The Role of Search Costs in Determining the Relationship between Inflation and Profit Margins

By Gwin, Carl R.; Taylor, Beck A. | Journal of Money, Credit & Banking, February 2004 | Go to article overview

The Role of Search Costs in Determining the Relationship between Inflation and Profit Margins


Gwin, Carl R., Taylor, Beck A., Journal of Money, Credit & Banking


A NATIONAL SURVEY of purchasing managers in 1993 showed that inflation was the top concern for buyers at that time (Anonymous 1993). These buyers suspected that inflation would cause volatility in the prices they faced. Purchasing managers worried that their suppliers would take advantage of inflation to raise prices faster than their own costs increased. (1) As the story goes, the accelerated price increases and the resulting price dispersion would allow suppliers to pad profit margins. These allegedly supernormal profits ultimately caught the attention of the popular press and the U.S. Federal Reserve. (2) The topic of the present study is timely, given renewed concerns about inflation in the new millennium and recent theoretical models that show that inflation can have both a positive and negative impact on markups. Particularly interesting is the concern among practitioners that companies may not be able to make profits without inflation. (3)

While the existing empirical literature points to a negative impact of inflation on profit margins, we ask whether inflation can lead to both increasing and decreasing margins. As the theoretical literature on the subject has suggested, the existence of significant search costs incurred by buyers may affect the relationship between inflation and markups. Our paper addresses this possibility by empirically estimating the relationship between both aggregate and industry-level inflation and the resulting price-cost margins across 57 four-digit SIC industries. The contribution of our study to the extant literature is at least twofold. First, to our knowledge, our study is the first to use actual measures of search cost for testing the dependence of contribution margins on inflation. Second, while the existing empirical literature uses markup series constructed from aggregate output (value added), factor inputs, and wages, we construct industry-level average contribution margins from firm-level income statement data.

Our empirical methodology follows that of Benabou (1992b) and Kaskarelis (1993). Benabou (1992b) studies inflation and markups in the U.S. retail trade sector, a sector in which, he asserts, low search costs play an important role in the empirically estimated relationship between inflation and markups. Benabou finds expected and unexpected inflation to have a small but significantly negative impact on retail markups. Benabou interprets his findings as support for the prediction that (S, s) pricing theory in the presence of inflation would lead to higher price dispersion. (4) With low buyer search costs, price dispersion promotes search and competition intensifies, leading to a decrease in markups. Kaskarelis (1993) finds similar results for the UK manufacturing sector.

Both empirical studies outlined above do not consider how interindustry variation in the search costs of buyers might affect the estimated relationship between inflation and industry markups. We find convincing evidence that inflation can have both a positive and negative impact on profit margins, depending on the level of buyer search costs. Among industries that sell to buyers with relatively low search costs, inflation is estimated to lower markups, while industries that sell to buyers with relatively high search costs benefit from inflation in the form of larger markups. This result reconciles a theoretical literature that predicts both positive and negative effects of inflation on markups with an empirical literature that has estimated only negative inflationary effects.

This paper is organized as follows. Section 1 introduces the data and empirical methodology. Section 2 articulates our hypotheses that are based on the pertinent theoretical literature linking inflation and profit margins. Section 3 details the results of our analysis, and Section 4 concludes.

1. DATA AND EMPIRICAL METHODOLOGY

The need to determine whether buyer search cost influences the effect of inflation on industry profit margin limits our analysis to industries for which data on buyer search costs are available. …

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