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I’ve put out a few posts in the past on the effect of higher markups on the growth in measured productivity. But in those cases I’ve generally avoided the question of whether higher markups have an effect on the level of measured productivity.

Evidence on higher profit shares and markups

Testing

The effect of markups on productivity levels

To say something about the effect that markups could be having on productivity, we need some conception of why firms are able to charge a markup over marginal cost, and also some conception of what drives those markups. For the why, we assume that firms have some market power based on …. something about them. Maybe they have a patent on a product, meaning they are the monopoly provider. Or maybe they have created some kind of brand, or reputation for quality (deserved or not), that makes people want to only buy that product. Think Apple. Or maybe they have some kind of locational advantage, like being a coffee shop in a busy train station. Whatever the reason, these firms have enough market power to charge a markup.

What determines the level of that markup, and why would it change? In general, the elasticity of demand for their product with respect to price is what matters here. The higher the elasticity (the “flatter” the demand curve), the less market power a firm has, and the smaller a markup they can charge. The lower the elasticity (the “steeper” the demand curve), the more market power a firm has, and the bigger a markup they can charge.

A high elasticity would be the case if there were lots of close substitutes for the product, so people were willing to abandon a firm’s specific product if the price went up just a little. Think of gas stations, which have a tiny bit of market power due to location. But lots of people would stop going to a gas station that raised its price by 1 or 2 cents per gallon. A low elasticity would be the case if there were few substitutes for the product, or the product was a strong complement to other things people buy. Then, no matter what the firm charges, people will buy some. Think of an iPhone. Apple has convinced people - whether you believe it or not - that there is no substitute for an iPhone; other smartphones just aren’t the same. So they can charge 600 bucks for one, while the marginal cost is something closer to 100.

When the evidence says that markups have gone up, then one interpretation is that the elasticity of demand for different goods has gone down. I think of this as meaning that people have gotten very picky. I want an iPhone, not a Samsung. I want a double chai skim latte, not a coffee. I want a Lululemon pair of yoga pants, not the ones from Target. Just imagine that everyone has become a 13-year-old girl.

Now, if markups are higher because the elasticity of demand for individual goods is lower, what does this imply for measured productivity? Well, in most typical settings, this would lower measured productivity. Why?

Let’s start with a very standard way of thinking about how to model this, with a constant elasticity of substitution across firms.

The crux of the paper is that if both labor’s share and capital’s share are falling, then by necessity profit’s share is rising.

Analytically, we like to talk about profits as a function of markups - the ratio of price to marginal cost charged by firms. If the profit share is rising, then it must be that markups are rising.

I’ve talked before about the impact of markups, but the Barkai paper lays out clearly the effect.

Why is output lower with higher markups? Within the setup that Barkai uses, it is because the lower shares going to labor and capital lower the wage and rate of return, respectively. With the benefit of working or investing lower due to higher markups, labor supply and savings are lower. Output is lower because we provide fewer inputs to the economy.

As an alternative, imagine that both capital and labor were inelastically supplied. Then, regardless of the labor or capital share, we’d have the same amount of inputs, and hence the same amount of output. The only difference would be the distribution of output.

In this case, wages stagnate for two reasons. First, labor’s share of output is lower, so they are taking a smaller slice of the pie. Second, the pie is smaller as well.

Other mechanisms

The mechanism here is that higher markups lower factor supplies. And that fits within the model Barkai uses, which uses a bunch of standard assumptions. There is monopolistic competition between firms, with a fixed elasticity of substitution between them.

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