Demand, Supply and Markup Fluctuations

Does monopoly power (i.e. markups) increase or decrease in recessions? If market power increases in recessions, production becomes more inefficient aggravating the recession. However, if market power decreases, competition works as a self-correcting mechanism in the economy increasing overall efficiency. For this reason, understanding how markups fluctuate has been so central in the debate about macroeconomic policy effectiveness.
This debate is far from being solved. Its answer is empirical. However, there are two empirical challenges to determining the type of cyclical behavior of markups: (i) separating supply (productivity) shocks from demand shocks and (ii) properly measuring the markups.

This work uses a large panel of Portuguese manufacturing firms in the 2004-2010 period. The fact that the data contain yearly price information of individual products for each firm, allows the authors to separate supply shocks to demand shocks (i) and observe how markups react to both. The paper measures markups (ii) using the share of intermediate inputs on revenues, instead of the more traditional labor share.

The results suggest that markups are pro-cyclical with productivity (supply) shocks and generally counter-cyclical with demand shocks. This means that when faced with a positive increase in demand for their products, companies reduce their markups. On the other hand, during recessions caused by negative shocks to demand, companies increase their markups, leading to an increase in inefficiency and further aggravating the recession. This suggest that demand enhancing stimulus can be effective ways to combat recessions, but only when recessions are originated on the demand side of the economy.

Click here to go to the paper by Carlos Daniel Santos, Luis F. Costa and Paulo B. Brito

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