Consequences of Inflation

Consequences of Inflation

Seen on a large scale high inflation and volatile economists have a range of economic and social costs - hence the importance of continuing attached to the control of inflationary pressures in the economy by the government alike, as well as the central bank (in thecase of the UK, and the Bank of England) . This chapter considerssome of the effects of inflation on the economy.

Why does inflation matter?

The impact of inflation on individuals and businesses depends in part on whether inflation is anticipated or unanticipated:

v Anticipated inflation: 

When people are able to make accurate predictions aboutinflation, they can take the necessary steps to protect themselves from its effects. For example, unions may exercise their collective bargaining power to negotiate with employers to increase wages inmoney and to protect the real wages of union members. Thefamilies also be able to switch savings accounts and depositsprovide the highest nominal rate of interest or other financial assetssuch as stocks or housing in which capital gains over a period of time may exceed general price inflation. In this way, people canhelp to protect the real value of financial wealth. Companies canset prices and lenders can adjust interest rates. Companies mayalso seek to hedge against price fluctuations in the future by thedealers in the "market forward." For example, most major airlinesto buy aviation fuel several months early in the forward market, duein part to protect from fluctuations in world oil prices.

Unanticipated inflation:

When inflation is volatile from year to year, it becomes difficult for individuals and businesses to correctly predict the rate of inflation in the near future. Unanticipated inflation occurs when economic agents (i.e. people, businesses and governments) make errors in their inflation forecasts. Actual inflation may end up well below, or significantly above expectations causing losses in real incomes and a redistribution of income and wealth from one group in society to another.

Money Illusion

It is a fact of life that people often confuse nominal and real values in their everyday lives because they are misled by the effects of inflation. For example, a worker might experience a 6 per cent rise in his money wages – giving the impression that he or she is better off in real terms. However if inflation is also rising at 6 per cent, in real terms there has been no growth in income. Money illusion is most likely to occur when inflation is unanticipated, so that people’s expectations of inflation turn out to be some distance from the correct level. When inflation is fully anticipated there is much less risk of money illusion affecting both individual employees and businesses

The Main Costs of Inflation

What are the main costs of inflation? Why is the control of inflation given such a high priority in macroeconomic policy-making? Supporters of tough inflation control would support the arguments made in this quote in a speech delivered in 2002 from Mervyn King.

The case for maintaining price stability

‘It is clear that very high inflation – in extreme cases hyperinflation – can lead to a breakdown of the economy. There is now a considerable body of evidence that inflation and output growth are negatively correlated in high-inflation countries. For inflation rates in single figures, the impact of inflation on growth is less clear.’ 

Impact of Inflation on Savers:

Inflation leads to a rise in the general price level so that money loses its value. When inflation is high, people may lose confidence in money as the real value of savings is severely reduced. Savers will lose out if nominal interest rates are lower than inflation – leading to negative real interest rates. For example a saver might receive a 3% nominal rate of interest on his/her deposit account, but if the annual rate of inflation is 5%, then the real rate of interest on savings is -2%.

Inflation Expectations and Wage Demands

Inflation can get out of control because price increases lead to higher wage demands as people try to maintain their real living standards.  Businesses then increase prices to maintain profits and higher prices then put further pressure on wages. This process is known as a ‘wage-price spiral’. Rising inflation leads to a build-up of inflation expectations that can worsen the trade-off between unemployment and inflation.

Arbitrary Re-Distributions of Income

Inflation tends to hurt those employees in jobs with poor bargaining positions in the labour market - for example people in low paid jobs with little or no trade union protection may see the real value of their pay fall. Inflation can also favour borrowers at the expense of savers as inflation erodes the real value of existing debts. And, the rate of interest on loans may not cover the rate of inflation. When the real rate of interest is negative, savers lose out at the expense of borrowers.

Competitiveness and Unemployment

Inflation is a possible cause of higher unemployment in the medium term if one country experiences a much higher rate of inflation than another, leading to a loss of international competitiveness and a subsequent worsening of their trade performance. If inflation in the UK is persistently above our major trading partners, British exporters may struggle to maintain their share in overseas markets and import penetration into the UK domestic market will grow. Both trends could lead to a worsening balance of payments. The UK government believes that monetary stability (i.e. low inflation) is a precondition for sustained economic expansion.  As the chart below demonstrates, the UK has made progress in reducing the volatility of its inflation rate in the last decade. The era of high and volatile inflation may have come to an end.

Contestable Markets

Contestable Markets

What is a contestable market?

