Explaining Price Markups During the Great Recession

The U.S. economy experienced severe economic slack during the 2007-09 Great Recession, but inflation didn’t fall as much as some might have expected. “One potential explanation for the missing disinflation is the upward pressure in pricing through an increase in the desired markup,” wrote Economist Sungki Hong in an August 2018 Economic Synopses essay.

In a previous essay, published in June 2018, Hong found that price markups (or the margin of price over the marginal cost of production) tend to rise during economic busts. Furthermore, small firms’ markups tend to rise relatively more than large firms’ markups do during these periods. Small firms were defined as those with less than 1 percent market share within their industries, whereas large firms are those with more than 1 percent market share. For that analysis, Hong used firm-level data in manufacturing sectors of France from the Bureau van Dijk Amadeus dataset.

In the more recent essay, he examined which of the two main economic models widely used in the literature is consistent with the markup dynamics during the Great Recession. The two models are:

1. An oligopolistic competition model
2. A customer capital model

Oligopolistic Competition Model

In this model, Hong noted, firms have different productivity levels (or firm-product appeal), and they compete for market share.

“In equilibrium, the firm with the highest productivity gets the largest market share and charges the highest markup, while the firm with the lowest productivity gets the smallest market share and charges the lowest markup,” he explained.

He also noted that this model implies more volatile markup movements for large firms. This is because a large firm would be slower to change its price after a shock to its marginal cost.

Customer Capital Model

In discussing the customer capital model, Hong noted that customer capital determines the level of demand of firms’ outputs.

“To enlarge its customer capital, a firm can sell more of its products today to gain more market share in the future. In other words, a firm sees product sales as a form of investment in customer capital,” he explained.

The idea is that the firm wants to attract customers and lock them in by lowering its price. Once customers are locked in, the firm wants to increase its price to “harvest the profit,” Hong wrote.

He added: “In a recession, because a small firm is more likely to exit the market, it puts less weight on the future benefit of customer capital and raises its price to harvest from customers as much as possible before exiting the market.”

Which Model Is Consistent with the Data?

Results from the oligopolistic competition model

Hong found that the oligopolistic competition model predicted that average price markups increased by 29 percent during the Great Recession. Firms that didn’t exit during the recession gained more market share, hence raising markups, he explained.

However, small firms’ markups increased by only 28 percent, while large firms’ markups increased by 35 percent. Hong pointed out that these results are inconsistent with the empirical evidence that markups of small firms rise relatively more during economic busts.

Results from the customer capital model

The customer capital model suggested that, on average, exiting firms raised price markups by 5.1 percent more than firms that continued to operate in the economy the next period, Hong noted.

He added that the effect of the exit decision was stronger for small firms. In particular, the exit decision raised small firms’ markups by 2.2 percent more than large firms’ markups.

Hong concluded: “Overall, although both models suggest that overall markups increased in the 2007-09 recession, the customer capital model does a better job at explaining the micro-level evidence in the data.”

Notes and References

¹ Small firms were defined as those with less than 1 percent market share within their industries, whereas large firms are those with more than 1 percent market share. For that analysis, Hong used firm-level data in manufacturing sectors of France from the Bureau van Dijk Amadeus dataset.

Additional Resources

• Economic Synopses: Firms’ Price-Markup Dynamics During the Great Recession
• On the Economy: Do Price Markups Differ by Firm Size Over the Business Cycle?
• On the Economy: Most Jobs Face Automation in Next 20 Years