Appropriate Pass-through of Wage Cost Increases to Selling Prices

Distinguished Senior Fellow (specially appointed), RIETI

One matter that is attracting attention regarding this year's spring labor-management wage negotiations in Japan is whether wage hikes will exceed the rise in the consumer price index (CPI) to achieve a real wage increase. The government and the Bank of Japan have described wage hikes as the key to a virtuous cycle of wages and prices, emphasizing the need to appropriately pass wage cost increases through to selling prices. A wage-price spiral, despite having been a matter of concern during the period of high inflation in the 1970s, is now a highly anticipated condition.

Recently, we asked Japanese companies, including small and medium enterprises (SMEs), about their future wage policies. Of more than one thousand several hundred companies that responded, 92% plan to raise wages. The largest share of respondents plans to match wage and CPI hikes to keep real wages unchanged. Only 5% of the respondents plan to achieve faster increases in wages than the increase in CPI. It is uncertain whether productivity growth would be reflected in real wages.

On the other hand, three-quarters of respondents say that they have passed labor and other cost increases through to their product/service prices. In general, passing 100% of cost increases through product/service prices is not the best course of action for companies because the negative effects of the action (decrease in sales quantity) would outweigh the positive effects (increase in revenue from higher selling prices). I suspect that companies have made considerable progress in passing cost hikes through to selling prices.

We sometimes hear an argument that large companies with monopolistic power can pass cost hikes through to selling prices, while SMEs under fierce competition cannot. However, this is not correct. The standard theory predicts that companies with price-controlling power are less likely to pass cost increases through to selling prices.

This is clearly explained in the leading textbook on microeconomics, "Mikuro Keizaigaku No Chikara (The Power of Microeconomics)" by Michihiro Kandori. Companies with monopolistic power usually sell products/services at higher prices, making them less sensitive to cost changes, and so their pricing is actually more rigid. Empirical studies overseas have also shown that the cost pass-through rate is lower in markets where sellers are monopolistic. According to my survey, there is no relationship between the size of companies and their potential to pass cost increases through to selling prices.

The Japan Fair Trade Commission has implemented measures for appropriate price pass-through targeting B-to-B transactions between SMEs as sellers and larger enterprises as buyers. These are justified as policy measures because when large enterprises have monopsony power, the price pass-through can be limited, unlike in sales to consumers.

However, there may be other possible measures within the government’s reach. The practices and mindset that are based on the assumption that wages and prices are difficult to increase, which have taken root during prolonged deflationary period, apply not only to the private sector but also the public sector. Due to budget constraints and precedent-setting, for instance, it is difficult to raise estimated unit costs or nominal contract values, meaning that price adjustment costs themselves are prohibitive. As a result, many companies may find it difficult to pass cost increases through to public-sector organizations.

If there were an indexation mechanism which automatically reflected cost fluctuations in product/service prices, it would be easier to pass cost increases through to selling prices. The mechanism used for inflation sliding for public works is similar mechanism to indexation. Although it would be difficult to widely adopt indexation, it is necessary to change systems and practices through such measures as speeding up price revisions on the premise that both inflation and divergence between nominal and real prices will become the norm.

>> Original text in Japanese
* Translated by RIETI.

February 22, 2023 - Published in Nihon Keizai Shimbun's "Economist 360° Perspective"

April 8, 2024

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