William Baumol definition of existing markets as the challenge "Thenewcomer has access to all production techniques available to the occupants, does not prevent the affection of the current customers,and entry decisions can be reversed without cost."

To challenge the market to exist there must be few barriers to entryand exit, so that there is always the possibility for new suppliers to come to the market to provide new competition for existingsuppliers. To challenge the market completely, and must enter and exit the market is not expensive

The reality is that there is no appeal against the market completely (there is always some "barriers to competition" - see your notes on the revision of the barriers to entry). He said it is also true that the market is, in fact each appeal to a certain extent even when the situation seems to be the preserve of the dominant seller iscontroversial. This could have important implications forcompetitive behavior (behavior) of existing companies, and is affecting the performance of the market and then from the standpoint of economic efficiency (for example, resource allocation, productivity, efficiency and vitality)

Contestable markets and perfect competition - the differences

Contestable markets differ from the ideal competitive markets. Forexample, it is possible to challenge the market for one company to dominate the industry, setting prices, as well as for energycompanies in the market for the production of differentiatedproducts, both of which conflict with the assumptions behind thetraditional model of perfect competition.

There are three key conditions for the pure competitive market:

1. Perfect information and the ability and/or the right of all suppliers to make use of the best available production technology in the market
2. The freedom to market / advertise and enter a market with a competing product
3. The absence of sunk costs – this reduces the risks of coming into a market

Sunk costs – a barrier to contestability

Barriers that prevent the existence of competition in the marketwhen there are sunk costs. These are costs that were committed by the business can not be recovered once the company entered the industry. It may be easier to think of fixed costs and costs that can not be avoided once they had been committed at a certain momentof time - a classic example of money being committed totelecommunications companies to win 3-generation mobile phonelicenses at auction in 2000. When sunk costs are high, and the market is more likely to produce prices and output that is similar to a monopoly (with the risk of failure incompetence / market in the allocation of resources following the day of this).

The Increasing Contestability of Markets

One feature of the British and European economy in recent years has been an increase in the number of markets and industries that are genuinely contestable. Several factors explain this development:

Entrepreneurial Zeal

Often be the case that markets become more competitive due to the continuing of the businessmen who simply do not accept that the structure of the current market is a given. Decisions to enter marketswhere there are already dominant companies with experience in the industry involves a significant risk - it is a new resource may be an advantage to create a product or business model more competitiveon the basis of different pricing strategies.

Blueback Taxis

It was just a taxi cab in the London market was shaken by the arrival of a new competitor, described the debt. Blueback aims to become the "Starbucks" in the market for taxis. What is using the strategy to enter the market?
Taxi market in London is very fragmented - that is provided by many small businesses and modified the name to a large extent.Blueback goal is to quickly grow market share through the launch of the service described clearly that will encourage taxi drivers to switch to the company.
Blueback has taken the paper from the Book of low-cost strategy airline easyJet with the way that developed its new service.Blueback one, and pricing policy in advance and works only one type of car, and Fiat Multipla. Each car carries the same distinctive blue and silver livery. Drivers to wear the same uniform, and provide customers with newspapers and mobile phone chargers as part of the service on board the plane. Blueback all drivers pass a driver training program and licensed by the PCO. Has been developed Blueback service marketing research asked people what they wanted to hire a taxi. This covers areas such as pricing and demand, and service experience. Long-term goal of the company is to have a fleet of 1000 vehicles in the next few years, and that the wages of workers in leading the market in London
De-regulate markets - also known as market liberalization, deregulation involves the opening up of markets to competition by reducing some of the legal impediments to the entry list. Good examples for the Liberation of recently include major facilities such as gas and electricity, as well as the liberalization of telecommunications and postal services as part of the initiatives of the
In the field of postal services, and must be on all the countries of the European Union opens the home and business mail delivery services so that there is a resource and at least one competing for the national postal service provider conditions. Is scheduled to be completed by the Liberation in 2007. Royal Mail is already negotiating agreements with other companies to provide the postal service their mail sorted by "last mile" to consumers. Opened the market of postal services in the United Kingdom up to full competition in January 2006. United Kingdom

In the field of communications, the emergence of the carrier pre-selection means that there is now increased competition for fixed line services. British Telecom (BT Group) now face the competitive pressures much greater than just talk, talk - 2, Talk, Talk (Carphone warehouse) and others.

Saw the retail clothing market in the United Kingdom is also not the least of rapid change with the arrival of a group of Western European retailers such as Primark, who took market share from established companies together with quick access from supermarkets in the discount clothing.

