Markups and the Business Cycle

As output and employment rise in business cycle booms, the marginal product of labor falls while real wages generally do not. So marginal cost, which equals the wage divided by the marginal product of labor, rises more than do prices. In this paper we examine this business cycle variation in the markup of price over marginal cost. We consider three leading theories of markup determination. The first is that firms are monopolistic competitors and that the elasticities of their demand curves vary over the business cycle. The second is the customer market model of Phelps and Winter (1970) where firms' markups also depend on the desirability of raising current market share in order to increase future sales. The third has markups depend on individual firms' incentives to deviate from an implicit collusive understanding, as in Rotemberg and Saloner (1986). We show that these three theories can be nested in a single specification that makes markups a function of current sales and of the expected present discounted value of future profits. However, the three theories make different predictions about the signs of the parameters relating the markup to its determinants. We thus estimate equations of this sort empirically to gauge the validity of the three models. This estimation is carried out both with aggregate data and with two-digit industry data. The two-digit data also allow us to see how the relationship between the markup and its determinants varies with the concentration of the industry. Finally, we also discuss in detail the causes of markup variation in two highly concentrated industries.

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