Inflation inequality in the United States is due to imbalanced product innovation

A recent study finds an intriguing link between different levels of inflation for products that are purchased by the wealthy, compared to items bought by everyone else in the United States. Even more intriguing, the reason appears to be that price competition for the dollars spent by the wealthy results in more product innovation for those goods, leading to less inflationary pressure on those products compared to products bought by everyone else—goods that do not benefit from more competitive product innovation.

The new paper, published in the Quarterly Journal of Economics by Equitable Growth grantee Xavier Jaravel, an assistant professor at the London School of Economics, finds that increases in the size of markets cause increases in product variety and thus those markets experience lower inflation rates. Because there is more product innovation among high-end goods, price changes favor high-income households, thus increasing income inequality.

Using data collected by cash register scanners at U.S. retailers between 2004 and 2015, Jaravel estimates that annual inflation for goods was 0.66 percentage points higher for low-income households than high-income households. After taking into account changes in product variety over time, this difference rises to 0.88 percentage points. Product categories disproportionately consumed by high-income households—such as organic produce, branded drugs, and craft beverages—experienced higher levels of innovation and lower levels of inflation when compared to product categories consumed by low-income households, such as generic drugs and nonorganic produce.

Jaravel’s findings show that increases in income inequality increase the size of the markets that serve high-income households. As a result, firms release new and innovative products aimed at high-income household consumption. With newer and older versions of products out in the same market, the price of older versions goes down in order to stay competitive, thus creating a cycle of positive and affordable innovation for the wealthy. The reduction in the relative size of the market serving low-income households weakens this cycle when it comes to serving their purchasing interests.

Jaravel highlights two potential implications for public policy. The first is that accurate measurement of changes in living standards requires inflation measures that vary across the income distribution. The second is that any cost-benefit analysis of proposed safety net policies must recognize the potential consequences of changes in market size.

Innovation is critical to long-run economic growth, but it is important that the benefits of innovation extend to all income groups. Jaravel’s research demonstrates that innovation is often responsive to other economic trends and—in a period of rising inequality—innovators may direct their efforts to serving high-income households at the expense of low-income households.