales with a proportional round of layoffs. Some workers would simply be retained, even if they weren’t entirely necessary for the moment, and put back to full work once the economy picked up again. This meant that, as output declined, the cost of labor declined by less, and the labor cost per unit of output rose. Of course, when sales picked back up, those cost increases would reverse. To be consistent with terminology used elsewhere in this textbook, we’ll call these costs average variable costs.

For the overall costs of the business the story is essentially the same. Producing cars, for example, doesn’t just require welders, painters, and other workers to actually do the manual labor or production; it requires giant factories, machines, computers, loans, contracts with marketing firms and dealerships, and so on and so on. All of these costs have to be covered by the price if an automaker is going to stay in business. But importantly, all of these costs (or most of them at least) stay the same even when there’s a decline in sales. The fact that the economy took a downturn doesn’t change the fact that General Motors recently built a new factory in Egypt. What it does change, however, is how many units all the costs are being spread over. That is, as sales decline all of these costs per unit sold are increasing. We’ll call these average fixed costs.

The important thing to understand here is that unit costs of all varieties vary inversely with quantity produced. In terms of the business cycle, then, if the average business is seeing a decline in sales and hence quantity produced in a recession, then the average business is seeing an increase in unit costs during that period. Those costs then decline in an expansion, when sales pick up again. And if prices are adjusted to maintain a constant markup then we get the same inverse relationship between quantity and price as we do with quantity and average cost. That is, if my costs go up because my sales are down, then I’ll simply raise my price to maintain the margin, my profit rate.

Although a full explanation would be much more complex, all of the above suggests why prices, at least between the 1940s and 1980s, were countercyclical. Note that this is not because of shifts in aggregate supply. As a matter of fact, it would generally make more sense to understand the changes in quantity produced above as being caused by changes in aggregate demand. But in reality we’ve moved completely away from the orthodox model of aggregate supply and demand. Instead, we have here an explanation of observed changes in the price level over the business cycle that is fundamentally built on the actual cost structures and pricing behaviors of businesses during this period.

But, as heterodox economists emphasize, there are no universals in social science (see chapter four). In the 1980s, prices in the US economy shifted away from being countercyclical, as you’ll learn in the final section of the chapter.

Glossary

labor hoarding

the tendency of businesses, especially prior to the 1980s, to keep some employees on the payroll even when business is slow (that is, when sales are down) and there is little for those employees to do