What is a strategic industry supply curve?
When there is perfect competition, industries supply what would be expected. But where one or more firms is big enough to have market power, for any given quantity sold, prices will be higher, and increasingly higher as demand for the product climbs.
This means that after a boost to demand, such as the one that followed the COVID stimulus and the end of lockdowns, firms with market power amplify the resulting inflationary shock.
The analysis works as follows. In setting prices, firms with market power balance the benefit of higher prices against the loss of sales due to reduced demand and increased supply from competing firms. When demand increases, the losses from markups are lower.
Market power cuts both ways
However, a different analysis applies in the face of cost shocks from energy and other commodities, of the kind we have seen this year.
When costs increase, firms with market power might choose not to pass on the full increase, so as to avoid losing sales and market share.
A large body of research suggests that increases in import costs are typically not passed on in full, at least initially. This has some interesting implications for fuel prices, to take one example.
Firms smooth shocks, even for petrol
A barrel of oil typically yields around 130 litres of liquid fuel along with some by-products, so the increase in world prices from US$80 to US$120 per barrel following the invasion of Ukraine added about 33 US cents (44 Australian cents) per litre to the cost of petrol. But in fact, the increase in pump prices in Australia was only about 30c per litre.
The Morrison government’s temporary halving of the petrol excise cut 22 cents per litre from the price, but much of it was recouped in the next upward swing in the fuel cycle, leaving a reduction of only 15 cents per litre by May, after which prices remained high.
In effect, refiners and retailers recouped part of the reduction in margins they absorbed in response to the initial shock.
The good news is the removal of the subsidy in September should see an increase of less than 22c per litre, as long as global oil prices don’t rebound.