Thread by @jasonfurman

Even if all firms are perfectly competitive an increase in demand will result in an increase in profits in the "short run"--the short run being a potentially long period until new entrants can compete the profits away.

A 🧵 with an refresher/explainer on the Ec10 of this.

The left-hand curves are the normal supply & demand, they show the market as a whole. The supply curve is the sum of the products supplied by many, many firms. Demand increases for some reason (a taste shift, strong economy, stimulus checks, whatever). The result is P and Q up.

The right-hand curves are from the perspective of a single firm. It is just a small firm in a big competitive market with no pricing power so it "sees" a horizontal demand curve. It can sell it wants at that price but nothing if it raises the price a penny above it.

Initially the market price is equal to the firm's average cost. This isn't a coincidence, firms will enter & exit until "economic" profits are competed away and "economic losses" are avoided so you end up there. (Economic profits are like the extra on top of the normal profits.)

When demand increases the price rises. Now the price is above the avg cost so the firm makes economic profits on each unit it sells. The total economic profits are the shaded red area.

Eventually the demand shock will fade or new firms will enter and the profits will go away.

Note that all of this happened for a firm that had no pricing power at all. It couldn't raise prices by a penny, it was only that the market price rose.

Note also that if prices didn't go up there would have been a shortage, with demand exceeding supply.

How is this model relevant? Like all models it is wrong. But it shows:

--Can have much higher profits with no pricing power.

--This is useful, without it we would have shortages. And it leads to more entry and profits being competed away.

I suspect this captures a lot.

More more realistic for many industries would include firms that can set their own prices (i.e., imperfect competition). In those models you find that the level of prices is higher but the increase in demand doesn't necessarily raise prices any more than in perfect competition.

The intuition is that a monopolist that raises prices can't sell as much. When demand goes up it will take advantage of that by charging more but also by selling more. The relative amounts that these happen compared to the perfect competition case are sensitive to assumptions.

Another realistic feature would be to compare the pricing power of businesses (which goes up when demand is strong) and workers (which also goes up). Which goes up more? Do prices rise more because businesses are more powerful or do wages rise more because worker power rises?

Finally, yet another realistic feature would take into account the frequency and timing of price and wage changes. Most prices adjust more quickly than wages (gasoline prices can change every day but people working at gas stations may only get an annual raise).

In the short run this can lead prices that rise more than wages. But firms are generally not going to lower their nominal wages so they'll have the higher nominal bill going forward and maybe prices will come back down. So the dynamics of profits may be different.

None of this is to settle the debate, just to say that the observation that profits are up doesn't settle anything either. My view is that if prices hadn't risen this much (given everything else) the situation would be even worse w/ widespread shortages & no supply increases. FIN