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Cooking The Books 1: Passing on costs

On May the index of the factory gate price of manufactured goods rose by 1.6 percent. As this was the biggest monthly rise since March 1981, the media began to talk of a summer of inflation (Times, 10 June). Since they mistakenly regard any price rise, however caused, as inflation what they meant was that a spate of price rises could be expected this summer which will affect not just those who buy producer goods but the rest of us too who buy consumer goods.

The manufacturers are arguing that they have to increase their prices because their costs have risen. It is true that their costs, particularly energy, have risen but manufacturers cannot increase their prices just because they have to pay more for their raw materials or energy (or, for that matter, wages). Prices are not determined by what the manufacturers would like but by what the market for their product will bear.

All firms aim to make as much profit as possible but will be satisfied if they can cover their costs and make the going rate of profit. This is the normal situation and is brought about by competition. If a firm tries to make a bigger profit by increasing its price above cost plus normal profit it wont succeed. Its product wont sell as those who use it will turn to other, cheaper suppliers.

This does not mean that they can never raise prices, or rather that the market will never allow them to do so. It is official government policy to inflate the currency so that the general price level rises at around 2 percent a year. So, other things being equal, firms can safely increase their price by this amount. As everybody will be doing it, it is something the market can bear.

Sometimes, due to an unexpected fall or interruption of supply, suppliers can increase their price to take advantage of this. This is the operation of the law of supply and demand: there are more paying demanders than suppliers so the price goes up. But this will only be temporary. Supplies will eventually be restored, even if by new suppliers being attracted by the higher profits, and prices (and profits) will fall again.

So, cost increases do not automatically lead to price increases (and this applies to wage increases as well as to other costs). This will only happen if the market will bear it. If the market wont then the capitalist firm, whether manufacturing or retailing, cannot pass the increased cost on to consumers. They have to absorb it, as reduced profits.

The figures for factory gate prices from the Office for National Statistics illustrate this well. They show that the index of input prices (i.e. costs) of manufactured goods has been rising faster than that for output prices. While the index for these latter rose by 1.6 percent in May that for input prices rose by 3.8 percent. In the year ending May 2008 the index of input prices rose by a record 27.9 percent but the index for output prices rose by only 8.9 percent. (

Clearly, to maintain their profits, manufacturers would have liked to raise the price at which they sold their products as fast as their costs. The fact that they didnt is sufficient proof that they couldnt. But there are limits to how far their profits can be squeezed. As Gary Duncan, economics editor of the Times pointed out:

The double whammy of stalled spending by struggling households alongside rising costs for every kind of business means that companies sales and profits are going to be under growing strain. This will spell cutbacks and layoffs. This raises the spectre that the economy could slide into a vicious downward spiral.