Profit margins do not appear to have been a hidden driver of Australia’s post-pandemic inflation surge, according to research using firm-level data covering most Australian businesses and structural models.

The research, presented by Dr Jonathan Hambur, Deputy Head of the RBA’s Economic Research Department at the 4th Firm and Industry Dynamics Workshop at UNSW Sydney, found that firms typically pass through less than the full increase in their costs to prices when faced by a sudden jump in their costs, undercutting claims that businesses used the post-COVID inflationary cost shocks as cover to expand margins.

Dr Hambur said there was little evidence of either version of the greedflation argument: namely, that firms deliberately used the cost shock to boost profits, or that less competitive industries passed on more of their costs. In fact, he noted that firms generally raise prices by less than their costs went up in response to a sudden outside jump in their costs, and that gap was even bigger in less competitive industries, the opposite of what the ‘greedflation’ theory would predict.

When his co-authors factored this into their research model (which was calibrated to Australian microdata), Dr Hambur said it didn’t produce any meaningful pickup in inflation, beyond what would have happened otherwise. If anything, the research suggests that firms’ pricing behaviour would have marginally dampened inflation in this episode rather than adding to it.

The findings from Dr Hambur’s co-authored paper, Competition, Markups, and Inflation: Evidence from Australian Firm-level Data, challenge the narrative that gained traction during the pickup in inflation just after COVID, that firms in concentrated markets used the shock to lift prices beyond what higher costs justified.

A model built on almost the entire firm population

The researchers built an economic model calibrated to detailed data on Australian firms from the Australian Bureau of Statistics’ Business Longitudinal Analysis Data Environment. The model allowed markups to vary by firm size and market share, rather than assuming that every business passed on cost increases in the same way.

Dr Hambur said the research made two contributions to the debate. The first was to build an economic model, calibrated with detailed data from Australian businesses across a wide range of industries, to test how firms actually behave in response to cost shocks.

Learn more: What’s inflation – and how exactly do we measure it?

The second was to test two versions of the greedflation hypothesis. The stronger version argues that cost shocks, such as the war in Ukraine and COVID-related supply disruptions, allow firms to raise prices beyond what higher costs would otherwise require, thereby lifting margins. The weaker version holds that firms in less competitive markets pass on a larger share of any cost increase.

A key element of the model is a parameter economists call the super-elasticity, which measures whether a firm’s pricing power strengthens or weakens as it grows larger. When estimating this model using firm-level data, the estimate was positive, meaning larger firms tend to have higher markups than smaller rivals, a result consistent with earlier demand theory. Because the parameter was positive, firms will tend to pass on less than the full increase in their costs in response to a cost shock, as they worry about losing market share to rivals.

Average pass-through sat below full cost recovery

That result translated into an average pass-through rate of 0.8 to 0.9, meaning firms typically absorbed part of any cost rise rather than passing on the full amount, even before accounting for the practical lags in repricing. About a quarter of industries showed close to full pass-through, but most sat below that level.

When the researchers ran the model forward to compare inflation outcomes with and without this size-based markup variation and pass-through, the difference was minor.

"If you look at 2022, which is the inflationary period, yes, it does look like the correlation between profits and prices was stronger – but it’s still below one"

JONATHAN HAMBUR

“There was a lot of work to see it does very little, at least based on our estimates,” Dr Hambur said. “The responses to inflation are very marginally dampened in the case of the Kimball aggregator (a version of the model that allowed for the differentiated markups). We showed that the pass-through was below one, so you get a little bit of damping, but it’s visually very small. You don’t really see much of a difference.”

Widening the analysis to the full range of outcomes across Australian industries, rather than just the average, produced a similar picture. Amplification of a cost shock only appeared at the extreme edges of the distribution, and even there it topped out at around 10 per cent.

Data backed up the modelling

To test the model against real outcomes, the team turned to two further sources. The first paired industry-level producer prices with a technique for constructing industry cost shocks using firm-level outcomes, known as a granular instrumental variable. They used these to check whether prices in less competitive industries responded more to those shocks.

“You have the cost shock, the pass-through of that to prices is higher in exactly those industries where our estimated pass-through is higher,” Dr Hambur said. “That’s pretty direct evidence that our pass-through parameter in the model does hold some weight. It is consistent with the structure of the Australian economy.”

A related test used industry markups instead of the estimated pass-through figure and found the same pattern: prices in less-competitive, higher-markup sectors responded less to cost shocks than prices in more-competitive sectors, again running counter to the weak version of the greedflation theory.

The second exercise drew on web-scraped pricing data covering about 60 retailers between 2018 and 2022, matched against those firms’ reported profits through tax records. The logic behind this is that if a firm didn’t pass through its full cost increase, profits should fall as costs outpaced prices, producing a negative link between price rises and profit growth.

The team found exactly that pattern across the full sample, equivalent to a pass-through rate of about 0.85. Dr Hambur noted this figure isn’t directly comparable to the earlier 0.8 to 0.9 estimate, since it also reflects price stickiness, but once adjusted using a separate rigidity parameter from related work, it converts to an implied pass-through of about 0.99, closely matching the model’s retail sector estimate.

Pass-through strengthened in 2022, but stayed incomplete

The researchers also tested whether the relationship between prices and profits shifted during the 2022 inflation spike.

“If you look at 2022, which is the inflationary period, yes, it does look like the correlation between profits and prices was stronger – but it’s still below one, so it’s still consistent with incomplete pass-through,” explained Dr Hambur, who linked this shift to separate research showing price rigidity fell during the same period, which would independently push pass-through closer to one without any change in firm behaviour around margins.

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Taken together, the modelling, the industry-level pricing tests, and the retail profit data point in the same direction: Australian firms, on average, absorb part of their cost increases in response to cost shocks rather than fully passing them to customers, and do so more in competitive markets than in concentrated ones. This is inconsistent with firms raising prices by more than their costs rose post-COVID, thereby pushing up margins and inflation, Dr Hambur concluded.

This research represents the views of the authors and not necessarily the Reserve Bank of Australia.