Sellers' inflation, price dispersion and substitutability: Schumpeter meets Lerner

The relationship between firm markups and inflation remains a topic of contention. Empirical findings suggest that many firms were able to maintain or increase their markups and profits amidst the recent wide-ranging cost shocks. This phenomenon, often referred to as sellers' inflation, raises two questions: i) why do firms change their price-setting strategies from previously competing for market shares via lower prices to raising prices in proportion or even excess of a price shock, and ii) why can they do so without impeding their market share and profitability? We argue that current supply-side explanations exhibit several theoretical and empirical shortcomings and instead propose a demand-based alternative based on the textbook argument of distorted price signals. We argue that higher price dispersion during periods of price shocks reflect informational costs for consumers and reduce consumers' price elasticity of demand by deranging the system of relative prices they oversee. Based on an agent-based model, we demonstrate that the combination of boundedly rational consumers and informational costs due to price dispersion enables firms to increase their markups and profits in response to wide-ranging cost-push shocks. As consumers increasingly struggle to monitor price changes, they become less able to adequately punish (or reward) firms for raising (or maintaining) prices. This straightforward mechanism offers a promising explanation for the emergence of sellers' inflation.