There Are More Signs Supply Shortages Could Stick Around Without Sparking Inflation

(Bloomberg) -- With lots of talk about supply shortages right now, there are plenty of concerns that companies will raise prices in response to booming demand, which could end up fanning inflation. There’s also an expectation that companies will eventually use those higher prices to ramp up capacity to produce more of those in-demand things — after all why would anyone want to leave the possibility of extra sales on the table?

It’s basic microeconomics: the kind of supply/demand equilibrium stuff you might pick up in an AP class. But of course, the real world doesn’t always follow rational economic theory and there are some signs that companies aren’t raising prices to invest in future capacity. 

Here’s George Pearkes, strategist at Bespoke Investment, who notes that companies have two ways to respond to surging demand:

“One is to raise prices and use the extra revenue to invest in new capacity, whether that’s investing in physical assets, inventories, or more workers. In other words, companies adjust along the margin of price (P), and total quantity (Q) supplied rises.

Instead, there’s a mounting array of anecdotal evidence that companies are simply declining to raise quantity supplied, and betting that their businesses will be better off holding prices in check but not taking the risk of investment to raise capacity.”

On Thursday, Bloomberg reported that some Chinese factories are choosing to avoid increasing investment as higher input costs and throttled transport networks squeeze their profit margins. “The future is very unclear, so there is not much push to expand capacity,” says the owner of a factory making glass lampshades for companies like Home Depot.  A casting company in Guangdong recently told customers that it wouldn’t be able to fulfill current orders because of the high price of metals. 

Away from China, there are some signs of this happening too. As Pearkes points out on Twitter, Toll Brothers, which builds luxury houses, on Wednesday reported higher than expected gross margins and a massive order backlog, but also warned that next quarter’s deliveries could miss estimates. Instead of raising prices to reach an equilibrium between supply and demand, producers might just settle for less volume.

“This ‘No P All Q’ means firms are intentionally throttling both supply and price. It’s rationing. In the simplistic world of microeconomics, it creates deadweight losses; lower profits for producers and less consumer surplus for consumers. From a macro perspective, it means lower inflation, lower employment, lower investment, and lower output versus the virtuous cycle that could play out.

Ultimately, businesses may be correct that demand won’t stay high and reward their investments now with profits later. If they are, this economic recovery is going to look a lot like the last one: much slower and weaker than if businesses were confident that demand would keep growing into the future.”

In other words, while supply shortages could be around for some time, they might not spark that much inflation. That might be good for people who are worried about a sudden spike in prices, but not so good for an economy that’s still digging itself out of a global pandemic-sized hole.

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