Competition Policy

More stringent laws designed competition that work againstpredatory behavior by the existing companies to make markets more challenging. In both the UK and the European Union andincluded tougher rules against price-fixing cartels. When competitionin the market is weak, and there is almost always more room for thecartel-type behavior by existing companies, especially if the market structure in which they operate closer to oligopoly.

The European Single Market

The development of the European market opened one up to the markets for the Member States. A good example of this is home and auto insurance, as well as the entry Outfitters the EuropeanBank in the UK high streets and shopping centers. The exemptionshould be abolished brick car trade within the EU also helps to make the market more challenging automotive retail in the United Kingdom in particular, and can help to reduce further the prices ofnew cars.

Technological Change (including the e-mergence of e-commerce

The impact of new technology is having a major impact, not least because it has dropped some of the costs to engage in some markets (leading to an increase in the movement of capital). The rapid expansion of e-commerce, for example, may lead to the emergence of new players in the travel industry and selling books online, insurance, and many other markets.

Technological extension can lead to the development of competingproducts by copying or imitating the properties of products fromexisting companies. A few years ago after the launch of Viagra, and now is an anti-impotence, Levitra, the first market rival toViagra very profitable, being manufactured by a German company, Bayer AG, and marketed by Glaxo Smith Klein, a British company.

Contestable market case study – the market for broadband in the UK

2005 was the year when the demand in the market at the end of broadband took off! After lagging behind most other Western European countries in our use of broadband, and the United Kingdom has seen a huge boom in take-up of broadband technology. Industry, telecommunications is one excellent study, not least because of the important role played by the regulatory body and industry, and OFCOM in the open market to new competition, and act as a catalyst for the successful entry of new companies in the broadband market.
OFCOM believes that the market for retail broadband market is now competitive enough so that it can operate without price regulation. In the past, been used in the industry, regulators recently privatized industries, where it stayed its monopoly power to impose price regulations in the utilities. But also strengthened competitive forces, and thus the role of the regulator has moved away from direct price controls, towards the wider role of monitoring the size and quality of competition within the market.
As part of the current legal arrangements in the telecommunications sector in the UK, there is a need to provide access to BT wholesale products regulate broadband so that other service providers from the sale of a wide range of homes and business customers. OFCOM has intervened to limit the access of these charges, which can make the BT to those of other suppliers, and this also was important in reducing barriers to entry in the market, making the industry more appeal. For example, slightly more than last year, Ofcom announced proposals to set the maximum price of 81,85 £ BT can charge competitors to lease the local loop completely disassembled. The roof is designed to promote competition in the broadband market by ensuring that BT charge is fair, reasonable and cost-oriented.

Contestable Markets and the Performance and Conduct of Businesses

How might the contestability of a market affect the conduct and performance of businesses? It is worth emphasising in essays and data questions that it is the actual behaviour of agents in the market that is more important that a simple picture of market share.

Perhaps in the graph above pure monopoly price of P1 and reach a balance of maximizing profits. If the market is challenged, there is downward pressure on prices, because there is profit supernormal provides a signal for new companies to enter the market, and if the monopolist in producing the price is too high, or allowed a total cost to the deviation average higher, and could detract from the entrants monopolists and would be There are some of the profit monopoly competition away. The natural balance occurs when the profit is equal to the average income of the average total cost (in Q2 production and price P2).

From the viewpoint of economic well-being, lower prices and increased production means an improvement in consumer welfare (which can be demonstrated by an increase in consumer surplus).

When the markets are really challenged - and we expect to see lower profit margins (ie, less "mark-ups") than when operating without the monopoly of the competition. But the threat of competition may be strong only as one of the factors affecting the behavior of firms in the market of physical access to new projects.If the company's dominant market knows that the challenging new suppliers may come in - this may be enough for them to charge a price closer to the level that can be expected from the competitive market structure.


If the market is a challenging industry structure, and behavior is determined strictly by the threat of competition - 'hit and run' entry.The market is similar to full competition, regardless of the number of companies, because the incumbents behave as if there was fierce competition.

Key revision points for contestable markets:

v  Be familiar with the barriers to entry and exit that might exist in any given industry

v  Understand how the threat of competition can affect current price and output decisions of firms within a contestable market

v  Understand that market share is not a reliable guide to market contestability. We need much more detail on aspects such as price elasticity of demand, the costs of suppliers etc

v  Be aware that the UK and Competition Authorities are increasingly turning their attention to the determinants of market contestability rather than a narrow focus on market share and the profitability of businesses. The emphasis of government competition policy is mainly towards opening-up markets and encouraging the entry of new suppliers (both domestic and international)