On Price Inflation

by John R. Carlsen

Abstract: The rate of price inflation within the United States is generally calculated based upon the Consumer Price Index (C.P.I.) published by the Department of Labor's Bureau of Labor Statistics. Casual observations reveal that the Consumer Price Index obviously understates actual rates of price inflation, and that the C.P.I. understates the local rate of inflation in Silicon Valley by a factor of approximately three. Counterintuitively, information technology (I.T.) purchases are often most efficient when delayed.

When I was still young and living in my parents home, my father once came to the breakfast table with the morning newspaper in hand, complaining of how the price of newspapers had gone up over the years.

To this I quipped, "You should have stocked up while they were cheap!"

I joked then, but the experience helped to stimulate my interest in economics.

Why Study Inflation?

Most of us accept the trend—often without complaining—that prices rise, without thought to how, why, or even by how much they do.

Unfortunately, this attitude often works to our detriment, as even savings or investments that yield financial gains may actually loose value (yielding economic loss) if they do not keep pace with the rate of price inflation. For example, $100 invested at an annual interest rate of 2% would yield a $2 financial gain, but if the annual rate of price inflation that year is 5%, the investment yields an economic loss of 3%, or $3.

Similarly, if our wages do not increase at a rate commensurate with our local rate of inflation, we experience what is called wage regression: we continue to perform the same amount of work while being able to buy less with what we are paid.

Simply put, price inflation reflects our money's loss of value over time.

Causes of Inflation

The reasons for price inflation (often popularly referred to as just "inflation") have long been debated. I believe that price inflation can – and ultimately will – be explained in terms of supply of and demand for resources (natural or processed into goods) and the costs associated with converting some of those resources into others. Factors contributing to price inflation may include:

• Population growth: increasing demand for natural resources (and possibly money, a synthetic resource)
• The time value of money: the degree to which people are willing to finance purchases to have them immediately (demand for certain resources)
• Adaptive expectations, including the price/wage spiral, through which workers attempt to counteract anticipated inflation by demanding periodic pay increases and employers pass these cost increases directly to their customers (perhaps without regard to any obtained increases in conversion efficiency)

For further discussion of causes of price inflation, see price inflation on Wikipedia.

Rate of Inflation

Whatever the causes, the effects of price inflation are reasonably easy to measure. With hardly any effort, I can recall observing prices of certain goods increase roughly ten-fold over roughly the last 30 years.

Examples

For example, the price of gasoline, though artificially depressed through the 1980s and 1990s, also fits this model; I see the steep increase since late 2001 as a price correction consistent with increases in prices from milk to real estate.

The cost of using public telephones (most still coin-operated) has also kept pace with by observation, rising from a dime to a dollar, despite technological progress that tends to drive prices down rapidly. (See below.)

A Counter Example: Postage

Interestingly enough, during the same 30-year span, the cost of first-class postage through the United States Postal Service has increased, as summarized in the table below, at only a fraction of the rate at which other prices increase. I believe that this has economically starved the Postal Service to the point that it now risks becoming ineffective.

Calculation

The price increase due to inflation may be described generally using the mathematical formula (P₀ + I)ⁿ = P_n, in which n represents the number of periods (years in this case), I represents the rate of inflation for each period, P₀ represents an initial price, and P_n represents a the price after n number of periods.

To solve for the periodic (annual) rate of inflation, I, let:

• initial price, P₀ = 1
• number of periods (years), n = 30
• observed increase in prices, X = 10
• future price (after n periods), P_n = X * P₀

So:

1. (P₀ + I)ⁿ = X * P₀
2. (1 + I)³⁰ = 10 * 1 = 10
3. 1 + I = 10^(1/30)
4. I = 10^(1/30) - 1 = ~0.0797

Simplified, this means that the sustained local rate of price inflation for the past 30 years has been roughly 8% per year.

Inflation and Technology

Being from Silicon Valley and at heart a technologist, I have also observed that prices of new consumer electronic products—the sorts of things I've often designed, such as music and movie players, personal computers, and the like—drop at twice the rate of inflation. For example, with annual price inflation at 8%, a new gadget on store shelves this year will be priced about 16% lower only a year later. Noting the difference between the monetary term price and the economic term cost, we could describe the thing as becoming 24% less costly (or that much less expensive) in only one year. To put that into perspective, one would need to work 24% less to afford the same purchase one year later.

The rapid decline in prices of most electronic products and services can be explained in terms of increased competition brought about by rapid advances in process technology and industrial efficiency. (A notable exception is telephone service, which seems to benefit from price protection through local municipal monopolies.) For example, the introduction of low-cost microprocessors enabled many to integrate them into products such as video game consoles and personal computers; those seeking large gains from being early to market invited competition from those able to produce more efficiently.

To this end, the worst waste of money through bad investment is to purchase of electronic products sooner than absolutely needed. So, individuals and organizations should strive to establish and maintain disciplined, rational purchasing procedures especially for electronic products.

Consulting and advising in this area is one of the ways I deliver high value.

Related Reading

For further reading about the study of economics, see R.A. Radford's classic essay The Economic Organisation of a Prisoner of War Camp.

For further discussion of causes of price inflation, see price inflation on Wikipedia.