Research

Abstract: A firm behaving optimally will set its markup -- the ratio of price to marginal cost -- based on the price elasticity for its product. One way that price elasticities might differ across time or across products is the ready availability, or not, of close substitutes – what we might think of as competition or market power. However, it might equally be that consumers differ in their individual price elasticities, at which point the composition of demand matters. In this spirit, this paper examines how the increase in income inequality since 1980 can help to explain the changing distribution of firm markups. Using a rich dataset on retail markups, I first show that income and markups are related: rich consumers tend to pay higher markups. In fact, as a consumer's income increases, they do not necessarily increase the physical quantity of products purchased, but rather trade up to more expensive products with higher markups. To match these facts, I create a novel model of satiable preferences. I show that these preferences can be aggregated and resemble a discrete choice model extended to a macroeconomic environment. I calibrate the model to match facts about income, consumption and markups in 2016 and then change the income distribution to that prevailing in 1983. The increase in income inequality leads to a change in the composition of demand across firms, leading high quality, high markup firms to increase their markups, while low-quality, low-markup firms leave their prices relatively unchanged. The model generates empirically consistent movements in the distribution of markups: the average and dispersion both increase. The model is able to explain approximately 25% of the change in the average markup.

Abstract: When preferences are satiable, the response of consumers to process and product innovations will differ by income. Low-income consumers care more about price than about quality, and thus their demand responds more to process innovations; vice versa for high-income consumers. Thus, the distribution of income will have effects on the form of economic growth. Equally importantly, the product vs process innovations will have different implications for aggregate markups: ceteris paribus, economic growth that relies heavily on process innovations will tend to decrease aggregate price elasticities and therefore increase markups.