The Cost-Price Illusion
One of the best parts of Alchian and Allen’s classic textbook, University Economics, is its discussion of the cost-price illusion. The analysis, though worded somewhat differently, is also in the newer textbook Universal Economics, which is based on the original. It’s free online from Liberty Fund.
Here’s the passage:
SPEED OF DETECTING CHANGES IN DEMAND OR SUPPLY: THE ILLUSION THAT COST DETERMINES PRICE
Buffer stocks, inventories, and reserve capacity help make it appear as if prices are sluggish or inflexible and are determined by costs, instead of by competition among consumer-demanders. Suppose that for some reason (possibly higher incomes) demand for meat increases. As sales and consumption increase, butchers’ inventories are unexpectedly depleted. Normally, as with any retailer, inventories are large enough to accommodate transiently increased sales without producers having to raise prices. Inventories larger than an average day’s sales help assure that supplies are immediately available to demanders at predictable prices.
One day’s above-average sales is not regarded instantly as a persistent increase at that price; nor is it viewed as a long-term sales increase that requires a higher price to keep inventories from being further depleted. When the increase in sales reflects a higher average demand, no seller will be able to detect the increase in demand immediately. A high transient deviation may induce retailers to purchase more for replacement of normal inventories, but they would buy even more if they knew the long-term demand had increased.
If the public’s aggregate demand really had increased (not just toward this one butcher and away from other butchers), the demand by all butchers to restore inventories would increase the demand facing the meat packer-suppliers. Packers will see their inventories declining as they supply more meat to retailers.
To replenish their extraordinarily depleted inventories, packers will compete with each other for more cattle than before. But with an unchanged supply of cattle, some packers must get less than the increased amount they demand at the old price. They bid up the price of cattle. The packers are, in this scenario, the first to see a price (cattle cost) rise consequent to the increased consumer demand, and they will correctly interpret that as a rise in their costs.
The existence of inventories in the chain of suppliers from producer to consumer can cause a delay during which the increased consumer demand is communicated Edition: current; Page:  from retailers to initial producers. That delays the price increase until the cattle-producer stage.
WHO IS RESPONSIBLE FOR HIGHER PRICES? LOOK IN THE MIRROR
Packers raise their prices to retailers, saying their prices are higher because their costs are higher. But we know that costs are higher because it was the increased consumer demand that prompted a higher price of cattle at the feedlot. Because of the increased consumer demand, a higher price is obtained and maintained in the consumer market. When consumers complain about the higher price of meat, butchers say it isn’t their fault. Their costs have gone up. And the packers can say the same. To see who really was responsible for the higher prices, the consumers can look in the mirror behind the butcher’s counter and see themselves.
Not all prices adjust instantly to the new equilibrium price to clear the market, as they do in the organized stock and commodity markets. In fact, a lag occurs between the time some demand or supply situation has changed and the time people detect and distinguish that from a random, transient, reversible change in the current purchase rates or in supply conditions.
As emphasized earlier, the amount demanded may refer to the underlying average amount demanded in an interval, with momentary random offsetting deviations taking place around that average value. Because of the transient variations around the average, a shift in that average may be hard to detect quickly. An increase in sales may be interpreted as only a randomly high sales rate, rather than as a new higher normal sales rate. And once a seller begins to suspect that demand has shifted, difficulties exist in knowing what are the best adjustments to make in supply response.
If the demand is believed to have fallen, should a supplier shift to some other production activity or should the price be lowered and work continued at a lower rate? Should an employer attempt to reduce wages of employees immediately when sales fall?
So-called delays and lags in adjusting price or output are the result of inability to foresee the future perfectly and to understand what really is happening. They are not results of some inherent inflexibility in, or inability to change, prices. It takes time to decide that an underlying change, rather than a random, transient deviation has occurred. And the time it takes to discover what is the most appropriate adjustment misleads outside observers into thinking that prices are “rigid.” Prices actually are instantly flexible—as instantly as it is discovered that a change is appropriate.
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Why is this particularly relevant today? Because many commentators argue that cost increases are the cause of price increases. That can be true. But more often, given the huge recent increases in the money supply, it’s demand increases that are driving price increases. But the way that often shows up is similar to the analysis in Alchian and Allen.