On Inflation

Parties to a contract want to take inflation into account. A problem arises when the expected inflation does not match the actual inflation. If, for example, a contract was negotiated anticipating 2.5% inflation and it came in at 1.5%,  the workers end up benefiting at the expense of the company.

To illustrate the advantage the workers gain at the expense of the company, assume that there were no pay raises in the contract other than that for the expected rate of inflation. This would mean that a worker making $10000 the first year would make $10250 in the second year and then $10506.25 in the third year of the contract. His real wage would be the same based on the assumption, having the same buying power as in the first year.

If inflation instead comes in at 1.5% instead of 2.5%, the company should be paying $10000 in the first year, $10150 in the second year, and $10302.25 in the third year to maintain the same buying power as the worker had in the first year. However, the contract was negotiated at 2.5%, so the employees benefit at the expense of the employer. In the example, the price of labor is the same in the first year. There is, however, a difference of $100 in the second year and then $204 in the third year. These amounts compound as even a difference of 1% adds up over time to make a material difference in a firm’s bottom line. Perhaps the next time they negotiate, the firm may look more carefully about its inflation assumptions.