Deflation – cheaper must be better

Although inflation is often considered to be an economic concept, it is of great importance to all firms and, consequently, to business management students. Inflation is part of the macro environment, referred to as PEST or STEEPLE in the guide, and sitting under economics as an external constraint.

Inflation is defined as “the rate of increase in prices for goods and services” – in other words the tendency for prices to rise in an economy. Inflation, therefore, reduces the value of money over time in terms of its purchasing power. Inflation is one of the most important issues impacting on businesses, customers, governments and economies in general. It affects what we pay for products and services, the returns we get on our savings, the level of our pensions and benefits and the money we pay in rents and mortgages.

Rates of inflation rates have fallen to historic lows in most parts of the world since the 2008 recession. There are a number of different measures of inflation in use, the most frequently quoted are the Consumer Prices and Producer Prices indices (CPI and PPI), which track how prices change over time – retail, wholesale and manufacturing. These may have other names in different countries. Inflation rates are expressed as percentages. If CPI is 2%, this means that on average, the price of consumer products and services is 2% higher than it was in the same period the previous year. As a result, consumers will have to spend 2% more this year to buy the same goods and services they bought 12 months previously.

The data from these inflation measures are used by governments when they set economic policy, such as interest rates and taxes. Government may also increase benefits and pensions in line with CPI. These ‘index-linked’ payments should, therefore, retain the same purchasing power year on year. Firms will include their assessment of future inflation in their business planning. Manufacturers will have to factor in any increases in raw materials into their budgets, pricing policies and strategies or they risk having their profit margins squeezed. However, it may not be possible to increase prices in line with inflation, if price sensitivity and competition is high, so they may have to look to cut costs to retain profit margins. Firms may also use the level of inflation to set annual pay rises, or face the possibility of industrial action by their workforces who realise that the purchasing power of wages is falling.

Calculating the prices indices

Consumer prices are tracked by surveying changes in prices of the goods and services regularly put in a ‘typical’ shopping basket. To produce an overall prices index, government departments record tens of thousands of prices of goods and services from a wide range of retailers, including online sales, which are growing in importance. The indices takes into account how important goods in the shopping basket are by given them a weight reflecting how much consumers regularly spend on them – this is often achieved by getting customers to keep diaries of their expenditure. The contents of the basket, and the weights attributed to each item need to be reviewed on an annual basis to ensure that the basket continues to be truly representative of what customers are buying. For example, tablet sales have overtaken those of PCs and this would have to be reflected in the ‘average’ basket’s content.

Some goods are bought by a large proportion of the population and represent a relatively large expenditure compared to other items. For example, a large rise or fall in the price of petrol and diesel would have a significant effect on the overall rate of inflation and these items will have a high weighting in price indices of most economies. Price increases of those items purchased less frequently, caviar perhaps, are given less importance and a lower weight.

What’s wrong with ‘deflation’?

Governments will set targets for the rate of inflation. In recent years, most developed economies set targets in the 2% to 3% range. The question could be asked, why governments do not target a stable or zero percent increase in inflation, and positively aim to prevent deflation – where average price increases are negative – in other words where prices fall over time.

It is difficult to understand why falling prices cannot be good – after all we will pay less for the items we buy and our standard of living will rise? Global oil prices have been falling over the last year which reduces costs for businesses and private individuals. These falls may indeed be welcome and beneficial, because motorists, both private and commercial, have little choice as to whether they buy fuel or not. Falls in prices will make both groups better off.

However, the same logic, may not apply to the prices of physical goods and in particular, consumer durables, like cars, furniture and electronic goods. In a period of sustained deflation, prices of durable items drop over a long period of time. In this case, firms and private buyers may rightly believe that the prices of expensive consumer durables, such as cars and trucks, will be cheaper in the future. As a consequence, both groups may postpone purchase, to save money later – they can always make their existing cars, sofas or tablets last a little longer. This reduces overall demand levels in an economy and will have negative consequences for all those involved in the production and distribution of goods and may lead to lower profits, falling wages and lower profits for reinvestment. This will feed into household budgets and make families worse off.

In addition, low levels of inflation tend to be associated with growing and vibrant economies, whereas, deflation is often a by-product of a stagnant or declining economy. Deflation is likely to lower business and consumer confidence and lead to cuts in investment and expenditure – further depressing economic activity. Japan, for example, has struggled for years to prevent deflation for these exact reasons – with limited success.

How can inflation be beneficial?

There are many positive effects of low rate of inflation.

• A little inflation encourages consumer to buy sooner before prices rise and this, in turn should increase economic growth, profits and employment.
• Rising prices make it easier for companies to put up wages. Low levels of inflation allow firms to more flexible in their wage structures. For example, if the rate of inflation was 3%, they may choose to reward groups they want to motivate and retain the most with a slightly higher increase than the inflation rate – say 4%, and award lower increases to the groups where they have no problem recruiting – say 2%. In this case, both groups have a pay increase as such, even if those awarded 2% are seeing their ‘real incomes’ (after inflation is taken into account) fall slightly. Psychologically, this does not feel like a ‘pay cut’. However, if inflation was zero per cent, firms would have pay for a higher than inflation wage increase for one group by actually cutting the wages of other groups, if they do not want to increase their overall wage bill. This would not be good for morale, recruitment or productivity.

Few extended essays or internal assessments refer to inflation or costs, which are significant omissions. As you set up your investigations for these assignments consider the macro environments in which your selected organisations operate and the effects of government policies on performance and operations. High on the list of important external variables is the rate of inflation as it underpins many other external factors.