Cost of Capital. The Past, Present and Future? | Part 6

Are We Looking at Wage Inflation?

In the first five installments of this series, we looked at the effects of US economic and monetary policy on the historical cost of corporate capital and how it may be affected in the future. We believe the implications are significant. In this sixth installment, we take a closer look at the signs of inflation – which can lead to much higher capital costs.

Cost of Capital

Headlines shouting “Striketober”.  Signs of inflation – which can lead to much higher capital costs – are all around.  Is there a common underlying message?  I think there may be.

Back to College Macroeconomics

For those who suffered through Econ 101 (Macro), you may remember utility/indifference curves.  For the labor force, these curves are expressed as a tradeoff between earnings from hours of work vs. more hours of leisure.  Essentially, this line represents the economic proposition offered by the providers of labor.

The demand for labor is represented by a different function.  Companies are willing to pay for more labor at lower wages than at higher wages.   The two curves are set forth below.


The point marked X in the chart is the where the curves are tangent and represent the market-balanced equilibrium among wages, free time and hours of labor.

Then came the pandemic.  People became accustomed to working remotely, working fewer hours, and receiving increased unemployment pay.  Many people may have exited the work force.  I think these dynamics have been transformative, and may have had the effect of shifting the labor indifference curve outward, as shown below.

Note that there is no place where the original demand function intersects the new labor indifference curve, creating instability.  If the new labor function is permanent, then the demand function must change as well.

There is no one single way the demand curve can move, as shown above with differently sloped lines.  But it is clear that the ultimate equilibrium point (i.e., X1, X2) will involve higher wages, fewer working hours (more free time), or both.

Real World Implications

Freshman-level economics tools may be overly simplistic, but they can also be extremely useful in separating the signal from the noise.  If indeed the labor utility curve has shifted outwards, then we are clearly looking at wage cost inflation as a big part of the challenges ahead.  This will not be “transitory”.  Instead, this could easily become a vicious wage-price upwards spiral.


Want to Discuss This Further?

This post and the accompanying exhibits were produced in-house by members of the Gordian team. Clients, potential clients and members of the media can book a call or meeting to learn more by contacting Leslie Glassman directly.

Commentary by Gordian Group CEO Henry Owsley