Counterintuitive Is Cool: The Case of Markups

19 November 2010 at 4:23 pm 4 comments

| Lasse Lien |

Counterintuitive empirical findings are endlessly more fascinating than expected or obvious ones. One counterintuitive finding I have picked up since the onset of the financial crisis is that markups are on average counter-cyclical. To spell it out: markups go up in a recessions and they fall in a boom (on average). Maybe it’s just me, but if asked about this two years ago I would have bet that markups were bid down during recessions in all but extreme market structures.

Here is a cool new paper that deals with this and several other interesting aspects of the dynamics of business cycles:

We characterise endogenous market structures under Bertrand and Cournot competition in a DSGE model. Short-run mark ups vary countercyclically because of the impact of entry on competition. Long-run mark ups are decreasing in the discount factor and in productivity, and increasing in the exit rate and in the entry costs. Dynamic inefficiency can emerge due to excessive entry under Cournot competition. Positive temporary shocks attract entry, which strengthens competition so as to reduce the mark ups temporarily and increase real wages: this competition effect creates an intertemporal substitution effect which boosts consumption and employment. Endogenous market structures improve the ability of a flexible prices model in matching impulse response functions and second moments for US data.

Etro, F. and Colciago, A., “Endogenous Market Structures and the Business Cycle,” Economic Journal 120 (2010): 1201–33.

Entry filed under: - Lien -, Bailout / Financial Crisis, Papers, Strategic Management.

Mirowski on Backhouse and Fontaine, eds., The History of the Social Sciences since 1945 Seven Deadly Sins of Contemporary Quantitative Political Analysis

4 Comments Add your own

  • 1. Rafe  |  19 November 2010 at 7:06 pm

    That is the point of TESTING your ideas rather than looking for confirming evidence.

    You create new problems which are the growing points of science, like new ecological niches that are colonised by new ideas.

  • 2. SkepticProf  |  21 November 2010 at 1:36 pm

    This paper seems to be basically the same story as price wars during booms — except that it’s caused by new entrants (rather than incumbents’ punishing would-be cheaters).

    What’s most interesting to me is that Lasse’s intuition was that markups would be cyclical. I think requires a restriction on entry and exit. For example, think about the demand curve. There’s no reason to believe that the high-value consumers disproportionately vanish during recessions; if the quantity demanded shrinks proportionately across the board, elasticity and thus the optimal (P-MC)/P markup should stay the same. Recurring fixed costs may not be recovered at lower quantities and thus firms will exit to equilibrate; for the remaining firms, however, markups will be higher. For markups to be cyclical during busts, this exit mechanism needs to be suppressed. (Similarly, during booms, new entrants find that they can break even even with a small market share, so they come in, which is basically the point that this paper makes.)

  • 3. lasse  |  21 November 2010 at 10:01 pm

    Nice post SkepticProf. You are certainly right that my intuition would include restrictions on entry and exit. My naive intuition would have been that high capacity utilization combined with positive entry barriers would allow markups to rise in a boom, while positive exit barriers combined with low capacity utilization would mean that they are bid down in a recession. Anyway, I now know that this is not true (on average).

    Rafe; well put!

  • 4. srp  |  28 November 2010 at 12:08 am

    Also Saloner and Rotenberg showed that in a repeated oligopoly pricing game the maximum sustainable markup is higher during a recession (another example of the “tipsy-turvy” principle).

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